A friendly commentary and analysis from China-based “doublewood” in reaction to James Rickards’ most recent Daily Reckoning piece entitled, “The Greatest Ponzi Scheme in History.” Certainly, some things to consider…
The situation depicted by Rickards is nothing new. Last month, RMB 30 billion of fake wealth management products （WMP）came to light, which brought up the question：how much more of these are there？ This is just a tip of the iceberg in global shadow-banking activities since traditional financial regulations were tightened after 2008. It is a question of how big it is in the US, Europe, Japan and China, respectively, and whether they pose imminent systemic risks to global finance and investments, individually or collectively.
I do think Rickards’ understanding of China is superficial at best, and his statistical application of the numbers is not analytically astute. He may yet hit the bull’s eye in his grand prediction of an imminent collapse, but China’s contribution to that scenario may be exaggerated. I can add some background knowledge to bring some balance to his doomsday perspective. There are mitigating circumstances unique to China that he is not aware of. But I am not challenging his soothsaying endeavours because who knows what are hidden, and how big？
Major Structural Difference
China is not the US. Fifty percent of China’s economy, in terms of annual GDP, is generated by state-owned entities and enterprises. That percentage would be higher in terms of the value of assets and enterprises controlled and/or managed by the government, such as all the land and the major industrial companies across the spectrum. In other words, the government in China controls much more resources besides monetary resources; therefore, it has more tools available to it to further monetize or de-monetize such resources.
If you think in terms of Western accounting, and eliminate all receivables and payables between state-owned units in one massive consolidation because they are effectively the left pockets and right pockets of the same enterprise, the net positions would obviously be much smaller. Even if they were to net out to a deficit (which may be the case on an historical cost basis), there are a number of measures to deal with it, or not deal with it, depending on the circumstances and stakes involved. There are a lot of hidden values and intangibles that are not reflected on the books, under normal accounting and basis of presentation.
Current Phase Of Reform
Nonetheless, the situation with stale liabilities and excess obsolete capacities has been the focus of the current phase of reforms. For the past few years, the government has aggressively pushed forward an integrated program. It encompasses（1）restructuring, （2）debt-equity swap, （3）equity recapitalization after capital restructuring,（4）privatization of spun-off good assets and （5）under stricter control，issuing more money by the central bank. As recently as last week, Xi Jingping led a financial management meeting of all senior officials, declaring financial market security as one of the country’s topmost responsibilities.
Market Is The Force, Systems Approach The Tao
However, there is no sense of crisis or alarm. The monitoring and managing of the financial system and conditions are the ongoing work involving the Big Brain and multiple agencies and leading groups, in meticulously-executed steps pursuant to a continually-updated master plan. The government’s priority is to let market forces do the job （“borrowing the winds from Nature”）as much as possible, on the microeconomic level. The objective is to achieve an improved capital structure through processes （1）through （4）above.
In the meantime, the government will use macroeconomic measures to facilitate and, at times, force the processes. That would include fiscal as well as monetary measures. Once again, the focus is to utilize and activate desirable emerging market forces (“adjusting the sails and steering mechanisms in tune with Nature”). For example, fiscal policies stimulating the efficiency and quality of the supply side, regulating the quotas on IPOs and private placements by listed companies, mobilizing insurance funds to participate in restructurings, creating economic opportunities and investment initiatives in new programs such as One Belt One Road, eWTP, internet-plus, and expanded military throughput, etc., are some of the measures taken to release latent market forces. In doing so, the government is also shifting the opportunities toward the growing strengths of the private sectors, with world-class giants such as Huawei, Alibaba, Tencent, etc. and nurturing a large number of startups and private equity enterprises and working in tandem with them.
Quantitative Easing As The Last Resort
Only in the last resort, when immediate liquidity is collapsing, would the government use measure (5), the issuance of massive new money to shore up the banking system. In fact, as observed in Rickards’ article, liquidity always seems to be on the brink of collapsing in China these days. The government is indeed propping up the financial system in drips and drabs of monetary easing every day. But overall, the growth in M-2 has actually slowed for the first time in comparison with previous years. That is in large part due to （a）more effective use of short-term repo and reverse-repo instruments to adjust for the temporary fluctuations in the supply and demand for liquidity, without necessarily increasing the money supply, and （b）clamp down on illegal and/or unauthorized leveraging activities for financial speculative activities.
Another device is to monetize previously non-monetized public resources, capitalize them as collectively-owned assets, and generate funds by financing transactions through either the markets or the central bank. They have yet to resort to that. Another policy option is to readjust the financial relationships between the central and local governments, shifting the taxation entitlements and funding responsibilities between the two, and enabling new means of managing public finance (for example, the introduction of property tax – yes, China has no property tax, yet!). And there are other tools in the box, which I will not go into.
Good Banks, Bad Banks
The commercial banks are a big variable in this equation. Their capital adequacy ratios and overall asset quality are a constant focus of the Big Brain. Noting that their overall asset mix is very low in residential mortgages, a relatively safe asset category which traditionally has been under-financed in China （40% loan-to-value ratio as opposed to 70-80% elsewhere in the world), the central bank has encouraged the boosting of residential mortgages relative to unsecured commercial lending by the commercial banks. This coincides with the IMF recommendation and markedly improved the banking sector’s overall capital quality over the past couple of years. (This in turn sparked a residential real estate boom which resembled a bubble-in-the-making. The government had to use selective measures to curb speculative activities. Such is reality in a nation with 1.4 billion Chinese.)
Overall, the Chinese population still enjoy a very high savings rate, making leverage capacity under-utilized relative to Western economies. Also, the spinning-off of nonperforming loans from banks into asset management companies (AMC) is highly-efficient since the bulk of major banks are majority-owned by the government, and the country is well-experienced in the AMC industry through prior history beginning in the 1990’s. Bad debts are bad stuff, but no big deal to experienced garbage salvagers.
Is Train-Wreck On The Way?
Is China on the brink of collapse？ Again？ I do not know. I only know that it is very much a managed situation under the government’s systems approach. It is always a monumental task, but that is life-as-usual in China. The outside world is understandably unfamiliar with the level of active management by the government that is characteristic of China today.
Rickards may correctly smell a Ponzi scheme, as he does with other rackets closer to home. But as Bernanke famously said, there is no bubble until it bursts. Famous last words.
Will Ill-Wishing Reap Rewards?
Will something hidden like the subprime and multiple-wrapped-around-derivatives situation explode upon the world from China？ My experience is that China monitors its financial regulatory system very microscopically. (I hope this will not turn out to be famous-last-words ala Bernanke. When I was called upon to advise on the stock market collapse two years ago, the main problem was simply massive illegal margin financing, to the tune of six times the regulatory limit, by entities organized outside the regulated-realm of the securities industry. How did THAT happen?)
As for spillover to the global financial markets, since over 90% of China’s financial markets are not open to the world, the aftermaths of such catastrophes would essentially be domestic RMB bloodbaths. This will have implications for domestic political stability more than global financial contagion. I know that measures are undertaken to withstand foreign currency liquidity squeezes and outward funding exodus (I have personally given advice on that recently).
Misunderstanding On China’s Foreign Reserves
In fact, the country is reevaluating its FX reserve policy. With its continuing surpluses in trade and positive inflow of direct investment funds, a continued buildup of FX reserve is counter-productive (FX reserve is both an asset and a liability). China would rather swap its FX holdings and float more RMB funds abroad and create future demand for the RMB as an international currency, instead of holding FX money that is not allowed to buy good products or invest in good companies in the US.
Tom And Jerry Will Continue
China’s regulatory regimes are much stricter and strongly monitored than we are aware of, perhaps. But so are the hordes of rule-breaking “take the money and run” Chinese monkey-kings. The only sure thing in this long-running soap opera and Tom-and-Jerry show is that there will be many more twists and turns in their plots and potential cliff-hangers in the offing. Meanwhile, Warren Buffett, Bill Gates and Goldman Sachs are not shying away from investing in Chinese equity. Let’s face it, what you miss would be the biggest opportunity of this generation. And if you get clobbered, everybody would understand it as “one of those things”. They (Buffett et al) are ready to sit it out, if necessary. Even George Soros is in now.
Bad News On China Will Continue To Sell
As for strategic think tanks like Stratfor, calling out China’s potential collapse would be smart business practice. It is a no-brainer. You get it right, it will be huge. You get it wrong, well, it is just “one of those things”. There will always be the next thing. Meanwhile, there is no money in the reverse thesis, yet.
As for Rickards, I wish him well in selling the products he offers, in conjunction with the promotion of yet another plausible scenario in an overdue global financial crisis. After all, that is his job and business. He may help many prevent getting fleeced, when the time comes again.