By John Richardson
CHINA is bringing down the hammer time and time again as it continues to play the whack-a-mole game.
The latest blow to one or several of the unlucky moles involves the People’s Bank of China’s (PBOC) decision to withdraw cash from the financial system for the first time since early August.
“The move followed surprisingly strong gains by the Yuan in recent days, as well as repeated pledges by Chinese Premier Li Keqiang to overhaul the economy, rather than relying on excessively strong stimulus measures for growth,” writes the Wall Street Journal in this article.
“Speculative capital from overseas, known as hot money, has been drawn to China by a strong Yuan and Beijing’s reluctance to use lower interest rates or other forms of aggressive monetary-policy easing to counter a slowing economy.
“As long as China doesn’t [lending] cut rates, people abroad can count on healthy yields if they pour money into the nation’s markets.
“But the hot money they are channelling-in, inflates domestic prices for property and other assets, and adds to risks in the banking system. Adding to the potential for disruption is that the funds can flow out again as quickly as they arrive.
This is the mechanism we described earlier this year, when we first warned that polyethylene (PE) was being increasingly used in this way to get hold of hot overseas money.
As a reminder, this is how it works:
Scheme A involves the following:
- A local trader buys an overseas PE cargo using a letter of credit (LC) raised with a foreign bank.
- He immediately sells the cargo on the Dalian Commodity Exchange’s LLDPE futures contract.
- He then uses the cash from his Dalian sale to invest in the shadow banking system. The money ends up in the hands of real-estate companies desperate for funding. The speculator hopes that he will obviously make a handsome profit, which will more than cover the cost of the interest on his LC and any paper loss he makes on the Dalian.
- And there is another potential plus: If further hot money inflows strengthen the Yuan by the time the LC has to be repaid, the speculator makes a foreign exchange gain.
And Scheme B goes as follows:
- Imports of LLDPE and LPDE film grades are sold by local distributors straight into the domestic physical market to converters at slightly discounted prices.
- The money is invested by a distributor in the shadow banking system in the hope that the returns will more than cover the cost of the LC and any loss made on the physical cargo.
- And again, if the Yuan strengthens by the time the LC is due, the distributor will make a foreign exchange gain.
This is the only logical explanation for the very worrying data on PE imports and domestic production.
Imports were up by 15% year-on-year in January-July. And the latest production data is now available. It shows a 10% rise, again on a year-on-basis, in January-August. This is a full three percentage points higher than in January-July (see below):
This compares with real consumption growth, adjusted for inventories, which is forecast to be no more than 6% for the full-year 2014.
And so, what will the impact of the latest PBOC initiative? We think it will be as follows:
- Domestic lending will become tighter, making it even more difficult for smaller plastic processors to both source and afford credit.
- The withdrawal of funds will help further cool the economy down, making it more likely that speculators will lose rather than make money from the shadow banking system.
- This makes a disorderly emergence of PE inventories more likely.
It is also worth noting that, in line with the government’s determination to stick to its reform agenda, economists are forecasting total social financing of Yuan 1.35 trillion in August ($185 billion), according to a Bloomberg survey (total social financing is borrowing via both the official state-owned banks and the shadow-banking system).
Combined with July’s slump in lending, that would be the weakest two months for China’s broadest measure of new lending since 2011.
The actual lending data for August is due to be released on 15 September.