Spotting China’s Main Event

WMPs27feb

By John Richardson

WE will get round to writing about the impact of US propane pricing on the operating rates of new Chinese propane dehydrogenation (PDH) –to-polypropylene (PP) investments, as we promised yesterday.

Honestly, we will – trust us – and we will also eventually talk about how China’s methanol-to-olefins (MTO) start-ups might be a lot less than had been previously thought in 2014 and 2015.

Some industry players are already getting excited about both the above on the grounds that they will result in stronger-than-expected PP profitability in 2014.

But whilst analysis of  this nature will always remain crucial, it still feels as if it is a bit of a sideshow at the moment.

One of the reasons could be that it seems too difficult to model the impact of macroeconomics because of all the conflicting economic data emerging from China. Some players are, as a result, sticking to what they can model – petrochemicals supply, with demand assumptions drawn from historic trends.

As we keep repeating, though, (and please print these paragraphs out and print them on your boardroom walls) we actually think that the underlying message from the most important of all data points is very clear:

  • Total Social Financing (TSF) would have to expand at annual rate of 12% in 2014 if GDP growth is going to hit 7.5%, according to the Chinese Academy of Sciences. However, in January, on a year-on-year basis – a much-better measure than month-on-month – TSF grew by just 1.6% (TSF is lending via both the official banks and the shadow-lending system).
  • Sure, this is again only one set of data, and we have to wait for the full Q1 lending figures before making any firm judgements – and so it could be that Beijing relents and once again loosens the stimulus spigot.
  • But the Chinese Academy of Sciences has warned that if credit were to be expanded at 12% in 2014 then this would represent an increase that “will cause massive macroeconomic risk, because non-performing loans will pile up faster and the goal of reducing the economy’s reliance on credit-fuelled expansion will recede even further into the distance.  To have more sustained and quality growth, we’ve got to let the growth rate go down.”
  • And all the signs are that on this occasion, China’s reformers really do mean business.

We might end up having to wipe the proverbial egg on our face if 2014 turns out to be another good year, thanks to another kick of the can down the road.

Or we may have  missed strengths in China’s economy that make credit the real sideshow.

But both George Soros George Soros and Bill Gross, the billionaire investors, have drawn parallels between the situation in China’s credit market right now and that in the US credit market before the 2008 global financial crisis.

And like the US before the 2008 crisis, more and more eyebrows are being raised at some of China’s financial practices.

Take wealth management products (WMPs) as, perhaps, the best example (see the chart above showing their increase since Q4 2011).

Here is how WMPS work:

  • One reason WMPs offer higher rates is that they are based on riskier bank loans. And what makes WMPs shadowy is that banks don’t hold these loans on their balance sheets or set aside capital against their potential defaults. Instead, they typically extend them via intermediaries called trust companies—firms that are not allowed to accept deposits or formally loan out money, but are allowed to manage it. The trust companies create investment products like WMPs, which banks market for them in return for a commission. The trust then invests the money gathered through a WMP in a given company (we’ll call this sum a “loan” for the sake of convenience, though, legally speaking, it’s sometimes more like an equity investment).
  • If the receiver of the WMP puts the money back into a state-owned deposit again then upward adjustments of the reserve requirement ratio (RRR) prevents further harmful credit creation. This the percentage of money that the banks have to set aside against lending and so the higher the percentage, the less ability they will have to re-circulate WMP funds.
  • But here’s the rub: What if instead of depositing its loan, the company turned around and invested in another WMP? For example, if someone invests $100 in a WMP, which disburses $100 to a company, that company could in theory invest $100 in another WMP (presumably one that promises a higher interest rate than it has to pay on the initial loan). That WMP will disburse those funds to another company. In the official banking system, that first $100 deposit created $180 in credit in two lending iterations; in the shadow system, it created $200. In other words, in these instances the RRR rate is effectively zero!

A crucial question then becomes “how much of China’s growth since 2008 has been the result of dubious money-circling practices, such as the one we have detailed above?”

And then you have to ask yourself: “If you end such practices, what does it mean for growth in 2014?”

We very much suspect that the answer is pretty much contained in the paragraphs that we have italicised above.

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