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China: Don’t Get Caught Naked

Business, China, Company Strategy, Polyolefins

By John Richardson

THAT’S it then, the evidence is in that the September surge in China’s exports was, indeed, as I thought, substantially down to fake invoicing.

“The gap between China’s reported exports to Hong Kong and the territory’s imports from the mainland widened in September to the most this year, suggesting fake export-invoicing is again inflating China’s trade data,” wrote Bloomberg, in this article.

“China recorded $1.56 of exports to Hong Kong last month for every $1 in imports Hong Kong registered, leading to a $13.5 billion difference, based on government data compiled by Bloomberg,” the wire service added.

Its conclusion was that this was speculators moving “hot money” into China in order to take  advantage of an appreciating Yuan (convert US dollars into Yuan, wait a bit and re-convert back into the dollars in order to make a currency gain).

Yes, this is part of the explanation, but, more importantly, we think that the return of fake invoicing reflects desperation on the part of property developers to complete deals and so  minimise their losses.

As the real estate bubble is deflated, through making credit via the state-owned banks much harder to obtain, developers are prepared to pay interest rates of up to 48% in the shadow banking system. And a source of liquidity for this shadow lending system is hot money flowing into China, via these fake invoices.

See the chart below, which describes how this scam works.

FakeInvoicingslide

I strongly suspect that fake export invoices have become the main means of getting US dollars into China because the government is already clamping down on another scam: Importing commodities, that again raise US dollar financing, this time via letters of credit (LCs) issued by offshore banks.

These imports have not occurred because people really wanted the commodities themselves, but they have instead happened because of a window of opportunity to make fantastic returns by investing the money raised by the LCs in the shadow banking system.

As I said, with real estate developers prepared to pay interest rates up to 48%, the potential returns for those lending into the shadow system are fantastic, by whatever means.

In polyethylene (PE), as the second chart below shows, this has worked in one of two ways and seem to have involved linear low-density and low-density PE.

PEscams

But,as I  have again already indicated, now that this window is being closed, fake export invoicing has become the preferred method of getting hold of US dollars.

It seem inevitable that Beijing will also eventually crack down on fake export invoicing as the deleveraging process continues.

What does this mean for chemicals and polymers companies?

It means that:

  • Headline data on exports, imports and GDP growth etc. have to now be taken with extremely large pinches of salt. Any chemicals company researcher who builds their chemicals demand-growth forecasts solely around these headline numbers no longer has any credibility.
  • Instead, growth in loans, in electricity consumption, and also chemicals industry operating rates, are very useful additional measures.
  • And it also  means, of course, that we have to worry where chemicals and polymers imports have ended up so far this year.
  • Are they sitting in a warehouse somewhere, unsold, because they were only really imported to raise US dollar finance for speculation purposes?
  • Or perhaps imports of, say, PE have been sold at knockdown prices to local converters, who have then made the resin into very competitive plastic films for export. In a later blog post, we will look at the latest local production and import data for PE. Suffice to say here, though, that the  growth numbers remain way out line with estimates of real demand growth.
  • On a wider basis, also, as China’s collateral trading scams in general unwind and the tide retreats, it will become clear who has been swimming naked out there, to borrow a phrase from Warren Buffett. In other words, it will become clear who has made totally false assumptions about the underlying, real strength of chemicals demand growth in China.