China’s financial distress turns all too visible

March 19, 2014 7:05 am
China’s financial distress turns all too visible
By George Magnus
Country’s economic change will have deflationary consequences
Investors have a lot to worry about without cause to fret about China, but now they have that too. Trend growth is slowing down, and markets have been shaken up by the actions of the People’s Bank of China (PBoC), which is trying to tame a virulent credit boom.

The incidence of financial distress is rising and becoming more visible. The recent drop in the renminbi, and the sharp fall in copper and iron ore prices are the latest high-profile manifestations of China’s changing outlook. These are not random developments or bad luck, but connected parts of a complex economic transformation with deflationary consequences for the world economy and skittish financial markets.
In the first two months of 2014, industrial confidence and output indices, retail sales, fixed asset investment, and credit creation were all weaker than expected. A slowdown in economic growth at the start of the year, coinciding with the Chinese new year holidays, is not unusual, but in each of the past two years, the government sanctioned faster credit growth and infrastructure spending to compensate. This time, those options are not available, or much riskier, because the government is trying to change China’s economic development model.
Change is mostly visible in finance, where market forces are slowly being brought to bear. The PBoC has announced the goals of full interest rate liberalisation by 2016, and of admitting private firms into the financial sector. It has introduced a two-way market in renminbi trading, and widened the trading band to plus or minus 2 per cent around a daily reference rate. These and other policy changes affecting shadow banking may already be damping the credit, currency and interest rate arbitrage behaviour of local banks, state enterprises and private companies.
Premier Li Keqiang confirmed a change in attitude last week when he said people should be prepared for bond and financial product defaults as the government proceeded with financial deregulation. He spoke in the wake of the country’s first corporate bond default and the failure of a significant steel mill to repay loans that fell due.
Slowing economic growth, chronic overcapacity and rising debt service problems in key industries are becoming more common, raising the risk of chain defaults involving suppliers and purchasers. Overcapacity recently prompted a senior executive in the Chinese Iron and Steel Association, Li Xinchuang, to say the problem was so severe it was “probably beyond anyone’s imagination”.
In an industry survey by the State Council, 71 per cent of respondents said overcapacity in iron and steel, aluminium, cement, coal, solar panels and shipbuilding was “relatively or very” serious.
Last week’s market scare, however, was focused on copper, which has fallen nearly 15 per cent this year, and by more than a third from its 2011 peak. Falling prices have embraced a swath of both ferrous and non-ferrous metals, sending ripples from Perth to Peru.
The underlying reason for the base metals shake-out is the mirror image of the prior boom, in which China’s voracious appetite raised its consumption to about 40 per cent of global production. Its per capita consumption is far higher than any other emerging country, regardless of income per head.
In short, what China gave producers and miners on the way up, it is taking away as the commodity composition and intensity of GDP growth tail off.
Large swings in market prices are happening also for murkier – and largely speculative – reasons that hinge on the use of copper and ore as collateral for loans, and as a means of raising finance abroad and bringing it onshore to spend or lend. As the authorities clamp down on credit creation and shadow financing, falling prices, including that of collateral, will expose participants to losses, and markets to the risk of distress selling.
The transmission effects of lower prices into emerging markets and the global economy are most likely to prove disruptive, even if the positive real income effects for consumers eventually win out.
China’s economic transformation is happening regardless. Its leaders have choices only about how to manage it, and when to accommodate what is likely to be a painful adjustment. Sage advice would be to grin and bear it now, so as to avoid harsher outcomes later. But the political willingness and capacity to do so is unpredictable.
It is still possible that China will blink, raise infrastructure and housing spending and new credit creation, and lower bank reserve requirements and the renminbi. This would introduce a sharp twist to the underlying plot, but lead to a more dramatic conclusion.
George Magnus is a senior independent adviser to UBS and former chief economist

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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