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China: Steel on Skulls China calls for a “This calls for a special blend of psychology and extreme violence.” That special blend of great 1980s philosopher, Vivian Basterd of Young Ones fame, was referring psychology and to the difficulties of opening the door of an errant washing machine, yet extreme violence 1such sentiments can equally well be applied to China. The central authorities are attempting to coax down excessive credit and investment growth, but it is by no means clear that those at the periphery are in any real mood to listen. Expect a few bank managers and property developers to be taken out and shot – metaphorically and literally – before this one is fully played out. Expect a few bank I have an admission to make. Whenever I happen to come across the managers and property professional wrestling of the WWE – normally when channel surfing when developers to be taken waking up with jetlag at 4.00am in some godforsaken American hotel – I out and shot before this one is fully played find the spectacle rather enjoyable. Almost invariably, early on in a bout, out one of the wrestlers gets a smack across his noggin with a steel chair. However, this rarely suffices to end the match and the wrestler staggers to his feet defiant before being subsequently dispatched by a further barrage of assorted props. In a similar vein, children rarely respond positively to a polite request to desist from whatever antisocial behaviour they may be displaying, ...
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China: Steel on Skulls
DSG
Asia
17 November, 2003
1
“This calls for a special blend of psychology and extreme violence.” That
great 1980s philosopher, Vivian Basterd of Young Ones fame, was referring
to the difficulties of opening the door of an errant washing machine, yet
such sentiments can equally well be applied to China.
1
The central
authorities are attempting to coax down excessive credit and investment
growth, but it is by no means clear that those at the periphery are in any real
mood to listen. Expect a few bank managers and property developers to be
taken out and shot – metaphorically and literally – before this one is fully
played out.
I have an admission to make. Whenever I happen to come across the
professional wrestling of the WWE – normally when channel surfing when
waking up with jetlag at 4.00am in some godforsaken American hotel – I
find the spectacle rather enjoyable. Almost invariably, early on in a bout,
one of the wrestlers gets a smack across his noggin with a steel chair.
However, this rarely suffices to end the match and the wrestler staggers to
his feet defiant before being subsequently dispatched by a further barrage of
assorted props. In a similar vein, children rarely respond positively to a
polite request to desist from whatever antisocial behaviour they may be
displaying, and generally require a swift clip round the ear to get the
message home.
Where are we going with this? The answer is that economies appear to
behave in much the same way. A central bank or a regulatory authority
starts by vaguely mumbling about irrational exuberance and is quickly shot
down by politicians, and hardly disinterested pundits such as stockbrokers
and real estate agents. When it then becomes clear that behaviour is not
moderating, the authorities begin to introduce tentative measures such as
interest rate tweaks and credit guidelines to make their point a little more
forcefully. This in turn brings forth assurances from commentators that this
is a “good thing” because it shows the authorities are ahead of the curve,
and that the inevitable soft landing will set the stage for even better days
ahead. And finally, the authorities are goaded into making that marginal
tightening and/or the markets decide to pre-empt the event, which leads to a
nasty and messy reversal of the bull market sentiment.
1
It is not an exact parallel of course – one can assume that Beijing is somewhat less
obsessed with Felicity Kendall’s underwear.
China calls for a
special blend of
psychology and
extreme violence
Expect a few bank
managers and property
developers to be taken
out and shot before
this one is fully played
out
Economic agents are
not particularly good at
responding to subtle
hints
China: Steel on Skulls
DSG
Asia
17 November, 2003
2
What is true for sophisticated developed economies is doubly true for their
partially reformed command counterparts. China has indeed made much
progress in enhancing its methods and tools of monetary policy in recent
years. Having learnt their lessons from the 1980s and early 1990s, the
realisation is well embedded with the country’s leaders that excessive
monetary creation leading to capital flight and inflation is the best way to
ensure the collapse of the rickety financial system. Discretionary powers of
credit extension have been removed from provincial branches of the PBOC
and centralised back in Beijing. A nascent interbank and secondary
government bond market has been developed, which provides something
approaching market signals of credit costs and availability. And the central
bank has started to issue securities on its own account and to conduct
increasingly sophisticated open market operations and sterilised foreign
exchange market interventions.
Moreover, the current cycle is giving the PBOC the opportunity to give its
new toys a whirl. Thus far, it has been quite subtle in its attempts to curtail
excesses via the deployment of reserve requirement tweaks, and verbal
exhortations to rein in lending to economic hotspots such as real estate. To
be fair to the monetary authority, its initial efforts seem to be having some
success. Reserve requirements were raised by 1% on September 21
st
and
subsequently interbank and bond repurchase rates have risen sharply. This
implies that the move has succeeded in draining substantial amounts of
excess liquidity from the banking system.
China Interest Rates
1.5
2.0
2.5
3.0
3.5
4.0
4.5
2001
M
M
J
S
N
2002
M
M
J
S
N
2003
M
M
J
S
N
1M Interbank Offer Rate
1M bond Repurchase Rate
What is true for
sophisticated
developed economies
is doubly true for their
partially reformed
command counterparts
The PBOC is giving its
new monetary policy
toys a whirl
China: Steel on Skulls
DSG
Asia
17 November, 2003
3
Anecdotal evidence also suggests that curbs on loans to property
development are having some effect with even blue chip developers
reporting that sourcing working capital and new lines of credit has become
more challenging. And latest credit figures just released for October suggest
that new loans extended have started to roll over. Indeed, the month-on-
month rate of credit expansion has moderated quite sharply since its peak in
July, a few weeks after the PBOC first announced its edicts on property-
related lending. After rising 3.2% July over June, outstanding credit has
been pretty much flat since then.
China money and Credit
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
98
99
00
01
02
03
M1
Bank Lending
%MoM, 3MMA
M2
The questions remain as to whether the PBOC and the broader government
think they have done enough, and whether the markets are going to reassess
their unmitigated bullishness about all things Chinese. The central bank will
doubtless be pleased by the direction of the last couple of months’ worth of
monetary statistics but it has continued to intimate that broad money growth
in excess of 20% annualised (October M2 growth was 21% YoY) is
inconsistent with the economy’s nominal rate of growth. This view is
clearly not shared by all arms of the regime – the Chinese Banking
Regulation Commission, or CBRC, has been sounding an altogether more
liberal note about rapid lending growth – but we believe that the PBOC’s
opinion about such matters ultimately carries greater weight. Nevertheless,
our sense is that between now and the spring, the PBOC will remain in wait-
Monetary tightening is
starting to bite
Do the PBOC and the
broader government
think they have done
enough?
China: Steel on Skulls
DSG
Asia
17 November, 2003
4
and-see mode and one should not expect any further steel chairs to be
deployed while it is still assessing the lagged impact of its initial moves.
Concomitant with the wish to see a slowdown in credit growth is the
broader governmental desire to see the rate of capital formation moderate.
This is not because of any great understanding of the subtleties of monetary
policy beyond the recognition that a loss of monetary control is associated
with inflation, and that inflation has often been the source of social
instability in the past.
2
Rather it concerns the very crux of Chinese industrial
policy, which aims to create globally competitive state champions across a
range of major industries.
To try to understand the PRC’s strategic industrial policy aims requires a
framework of reference dating back to the 1800s and specifically an
understanding of the ideas of Friedrich List, the economic inspiration
behind Bismarckian state-led development. We will not delve into this
subject in any great detail here but what is crucial to recognise is that
modern
day Anglo-Saxon concepts of open competition remain anathema to
Beijing, despite the lip service it pays to such ideas. By contrast China is
employing strategies similar to those of 19
th
Century German and Meiji
Japan, where infant industries are protected and imports and foreign
investment are only encouraged if they afford the ability to backward
engineer processes and aid the development of state champions.
3
What
2
The return of the CPI to significantly positive territory last month will not have worried
the authorities unduly since it was driven by higher food prices which boost rural incomes.
Goods price inflation remains subdued primarily due to reasons of excess supply, which is
hardly a good portent for improved industrial profitability given that raw materials input
prices have been rising strongly. Nevertheless, while liquidity creation is unlikely to be
reflected in rampant headline inflation any time soon, we suspect that like in many other
places, its impact is being felt in rising service and asset prices which are not properly
captured in CPI baskets. Certainly we have never been buyers of a China deflation story
preferring to see the economy as akin to late 19
th
Century America.
3
The Japanese and the Germans certainly employed more overtly centralised economic
models, but the Brits and the Yanks were also selective practitioners of what they preach
today. We say
modern
day Anglo-Saxon ideas above since in their early stages of industrial
development, both the UK and America employed highly protectionist policies to give a leg
up to their infant industries. It was only once these industries had become globally
competitive that the rhetoric and action shifted towards pushing for free trade. For readers
Until the spring, the
PBOC will remain in
wait-and-see mode
while it is still
assessing the lagged
impact of its initial
moves
Chinese industrial
policy aims to create
globally competitive
state champions
across a range of
major industries
China: Steel on Skulls
DSG
Asia
17 November, 2003
5
seems to concern the authorities is that duplication of investment is leading
to excess capacity across a whole range of industries,
4
which is driving
down profitability and undermining the aim of producing globally
competitive domestic entities. Such fears are behind the exhortations in
recent months to rein in wasteful and overlapping projects. But for now, the
provinces, all of which seek to have their own car factories, steel plants,
telecommunications equipment manufacturing capability, etc., do not seem
to be listening.
In many ways the authorities have been the victims of their own success in
encouraging fixed investment – especially by state-related enterprises. The
aims of policy were initially to offset weaknesses elsewhere in the economy
in the aftermath of the Asian crisis and the bursting of the US tech bubble,
and, more structurally, to attempt to redistribute resources from the coastal
areas to inner provinces and the rural sector. To the extent that red-hot
aggregate growth has been generated, the policies can be judged to have
been a success. Domestic fixed investment has risen over 30% in nominal
terms year-to-date and shows few signs of having come meaningfully off
the boil in recent months. While we are only provided expenditure based
GDP numbers once a year, this implies the investment-GDP ratio has risen
from around 42% last year to 47-48% this.
5
who wish to delve into these ideas further, we recommend Peter Nolan’s excellent “China
and the Global Economy” and also Ha-joon Chang’s “Kicking Away the Ladder”.
4
For example, while Chinese bought 1.8 million cars over the last year, installed capacity
can produce 2.8 million. In a similar vein, telephone equipment makers report millions of
unsold handsets. The SARS excuse does not hold water since such inventories have been
building since late 2002.
5
As an aside, it is worth puncturing the myth that external funds and investment have been
driving China’s growth rates. FDI, at around USD50 billion a year, has been relatively
stable and in any case, is overstated by a factor of perhaps two given the extent of round-
tripping by Chinese companies booking investments via offshore entities in order to garner
tax incentives. Even assuming the USD50 billion figure is correct, this only represents 4%
of GDP. In a similar vein, an USD100 billion increase in FX reserves would only
contribute four percentage points to broad money growth.
Red-hot aggregate
growth has been
generated by
investment-friendly
policies
China: Steel on Skulls
DSG
Asia
17 November, 2003
6
Less positively, this rapid growth in investment appears to have often failed
to deliver material benefits to those who have been targeted. Local officials
in cahoots with property developers have regularly skimmed off funds
earmarked for rural development projects, and diverted them into the
construction of hotels, golf courses, karaoke bars, massage parlours and
opulent office buildings and private residences. And in turn, such
expenditures have further threatened the health of an already weak financial
system. As we discussed in last week’s piece, it is rather worrying that a
more than 60% increase in credit outstanding since 2001 has failed to be
accompanied by a meaningful reduction in NPLs. Indeed the economy’s
rapid further monetisation has resulted in the government’s potential bill
rising by over ten percentage points to 53% of GDP since its 1999 bad loan
carve out.
6
Some argue, with some validity, that the numbers reported are probably
overstated and that given the country is pretty near current account balance,
the investment rate could be at least ten percentage points lower. We have
no problems accepting the argument that China’s economic statistics are
crock, though our normal working assumption that second differentials lie
less still implies an unsustainable acceleration in money, credit and capital
formation. However, we believe the assertion that data misreporting and
mismeasurement suggest that the economy is a long way from overheating
rather misses the point. Quite frankly, it does not matter whether outsiders
think China is nearing bubble territory or not. What does matter is what the
authorities themselves think, and their statements and actions suggest they
are concerned and are intent on taking rectifying action. Talk to any Chinese
official, or just read their public statements, and the recurring theme is a fear
of a repeat of the mid- to late-1980s Japan experience. Officials are scared
rotten that excessive investment is driving down returns on capital and risks
leaving the barely reformed banking system with an even bigger hole
further down the line. Again it is quite easy to offer counter arguments to
the Japan parallel case and clearly there are major differences. But our view
remains that despite obfuscation in many other areas, the Chinese
authorities are generally quite clear in presenting their big picture macro
6
See our snappily titled “Fiscal Sustainability and Financial Sector Health in Post-Crisis
Asia – An Update”, November 10
th
2003.
Investment has often
failed to deliver
material benefits to
those who have been
targeted
Quite frankly, it does
not matter whether
outsiders think China
is nearing bubble
territory or not. What
does matter is what the
authorities themselves
think
China: Steel on Skulls
DSG
Asia
17 November, 2003
7
ideas and that when they say they want to slow things down, one should
take them at their word. This is still a command economy after all.
7
Returning to the subject of inventories, we have been writing for quite a few
months that stocks have been building across a whole range of industries.
Accepted the levels of stocks are far lower than a decade ago since even
Chinese state-owned firms have trimmed back their production of un-
saleable goods in recent years. Accepted also that the inventory build
appears to have little to do with insufficient demand in the economy but
rather is due to exceptional growth in supply. But akin to our earlier
arguments, it is second differentials that matter and the upswing in stocks
may have contributed around 1-2% to growth in recent quarters.
Moreover, and more worrying, there is growing anecdotal evidence that
stock building in raw materials has taken on a more malignant dynamic in
the past couple of months. There is no doubting that Chinese demand has
provided a genuine boost for commodity prices and has also been behind the
surge seen recently in global shipping rates. Indeed, the argument that a
world of quasi-infinite supply of manufactureds combined with a quasi-
fixed (short-run) supply of raw materials should drive a terms of trade shift
in favour of commodity producers has been a longstanding theme of ours,
and has underpinned our bullish view on the AUD, the NZD and gold.
7
This raises a further question as to the real value added provided by so-called “China
insiders”. There is a whole cohort of economists floating around the markets whose
analyses and reputations reside almost solely on their claim to have the inside track into
government thinking. After all, they went to school with the senior officials now in charge
and as a result, they are going to be given the real scoop before everyone else. There is no
doubt that the China insiders find it easier to set up meetings or to talk more in-depth in
their own language with officials, and that many are also good analysts. However, it
beggars belief that any official is going to give away strategic information to a particular
employee of a foreign investment bank unless he or she has been instructed to. As in almost
any country, bureaucrats face major sanction if they selectively leak information and in the
case of China, such sanction can be pretty harsh. Hence the techniques of bureaucratic
engagement are pretty similar in the PRC to elsewhere. What matters most is to determine
the intellectual framework and reference points of officials revealed by how they answer
questions and, crucially, by what they do not say. Of course one might counter that North
London, white trash analysts, who did not go to school with the Mandarins, would say this.
We have been writing
for quite a few months
that stocks have been
building across a
whole range of
industries
There is growing
anecdotal evidence
that stock building in
raw materials is taking
on a more malignant,
speculative dynamic
China: Steel on Skulls
DSG
Asia
17 November, 2003
8
China: Change in Inventories
-20
0
20
40
60
80
100
120
00
A
J
O
01
A
J
O
02
A
J
O
03
A
J
O
-20
0
20
40
60
80
100
120
Nominal RMB bn, 12-month change
Expenditure Based GDP Statistics -
Annual Data Only
Aggregate Industry Survey
Data
China: Inventory Growth by Product Group
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
00
A
J
O
01
A
J
O
02
A
J
O
03
A
J
-20%
-10%
0%
10%
20%
30%
40%
50%
60%
RMB mn %YoY
Transportation
Equipment
Metals & Mining Raw
Materials
Processed
Metals
Petroleum&
Chemical
Products
Electronics
Goods
China: Steel on Skulls
DSG
Asia
17 November, 2003
9
However, it appears that commodity demand is now going well beyond that
for pure industrial purposes and is manifesting itself in rampant price
speculation by Chinese enterprises. From a broad macro perspective, this
makes some sense since the Chinese (and other Asian) monetary authorities
are rather trapped by the need to continue to buy US Treasuries, yet would
like to diversify their currency exposure nonetheless. As we argued in “A
Golden Moment for Asian Reserve Management?”,
8
there is little rationale
for Asian central banks to increase their euro or yen exposures markedly,
yet their holdings of gold of only around 1% of foreign exchange reserves
do argue for greater diversification into hard assets. Hence, the argument for
continued US bond purchases which keep yields under control but which
are then hedged into commodities. Nevertheless, growing evidence of
speculative excess does not appear to be a state-mandated phenomenon. In
fact the authorities appear to be getting increasingly jumpy and have started
to tighten margin requirements for certain metals and minerals.
Exacerbating the situation is the decision to trim export VAT rebates by 3%
from January 2003 as a sop to American pressure to revalue the RMB. This
appears to have provided the incentive for exporters to front-end load their
import demands in an attempt to push out and forward sell as much product
as possible in order to maximise tax benefits. If this assertion is correct, a
combination of weaker imports into Q1, higher margin requirements for
speculative commodity positions, and the lagged effect of monetary
tightening, could all serve to produce a nasty reversal in the ultra-bullish
sentiment currently prevailing.
As we wrote in our November “Trade Winds”,
9
we would not be looking to
put on aggressive shorts before January 22
nd
2004 since fund flow
momentum should remain extremely strong up until Chinese New Year, and
most investors will remain impervious to any evidence that the China story
is not quite all it is cracked up to be. The one immediate trade we would
recommend is to be short the RMB NDFs. There is an awful lot of long
money sitting in these positions and rather like the HKD a month or so ago,
if even a few people try to close these out, if only to try to book some
yearend profits, then we suspect the liquidity just will not be there. Further
out, and more fundamentally, we would certainly advise lightening up on
8
February 10
th
2003.
9
November 3
rd
, 2003.
Commodity demand is
now going well beyond
that for pure industrial
purposes and is
manifesting itself in
rampant price
speculation by
Chinese enterprises
The authorities appear
to be getting
increasingly jumpy and
have started to tighten
margin requirements
for certain metals and
minerals
We would not be
looking to put on
aggressive shorts
before January 22
nd
2004, though we would
be long USD/RMB
NDFs
China: Steel on Skulls
DSG
Asia
17 November, 2003
10
China exposure once we move into the spring. While the timing remains
tricky, shorting adjunct China plays such as Aussie resources, commodity
currencies, shippers and machine tool exporters could be very rewarding.
Stay tuned.
___________________________________________________________________________________________
Copyright
DSG
Asia
, DSG Asia Limited and Galaxy Consultancy Limited.
This report has been prepared from sources and data we believe to be reliable but we make no representation as to
its accuracy or completeness. Additional information is available upon request. This report is published solely for
information purposes and is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or
derivative. This report is not to be construed as providing investment services in any state, country or jurisdiction
where the provision of such services would be illegal. Opinions and estimates expressed herein constitute our
judgement as of the date appearing on the report and are subject to change without notice.
The price and value of investments mentioned herein, and any income which might accrue from them, may
fluctuate and may fall or rise against an investor’s interest. Past performance is not necessarily a guide to future
performance. This report has no regard to the specific investment objectives, financial situation and particular
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Investors should seek financial advice regarding the suitability of investing in any securities or following any
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levels and bases of taxation may also change from time to time.
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Asia
is a trademark of DSG Asia Limited and Galaxy Consultancy Limited.
_________________________________________________________________________
