Friday, January 29, 2016

Why China is the elephant in the room

The sell-off in the first two weeks of this year have been attributable to two major themes:
1) The negative news coming out of China, [eg slowdown in PMI, GDP growth, Yuan depreciation, Capital outflows to be precise]
2) Second, oil breaking the once un-conceivable level of below $30 level

After briefly touching upon why lower oil prices (which is a input costs in production) are seen as negative, we try to examine the scale of problem that is "China"

First, lower oil prices are good when oil producers are making an economic profit and demand growth is positive. However, in this episode of oil price collapse, almost all producers are NOT making a sustainable economic profit and the needle on demand growth has not moved much. The reason for supply remaining unchanged or even increasing is that the once dominant OPEC is dysfunctional in its role of adjusting supply to price and the shale producers in N. America are forced to keep pumping oil irrespective of making economic profit or not, just in order to gather enough cash to service their huge debt pile. This way the whole sector is undergoing a sort of price war. As conventional economic wisdom dictates, price wars are ultimately won by the lowest costs producers. Nevertheless, the longer and lower oil prices go, they will undermine new production coming on stream proportionally and hence after the dust settles and many shale oil operators finally throw in the towel, market pricing power will return to OPEC.Expect shale operators to start biting the bullet this year and market pricing power to return to OPEC by 2017. This has been the very logic behind KSA unwillingness to cut production, they have the tenacity and political will to force utter capitulation on its competitors and enjoy LT benefits that come it higher real oil prices.

But for the while, lower oil prices are in unison with multi year lows for most other hard commodities, such as copper, steel, coal, aluminium, etc. the demand slowdown in these commodities is mainly attributable to ​slowing China as China constituted roughly 40% of the supply growth in these commodities over the past decade. China may already be on its way in deflating the property and excess manufacturing capacity bubble that was in the making for more than two decades. If China were politically determined to refrain from providing any federal bailout to failing 'zombie' corporates, the impact of slowdown in that country, due to rising bankruptcies and credit squeeze will be gigantic. A much slower growing China than what the world has been accustomed to for two decades will further lead to depression in commodity prices -esp, more pronounced when calculated in strengthening dollar. Deteriorating terms of trade for commodity exporters  means they will face tougher times with their own balance of payments and will in turn curtail demand in their domestic economies. In summary, lower commodity prices indicate slack in demand and that is, atleast in our opinion, why falling oil prices, inspite of being a factor of production, is viewed as a negative for the health of the global economy.
In this way, to some extent the rout in oil price is tightly intertwined with the economic prospects of China-atleast in the psychology of oil traders and hedge fund managers buying and selling oil derivatives worth hundreds of billions everyday. China is indeed the proverbial "Elephant in the room" for almost all commodity exporters, including GCC. 
Now lets us focus in understanding what really is going on in China.
Chinese rulers "The partymen" have historically had some kind of insane obsession with GDP growth numbers. Economic growth was made the top priority by none other than Mao Zedong himself and continued under his lieutenant Deng Xioping and those who followed after him. Interestingly, the Great Wall of China is the greatest epitome of Chinese mindset of forcing the masses into achievement of what rulers dub 'national pride'. Two thousand years back the Ming dynasty forced the peasants in the countryside to abandon everything and go and work in the hills. Almost a million died of cold, starvation and diseases and buried in the same wall that they built. in the mid 50s. Mao forced millions more peasants to forcefully work in small make shifts steel mills, producing more toxin than steel. The point here is to underscore a deep seated cultural need among Chinese rulers for achievement that looks physically overwhelming without any regard to the price paid. 

Something similar has happened with China urge to produce outsized GDP growth.In doing so, they may have paid a huge price: namely a massive misallocation of capital and a large percentage of the country's wealth tied up in economically impaired or outright worthless capital assets. These investments were financed mainly by keeping real interest rates artificially suppressed. Low real return to the Savers lead them to divert capital into real estate and lately into stock and corporate bong market as better protection for inflation and yields. It also gave rise to the now infamous 'shadow banking sector' where yields were roughly twice or thrice as high as in the formal banking sector. Although the return in the shadow banking sector reflected market demand/supply dynamics, the assets financed were still of dubious quality and increasingly funding of riskier and riskier assets which otherwise could not get funding from the conventional banking sector. The shadow banking sector become the de facto vehicle for funding the property and excess capacity bubble since the 2008 crisis. 

Since mid 2013 the shadow banking sectors access to capital has been incrementally restricted with rise in interbank repo rates with the blessings of the PBoC which is leading to a mini-liquidity crisis in that space. And, the assets on the other side of the banks balance sheets are worth increasingly less as the property bubble pricks and zombie corporates are unable to refinance or rollover their massive debt loads. This trend has been in play since mid 2013 but starting off a very low base was not getting reflected in the growth statistics aggregated at the national level. This triangular dynamic of evaporating liquidity, the inability of over-levered businesses to repay or refinance maturing debt and the reversal in property prices is now accelerating and having a material impact on demand and contributing to the economic malaise. Also, sharing the trophy is global slowdown in merchandise trade, where China is the biggest actor and appreciation of Chinese yuan over the past five year period vis-a-vis other competitor country currencies in inflation adjusted terms making economic viability of already sub-optimal manufacturing harder by the day. 

In a more simple terms, GDP growth is a function of growth in capital, labor and technology. Over the past 30 years, China economic success rode behind the back of large increase in the former two factors, achieved by artificially keeping their costs low by heavy political hand wringing. To start with China also had plenty to room to import low IP commodity type technology from the West (or from the East from Japan!). 

The former two factor of growth seem to have peaked with China's working age population expected to slightly contract from now onwards due to its single child policy in 80s and 90s and migration trend of the 2000s from countryside to cities having run its course. 

Capital formation also seems to have peaked in 2014 with capital investment to GDP ratio topping out at 49%. China has been a country with high level of household savings, but those savings which owners expect would be a source of future financial security have been wasted upon creating capital assets which have low economic earning capacity. A large percentage of household savings have been locked into over-valued assets and nothing much can be done when the bubble pricks and the elderly savers watch their wealth erode month-by-month. On the other hand, a lot of Chinese businesses have borrowed in foreign currency (read $) and a lot of FDI has got into the country, under the widely prevalent assumption that Chinese yuan is undervalued to pump exports and hence the LT trend for the yuan is for the currency appreciating vis-a-vis dollar. With wages rising, supply of labor peaking out, and easy access to credit getting difficult and demand slowing, that capital is desperate to exit. Also desperate to exit is the domestic capital which is afraid of president Xi's 'corruption campaign' and savers who want to avoid putting more money behind hugely overvalued property/stock investments. This capital flight-via Hong Kong and Macau-has been pointed out repeatedly by many noted China bears for as much as past three years. it is only now, that it has started to grab headlines in pink papers! 

To give you an idea of the scale of capital flight, Chinese investors are the largest single group in terms of US real estate investments by foreigners. Children of the elite class study in the US with the ultimate intention of settling in the country and parents moving family liquid assets to US. 

It will also be somewhat difficult for China to innovate and encourage new generation of businesses without personal liberty and deep and free capital markets to support these businesses. No facebook or Sequoia Venture fund here. That makes GDP growth through technology leadership also a challenge. Albeit, there is still a lot of scope for technology assimilation and productivity growth in China, but the political structure and incentives for it have to be more market driven.

In summary, China has exhausted atleast two of the three factors driving growth. The adjustment to the new reality will undoubtedly lead to some near term noise and the lack of transparency and scale of the adjustment means significant costs of cleaning for both China and its trading partners. 

What exactly are these costs?
The most immediate is to stem capital flight. Which is proving difficult. Once investors start to panic, it is usually very difficult to soothe them, especially if the governments words and actions seem inconsistent. Stemming capital outflow can be achieved by either:
resorting to capital account convertibility controls, or, 
outright currency devaluation, or, 
letting the currency float freely. 

Capital controls which although seeming to work on paper will lead to underground means to transfer wealth out of the country, but the costs of currency depreciation in the black market will fall entirely on the private investors and not on the PBoC. Nevertheless, capital moving out of the country will still tighten liquidity and exacerbate the slowdown. It may also damage China reputation and become a risk factor in attracting capital in the future.

The second option is to gradually depreciate the yuan while making under cover attempts to tighten capital controls in more informal way (muddle through option). It seems this is the path chosen by Chinese authorities for now. However, this choice does not guarantee the problem of capital flight will be solved. Lets assume, China devalues the currency over the course of the year by another 5-6% but capital flight remains undeterred as speculators and investors think the real level of depreciation vis-a-vis economic reality should be 10-15%. In that case, PBoC will still end up burning a lot of reserves to support the currency without really solving the underlying problem. Usually a controlled devaluation is actually a lost battle even before it gets started. 

So, what is stopping the Chinese to go for a one-off sharp depreciation to the same extent as the market forces believe to be the level reflecting reality? The problem will be one of perception and investor confidence. If the PBoC suddenly moves from a defensive posturing to aggressive one, the markets will think that the shit in store is much worse than what even they thought to be the case! More importantly, Chinese financial market and world markets will go into a tailspin on the "unexpected" magnitude of the official currency adjustment. The shock on Chinese economy in the immediate aftermath will be substantial as will be the transmission of the shock on the terms of trade of Chinese trading partners and competitors. Lastly, a PBoC engineered sharp devaluation will incite cries of currency management for export competitiveness from US and rest of Asia. This will be quite a episode just when the yuan was two months back finally included in the IMF SDR basket. 

The last option to let the yuan float freely is especially attractive as it will achieve the same objective that Chinese authorities want to achieve by the one-off gradual adjustment to the currency. And this will be achieved without burning reserves any further or take the blame of being culprit of deliberate currency management to support exports. As a bonus, the free flowing currency will most likely depreciate (but appreciate again as deflation sets in) and help Chinese exports from the back door. It will have negative repercussions on the domestic credit bubble and lower currency will make foreign denominated debt payments more pronounced. However, the economy is already slipping out of the control of the government and given the situation, the timing of exercising this option may not do any more harm than any other option in terms of economic contraction. In the worse case, it may only bring the harm forward instead of dealing with it for many years and cleaning the recklessness of pvt sector through burning public resources. 

All said and done, China has managed its currency for the past 30 years or so and stepping into a new world from a position of weakness is something government are always ill suited to do. In this way the public policy challenge for China and GCC is somewhat similar. Letting the currency to freely float is in your best interest, but can to pull the trigger now given that you haven't in 30 years?

A thought on the impact of Chinese trading partners in case of a sharp Chinese devaluations is also in order.

With imports becoming more costly and domestic demand decelerating, Chinese demand for imports will obviously fall further post the downward adjustment to the currency. Which will hurt commodity exporters like Australia, S. Africa, Brazil and the oil exporters of GCC. China is fortunately running a small current account surplus and has financial resources to run large fiscal deficit for a year or two to stimulate domestic demand. 

However, most EM commodity producers are not that fortunate, they are running twin deficit (current and fiscal) and hence will not be able to afford currency depreciation of the same magnitude as China (excl. GCC with pegged currencies). Weaker currency will be the last thing they need on the platter to repair their already battered current and fiscal deficits. To stem the sell-off in their own currencies they will be forced to tighten monetary policy and possibly fiscal spending just at the wrong time. Higher interest rates mean they will helplessly be staring at demand contraction in their respective countries. India is a case in point where monetary policy has remained relatively tight inspite of domestic demand weakness. Also, as Chinese terms of trade fall post the yuan devaluation, it will export deflation into China export markets, including US. The deflationary pressures will be a further downside risks to World financial and commodity markets. 

In conclusion, thinking about how China will manage the transition from super growth to more moderate growth and at the same time contain the fallout from the credit bubble, the options are all bad. There is no easy way out for China or for the rest of the World. This way or that, China will need to bite the bullet and this will be a major downside risk for World financial markets. Also the rising risk of China exporting its deflation to the rest of the World means asset prices in nominal terms might still be pricey in some quarters inspite of the sell off. This market scenario is neatly set up for a fat short trade, who will pull the trigger?

Siraj Presswala,
San Diego, 29/Jan/2016