What happened in April?

What’s going on in China? The commodity-guzzling engine and goods-producing factory of the world is sending some odd signals.

Without Chinese growth the FTSE 100’s commodity producers would be in trouble, the oil price would fall even further and Britain’s intermediary goods boom (making machines for making machines) will falter. So the Middle Kingdom is important to us.

One thing’s for sure – something dramatic happened in China in April. The question is what?

China’s export and import data came up well short of expectations that month. Chinese oil demand fell 12%. The producer price index, which measures inflation for producers of goods in China, fell from the highest in nine years at the start of 2017 to 6.4% in April. Consumer prices rose just 1.2%.

The biggest problem is in Chinese financial markets. Fears of dodgy loans in the shadow banking sector have had investors and regulators up at night for years.

From the Financial Times:

“It is clear that ‘inappropriate’ transactions and financial arbitrage are system-wide phenomena in China, not the actions of a few isolated entities,” said Chen Long, economist at Gavekal Dragonomics, a research company. “Basically every commercial bank in China is involved in at least some of the long list of activities now targeted by regulators.”

Two weeks ago the FT reported China’s bank regulatory boss said this: “If the banking industry becomes a complete mess, as the chairman of the China Banking Regulatory Commission, I will resign!”

Threatening the bank industry with the regulator’s resignation seems like an odd way to enforce policy. But not as odd as this: Chapter 3 Article 15 of China’s Risk Management Collateral Guidelines requires that “the collateral is real” in commercial bank lending. Fake collateral just won’t cut it in the Chinese banking sector…

FT Confidential Research found that the demand for loans to meet deposits on property – a loan to get a loan – fell. Many Chinese companies have cancelled their attempts to raise money in the bond market. 154 companies aborted their bond issues in April, five times February and January’s number. The Chinese government issued five-year bonds at the highest cost since 2014.

In an attempt to keep the country awash with cash, the Chinese government has pressured big foreign companies to keep their money in yuan. According to the South China Morning Post, Sony, BMW, Daimler, Shell, Pfizer, IBM and Visa, were asked to “cooperate”.

The commodity sector in China uses a lot of debt to fund itself. And so, as the financial concerns heighten and the price of borrowing rises, commodity firms are having to sell their inventory to make payments. That sent the price of iron ore and copper in China falling fast to 2017 lows.

It’s interesting to think about how China has gone from being a production powerhouse to a housing bubble to a debt bubble in the space of only a few years. It took the Americans decades. Plus the Chinese did it on an even bigger scale. The Americans had ghost developments in 2007 while the Chinese have ghost megacities.

All this translates to a falling Chinese stockmarket (in blue) while the FTSE 100 and S&P 500 turn up. The divergence stated in mid-April.

China’s wealth management products could pop the bubble

Kyle Bass, the hedge fund manager who made his name and fortune on the sub-prime shemozzle, has picked out what he thinks will trigger a storm in China. They’re called wealth management products (WMPs).

These funds borrow money from investors and banks for short periods, relying on those debts being renewed, or rolled over, continuously. They invest the money in longer-term assets. Usually long term has a higher rate of return than short term, and so the Chinese wealth management products are just profiting on the difference.

The risk here is that the short-term lenders and investors refuse to renew their loans and deposits. Then the wealth management products are insolvent because it’s hard to sell up on your long-term investments to meet the cash outflow. Especially if all the other WMPs are trying to sell their long-term investments at the same time.

Depositors and lenders get nervous when they find out that the wealth management products’ long-term investments aren’t doing so well. That’s where we’re at now, according to Bass. The next step is when investors and lenders want their money back.

The mismatch between wealth management products’ long-term investments and short-term liabilities is rather dramatic according to Bass. They’re valued at $4 trillion in assets with a $34 trillion banking system feeding them.

Here’s what Bass said on Bloomberg TV: “think about this – in the US, our asset-liability mismatch at the peak of our subprime greatness was around 2%!… China’s mismatch is more than 10% of the system.”

Bass also explained that it’s tough to figure out when this Chinese WMP issue will blow up. But if you make a list of things to watch for, that list is flashing red right now. For example, the interbank lending rate between Chinese banks would occasionally spike up as banks get cagey about who they’re willing to lend to. And it is doing just that.

Bloomberg summed it all up:

The tightening campaign has erased at least $453 billion from the value of Chinese stocks and bonds since mid-April, spurred $21 billion of cancelled debt sales and compelled the People’s Bank of China to inject $48 billion into jittery money markets. Sales of asset-management products by lenders and trust companies have plunged by more than 30 percent, while domestic real estate transactions have slowed and metals prices have buckled.

Apart from the secondary effects on your investments, there’s another reason to take note of China. A Chinese credit crunch is easy to profit from.

In response to a crisis, the People’s Bank of China will print money, just as every central bank does. Deutsche Bank recently pointed out that 90% of Chinese lenders are still government owned or controlled, so the government will come to the rescue of banks. All this new money will push down the Chinese currency. And that’s something you can punt on.

Why you need to become a currency trader

The idea of punting on a sudden decline in the yuan suggests something unexpected. These last few weeks we’ve looked at whether stockmarket crashes can even happen in a world where central banks can and do buy stocks to avoid a stockmarket crash. The internal debate between me and myself inside Capital & Conflict isn’t settled yet.

But if stockmarket crashes are prohibited by order of the central banks, where does that leave you as an investor? Can markets only go up?

That’s a rather risky bet. A better way to profit is to become a currency trader. Each time central banks rescue their financial markets with new interventions, it weakens their currency. The Swiss are a good example. They’ve been pumping money periodically and buying up US stocks with it. Their currency has weakened as a result.

At the moment, the Federal Reserve has gone quiet while the European Central Bank continues to print. The result is a surging dollar against the euro.

Do you get the idea?

Until next time,

Nick Hubble
Capital & Conflict

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Category: Geopolitics

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