China Is Sending In The Bulldozers

Shadow

By John Richardson

YOU can spend as much time as you like crunching petrochemicals supply and demand data, but in the end, what will matter the most in China in determining the strength of markets during 2014 will, surely, be the availability of credit.

This was starkly underlined by this New York Times article, which pointed out that, since 2006 China’s money supply has tripled, yes tripled. Most of this increase has been since 2008, of course, in response to the global financial crisis.

Not surprisingly, as the NYT article adds, such an enormous surge in the money supply has created some major imbalances. For example:

  • A flood of loans from the formal banks and the shadow lending system has kept afloat many inefficient state-owned enterprises and bankrolled the construction of huge overcapacity in the manufacturing sector.
  • Cao Maolan, a real estate broker in Nanjing in east-central China, helped a young woman buy her first apartment seven years ago, a 650-square-foot unit for which she paid the equivalent of $60,000. The young woman sold the apartment in less than two years for a 50%, Ms. Cao said, and has traded up to a bigger apartment every year since then, now living in a 2,150-square-foot apartment for which she paid $985,000, mostly in cash with the profits from previous deals.
  • But young college graduates, whose numbers have quintupled in the last decade as China’s universities expand rapidly, worry that they may never be able to afford to buy a new home. Zheng Yilong, a 22-year-old college graduate in Wuhan, an industrial hub of 10 million people in central China, is paid $575 a month in a low-level banking job with limited opportunities for raises. But he has found that even a 540-square-foot apartment on the outer edge of the metropolitan area, with a long commute, costs $98,400, or 14 years’ pay.

The losers are also the hundreds of thousands of people dying prematurely because of China’s appalling air pollution. This is the result of decades of run-away industrialisation and rising auto ownership, but, again, since 2008, the problem has become a great deal worse.

This Wall Street Journal article once again supports our argument that successful analysis will depend on an intimate and accurate understanding of the political struggle taking place in right now between the reformers and the anti-reformers. As the article points out:

  • The Peoples’ Bank of China, which is pushing for reform of the shadow-banking system, is facing strong resistance from the China Bank Regulatory Commission.
  • At the centre of the current debate over shadow banking is an increasingly popular strategy among Chinese banks that involves disguising corporate loans as bank-to-bank loans. Often made through a web of transactions that take place in the interbank market, these loans help banks skirt regulatory limits on lending and at the same time hide the riskiness of the corporate loans, because they appear as less-risky loans to other banks. As a result, banks have been able to set aside less capital and reserves against these loans, making their books look healthier than they really are. Analysts at Standard Chartered estimate as much as 2 trillion Yuan could have been lent under this method as of June 2013. That figure made up nearly a quarter of total credit.

The steps taken so far to regulate the shadow-banking system seem to have very limited effect. As the above chart from UBS shows, new off-balance sheet (shadow) lending grew at almost the same pace as formal lending in November-June last year compared with the same period in 2012.

And Reuters reports that whilst Chinese banks made 482.5bn Yuan of loans in December compared with the previous month’s 624.6bn Yuan, China’s total social financing aggregate, a broad measure of liquidity in the economy, was 1.23 trillion Yuan in December – unchanged from the month before. In other words, there is still the same of money flowing through the Chinese economy, despite attempts to control shadow lending.

Shadow lending is crucial, as we have discussed many times before, for many of the small and medium-sized enterprises (SMEs) in China, as they have much more limited access to lending from the big state-owned than the favoured SOEs. It is the SMEs that buy the bulk of China’s petrochemicals.

Assessing what happens from now on in is therefore absolutely crucial, pivotal, for every petrochemicals company, or service provider, that either operates in China or does business with China; in other words, most of the global industry.

Perhaps the  economic slowdown we warned about earlier this month might be fairly modest because the reformers look as if they have yet to make much progress.

But here’s one more scenario:

  • The incredibly forthright Wall Street Journal article, which we linked to above, was the result of reformist government ministers giving access to analysis and data that would normally be kept behind closed doors. It could be a sign that the People’s Bank of China is about to be given a lot more powers.
  • China is in fact, therefore, in the process of sending the bulldozers in – literally, in the case of outdated, polluting steel mills in the city of Tangshan in Hebei province. The central governments, with the TV cameras watching, sent the bulldozers in to demolish mills that that the local authority had refused to close down; and metaphorically, also, as economic reforms are sometimes brutally enforced from the top down. Xi Jinping, China’s president, is giving all the indications that he is willing, and crucially has the backing, to make tough decisions.

There are many possible outcomes. How rigorous is the scenario planning at your petrochemicals company?

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