Doublewood: What’s Up With China? – Part 2

Economic Reform and Financial Environment
There is a saying: “When Wall Street catches the flu, the world goes on a spin”.
Now we should add a saying: “When China sneezes, the Federal Reserve freezes”.

Turbulence And The New Normal
The current state of global financial turbulence is in part a result of China’s major undertaking of reform in its economic structure, a process that will take years, not months, to complete. Because of China’s current and prospective economic size (particularly because of its weight in the real economic sectors, in global trade and, increasingly, in global investments), her structural reform inevitably affects the whole world.

One of the central ingredients of the reform process is to link up with the world’s financial markets. To do so, there are a lot of arcane and esoteric financial phenomena and practices inside China that have to be “uncovered and fixed”. That has given rise to uncertainties and turbulences that will at times reverberate around the world. And that has become what I call the New Normal.

Why China Is Reforming? Why Now?
In the judgment of the Chinese leadership, the aftermath of the 2008 financial crisis is still shrouding over the global economy. To prevent economic dislocation and/or collapse, major countries everywhere have taken exceptional measures, for an exceptionally long period of time (such as QE in the developed world and massive fiscal injections and internal borrowings in China). These measures cannot be sustained forever. Their stimulative effects have worn off and the world’s economy has entered into another slump (as witnessed by the oil piled up at seaports around the world, with nowhere to unload).

China has decided to undertake major structural reforms to prevent her economy from falling into a stagnant trap (like Japan for over twenty years and some emerging economies that have failed to hurdle over the so-called “middle-income trap”).

The reform is not just about economic growth. It is also about more equitable distribution of the fruits of development, and social, cultural and spiritual upgrades. But for this installment, we focus only on the economic reform and its financial ramifications.

The Gist Of The Economic Reform – The Immediate Tasks
Xi Jingping’s economic reform will be sweeping, and aimed at major structural transformation. In a nutshell, the Chinese leadership summarizes the immediate tasks of the elaborate design of the structural reform into the simple slogan: “4 Reductions and 1 Supplement”. They are:

1. Reduction of Excess Capacity.
2. Reduction of Inventory Accumulation (particularly, but not limited to, real estates).
3. Reduction of Costs and streamlining of Cost Structures.
4. Reduction of Debt and Deleveraging of capital structures.
5. Supplement and augment the Weak Links of the economy (there is a list of specific areas and priorities).

The overall strategic approach of the structural reform will involve (a) further opening up to the world, and (b) letting market forces do the job to the fullest extent feasible. However, it is not laissez-faire capitalism. The reform measures are prioritized, flexible in timing and degree, experimental in some instances, tweaked through trial and error, and managed by and coordinated with state resources. (In China, the state still commands enormous economic resources and can wield what it calls “political resources” to administer changes, in a system referred to as “socialist market economy with Chinese characteristics”.)

Finance — The Ways and Means
Finance, point (4) above, is both the chicken and the egg in the economic reform package. For example, unless you achieve progress in (1) (2) and (3) above, you cannot bring about (4). But unless you have (4), which requires the existence of efficient funding and capital markets, you will lack the funds and capital to achieve (1), (2), (3) and (5), which may cause massive unemplyment and bankruptcies, or an economic hard-landing.

Financial reform, therefore, has decisive impacts. With the banks heavily weighed down by loans that are in-substance nonperforming but kept rolling over, the funding for the economy is severely hampered. The reform aims to free up and enhance financial markets to achieve higher efficiency and proper allocation of capital resources through open and fair pricing. Up to and including now, funding in China are not “rational”. To make money “work”, they have to practically revamp many of the existing practices and arrangements. It is a huge systems project, requiring multiple stages and reiterative tinkerings. This is only the beginning.

The US-China Chain-Gang
Another main feature in the New Normal that everyone should get used to is the Currency Co-dependence between China and the US. Recently, I have said that China and the US are tied in a chain-gang, which implies that it is not necessarily a voluntary state of affairs, but a reality. Mutual potential jeopardies force cooperation which, unless and until coordinated, can bring about unpleasant experience. This is critical in the global monetary and funding dynamics.

China is a significant funding source for the US treasury and, as such, is a structural component of overnight liquidity for the capital and commodities markets (including derivatives). This is made more critical as the US tries to wean itself off quantitative easing, while still having to fund substantial recurring deficits. In the current stock market rout in China, we are witnessing conversion of foreign currency liquidity to cover stock positions. Immediately, it affects global credit and capital market pricing.

The US-China co-dependence is vividly evident when China’s monetary reserves denominated in foreign currencies, mostly US dollar, shrank from its peak at US $4 trillion to now US $ 3.5 trillion. This decrease took place from last June to December and is continuing. It coincides with the sharp corrections in China’s stock market (although the full picture also includes other factors, for example, China’s increase in imports). Nonetheless, this represents a potentially significant shift in global monetary and financial dynamics.

Global market forces can also be a prankster. The substantial speculative sway of international hedge funds and related shadow-banking are posing potentially crushing systemic risks. China is proactive in curtailing the massive underground financing activities in this round of reform. Not only do these forces need to be surveilled and regulated, they must be countered before another global meltdown materialises. (The year 2015 reminds me of the atmosphere surrounding the failing Bear Stearns in 2007; let us hope 2016 is not another 2008, and episodes similar to Lehman Brothers and AIG will not be repeated.)

Currency and Monetary Dynamics
Contrary to what some Americans fear, China can ill-afford to “dump” USD-denominated financial assets since they represent her fortress and last bastion of liquidity. She needs them to provide support for the off-shore RMB that are functioning as actual international currency (to a large measure, US dollar acts as a medium for RMB exchangeability, a reality that will not change any time soon).

Also, with China beginning to engage in massive international development activities and financings, such as the AIIB and BRIC Development Bank, she will be both a user and a provider of US-dollar currency facilities. Her foreign currency reserves are still weighed down by some US mortgage-backed securities (unlike Russia, China had stayed “loyal” during the 2008 financial tsunami and afterwards, and held onto their share of MBS, which probably saved Wall Street). It may sound strange to some, but China is likely to be the strongest ally of the US dollar, as the US adjusts her financial position. The much-touted Currency War should not take place between China and the US (at least not one initiated by China). Instead, we have to deal with periodic Currency Fumbles, which are happening!

Under the current New Normal, China’s reform measures include freeing up some of the restrictions on currency conversion and trading in designated off-shore RMB markets. As domestic liquidity gets tight, more parties access RMB in the off-shore markets, causing those markets to temporarily “dry up”. The magnitude of such an episode causes immediate jitters in the inter-connected global credit markets. Last week, for example, demand on off-shore RMB was so high that it sent the borrowing rate on overnight RMB facilities to as high as 67%, and the US stock market plummeted.

Even though markets may recover from these funding abberations quickly, sneezing can sometimes be the precursor of an actual flu.

Once again, brace yourself.


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