Talking Point

Expecting the worst

Are things as bad as the bleak headlines about China’s economy suggest?

Soros, Chairman of Soros Fund Management, speaks during the session 'Recharging Europe' in the Swiss mountain resort of Davos

By George: Soros says Chinese economy faces a “hard landing”

There’s a eureka moment in the new movie The Big Short when an investor grasps the immensity of the US subprime debt problem and the threat that it poses to the entire financial system.

The screen turns black and a quotation pops up on the screen: “The truth is like poetry and most people [expletive beginning with ‘f’] hate poetry.”

The quote is unattributed but its meaning is clear enough. In the run-up to the 2008 financial crisis the massive majority of people were blithely unaware that there were any problems, or in denial.

A few fund managers in the film – based on the book of the same name by Michael Lewis – made up the contrarian group of ‘poets’ that did sense something was badly amiss. They had visited abandoned housing estates in Florida, spoken to ratings agencies and analysed the individual loans that had been packaged into mortgaged-backed securities. They concluded that what was supposed to be one of the safest classes of investment was a Titanic heading for an iceberg. Thanks to the leverage that derivatives added to the mix via flaky CDOs (collateralised debt obligations), America’s banks were on the verge of a life-threatening moment.

We all know what happened next. The predictions of these ‘big short’ investors were vindicated in the most serious financial meltdown since the Wall Street Crash of 1929 (although according to the wife of Mark Baum, one of those savvy shortsellers, he was so shaken by the fallout that he never once said “I told you so”).

Fast forward to January 2016 and there is another group of investors warning about unsold apartment buildings and a debt bubble that’s set to burst. This time, they say, the problem is China.

The Chinese economy has been a central topic of discussion at this month’s World Economic Forum in Davos. One of those attending the annual shindig was George Soros, who was asked by Bloomberg if there was a risk of a repeat of the 2008 crisis. “The source of the disequilibrium is different,” the hedge fund guru replied. “In 2008 the main cause was the US subprime crisis. Now the root cause is basically China,” he warned. He specifically cited the nation’s excessive debt as a key issue.

Soros was broadly bearish on China’s economy, telling Bloomberg that “a hard landing is practically unavoidable”.

Will his forecast prove as accurate as those made by Baum and the ‘big shorts’ a decade ago? That remains to be seen. But what is evident is that money managers, analysts and journalists all seem ready to believe the worst about the Chinese economy.

How did the sentiment sour?

Global stock markets have had one of their worst Januarys ever. As The Economist puts it: “Among the primary causes of the sell-off is worry about China’s economic health, despite the latest GDP numbers, published last week, that were in line with forecasts of 6.9% growth. Investors fear that the real numbers are worse than the official data suggest, and see the sharp fall in commodity prices, particularly oil, as evidence for the hypothesis of weaker Chinese demand.”

Overseas investors have never placed great confidence in the accuracy of Chinese GDP statistics and this is now backfiring on the country’s policymakers. Instead, the bears (and much of the media) are seizing on a range of other data, fitting it to their downbeat narrative.

For example, the Economic Observer has pointed out that local coal prices have reached record lows and that annual power generation in 2015 actually declined for the first time (albeit by only 0.2%). “This indicates that the slowdown facing China’s traditional heavy industries is accelerating,” it posits.

The newspaper says another telling indicator is rail freight volumes, which fell by as much as 15.6% in November and declined last year to levels seen in 2008 and 2009.

Meanwhile the closely tracked Caixin/Markit purchasing managers index (PMI) continues to show that the manufacturing sector’s output is contracting. And this week the country’s statistics bureau admitted that annual industrial profits fell for the first time since 2000 (they declined 2.3%).

“Economists seem to be more pessimistic about the economic situation in 2016,” the Economic Observer concludes. “From the reports of a number of research institutions we see no shortage of words like ‘downward, slide, risks, closures, devaluation’ and so on.”

Thus far there have been no trigger events in the Chinese economy that come close to matching the sense of abject panic generated by Lehman’s failure or Bear Stearn’s bailout. But there has been plenty of drama, nonetheless.

Blame misguided policymaking?

In terms of sapping sentiment, it is now clear the government scored an own goal when it encouraged a runaway stock market boom from late 2014. As we reported at the time, state media suggested the only direction for local share prices was up, and in China’s highly speculative environment that held true for a while, as retail investors opened hundreds of millions of new broking accounts.

Of course, the rise in the A-share market bore little correlation with the real economy and when the Shanghai Composite index reached 5,178 last June it was obvious to seasoned observers that it was another stock bubble.

However, having fostered the bubble, the government also created a source of vulnerability. When the inevitable happened and the market crashed, the first casualty was its reputation for competent leadership, made worse by a bungled rescue effort. (This month China’s stock market regulators took another beating when a renewed sell-off led to the circuit-breaker system being abandoned less than a week after it was launched.)

For the past seven months the A-share market has been a troublesome diversion for the central government. The downturn has also had a major impact outside China. With each lurch downwards, the bourses have triggered panicky attention from television channels and newspapers around the world, and embellished the view in Europe and the US that the Chinese economy is in trouble. Given that a lot of foreigners naturally assume the bourses in Shanghai and Shenzhen must be correlated with the real economy (when they’re really not), it’s no surprise that plunges in the A-share market spook international opinion.

The signals sent by the A-share market may be warped, but it’s easy to see why they are being seized upon. China’s economy is remarkably lacking in transparency, despite its size and global importance, and this paucity of reliable, actionable data has seen stock market performance treated with outsized importance in recent months.

Another negative feedback loop is the exchange rate, and again Beijing must take some blame for its impact on the downbeat mood.

Last August the Chinese authorities sparked a global panic when reforms to its currency policy were misinterpreted as a competitive devaluation of the renminbi. In the months that followed traders have been second-guessing the renminbi’s erratic moves. Within China this has sparked new surges in capital flight. It has also seen the country’s foreign reserves fall as the authorities defend the yuan’s level against the dollar. In December alone China’s forex reserves plunged by a record $108 billion (they fell about $700 billion over the past year).

The upshot of all this: each downwards move in the renminbi triggers yet more international headlines and renewed worries over the state of China’s economy.

Has Beijing learned?

One of China’s most senior representatives at Davos seemed to acknowledge that his country needed to improve its messaging.

Fang Xinghai, a member of a key financial policy committee and vice-chair of the securities regulator, told the audience in Switzerland: “Our system is not structured in a way to communicate seamlessly with the markets. You bet we can learn.”

Fang admitted these communication failures had contributed to market anxieties but stressed that there had been a lot of misunderstanding about Chinese intentions. One example was the renminbi: Fang insisted that a depreciation of the currency isn’t in China’s interests as it wouldn’t be good for boosting domestic consumption.

Subsequently there seems to have been more of an effort to give a steer to international markets. For example, the Wall Street Journal obtained minutes of a meeting held by the central bank last week with local bankers, where the topic was how to deal with the annual surge in demand for cash ahead of the Lunar New Year in early February. The bankers wanted the reserve requirement cut to free up liquidity but the central bank demurred, stating that “currently, we need to put a high emphasis on maintaining the renminbi’s stability, when managing liquidity” and adding that a cut to the reserve ratio would send “too strong an easing signal”, putting more pressure on the yuan.

The preferred solution was to pump Rmb1.6 trillion ($243 billion) of temporary liquidity into the banking system via short and medium-term loan facilities.

Furthermore the central bank reiterated that individuals would still be allowed to convert the equivalent of $50,000 per year from yuan into dollars, but warned the banks against creating “panic” and encouraging customers to switch into foreign currency on fears of a coming renminbi devaluation.

Like its recent move to clamp down on volatility in the offshore renminbi market, the message here was clearer: our intent is to keep the currency stable against the dollar.

And after the volatility seen in the stock markets more efforts are being made to curb global pessimism about the economy.

Again, Davos was the selected venue. As the New York Times reported: “Behind the doom and gloom [about China] a more complex picture is emerging among the global elite in this Alpine ski resort. Some of it is coming from those who have lived and worked in China.”

“China’s most influential executives could be seen this past week in Davos including Zhang Xin, the chief executive of real estate developer SOHO China; Zhang Yaqin, the president of the search engine giant Baidu; Jiang Jianqing, the chairman of ICBC; and Jack Ma, the founder of Alibaba. These leaders have stepped in to argue for a more nuanced view of China.”

The New York Times interviewed Melissa Ma, founder of the $6.8 billion private equity firm Asia Alternatives. As she noted: “In Davos, there is a gap between perception and reality. If you’re on the ground in China, you’re not worried.”

Ma’s Alibaba doesn’t look like a proxy for a slowing economy. On Thursday it announced its quarterly revenues surged 32% and its profit doubled. The online retailer comfortably beat analyst forecasts.

“The Chinese economy is going through a structural shift to more moderate, but more sustainable growth,” Joe Tsai, Alibaba’s executive vice-chairman, said in a conference call, adding “it’s still one of the fastest growing economies in the world and we have no reason to think anything different in the future.”

And this week the Ministry of Commerce reported that China received $126 billion of foreign direct investment in 2015, a figure that was up 6.4%. The China Daily noted of this: “Although the growth of foreign investment may not be as large as it used to be, it still represents a vote of confidence in the Chinese economy.”

Likewise Dealogic has noted that Chinese firms have raised $19.7 billion from local equity markets so far this year, higher than capital raisings in either the US or Europe in the same time period.

Plus, not all media commentators are negative. In his column for the South China Morning Post, the Hong Kong paper’s former editor Wang Xiangwei wrote that “some investors have fretted about the Chinese economy heading for a hard landing, but they have consistently been proven wrong”.

He added: “The truth is the nation’s economic fundamentals remain strong and it is making progress in rebalancing its economy towards consumer spending. For the first time, consumption accounted for more than half of economic growth last year.”

Wang continues to see huge potential from infrastructure spending in the inland provinces and warned about being caught out by all the noise: “Much of the current bearish sentiment stems from plunging stock prices but China’s stock markets, labelled by some as ‘casinos’, have never been a reliable barometer of the economy.”

And as one netizen put it on his weibo, it would also be wrong to infer that lower oil prices are a byproduct of the slowdown in Chinese economic growth. The price drop has as much to do with Saudi Arabia, he argues, and its strategy of using supply to lower prices and drive US shale producers out of the market. The kingdom’s commitment to the China market was also reiterated during President Xi Jinping’s visit to Riyadh last week, when a deal was signed to invest in Chinese refineries.

Given China imports 58% of its oil needs and wants to increase its strategic reserve from 70 days to 90 days, the current low oil price is more of a boon than a bane for its energy-intensive economy. The Economist pointed out last week that like India, China should be a net beneficiary of cheap oil. That said China’s motorists will not enjoy the full benefit. The magazine reports that the government will not allow petrol prices to fall “in line with oil below $40 a barrel”. Thus if oil continues to plummet, China’s consumers will not see savings at the pump – which means falling oil prices will not prompt them to spend more on other items as tends to happen in the US.

Financial sector issues?

For those that want to flag legitimate worries about the Chinese economy, one of the first places to look is the financial sector. In our Q&A with economist Jonathan Anderson last week the bull-turned-bear forecast that – if it remains on its current borrowing trajectory – China will experience a banking crisis in the next five to six years (see WiC310).

The veteran Chinese economist Mao Yushi agrees. He told The Economist earlier this month that “a crisis cannot be averted” because China has too many empty homes and its banks too much bad debt.

Uber-bearish hedge fund manager, Jim Chanos, not surprisingly, is in the same camp telling the New York Times “China’s debt problems lie ahead of it”. Even Blackrock boss Larry Fink is worried, with Bloomberg reporting this week that he thinks the Chinese are “frightened of the future”, hence the capital flight as the wealthiest try and move money out of the country.

There are already signs of strains in the system. In what the Financial Times describes as a sign of cashflow problems, shareholders of four rural banks sold their stakes over the past two months either on Alibaba’s Taobao site or on the OTC National Equities Exchange and Quotations (NEEQ). The transactions on Alibaba’s shopping platform were particularly unexpected (the platform is “better known for Korean cosmetics than for financial holdings”, the Financial Times noted). Securities Daily viewed it as yet another bad sign, labelling it a “clearance sale” . It believes the move shows existing shareholders are desperate to exit a sector struggling with bad debt and falling returns.

The Economist, meanwhile, points to problems in the peer-to-peer lending sector, where yet another P2P boss has just done a high-profile disappearing act. In fact, such acts are now so common that it says the Jinling Evening News believes “runaway P2P bosses are no longer newsworthy”. But the statistics suggest some serious credit problems (and fraud). Online Lending House, an industry website in China, calculated that by the end of last year 1,263 out of 3,858 P2P lenders had “run into difficulties”.

Currency conundrum continues…

For the moment all eyes are on the Chinese renminbi and whether Beijing can pull off a tricky feat: keeping the yuan stable without draining liquidity out of the financial system (and thereby accelerating the slowdown in the economy).

At Davos the Bank of Japan Governor Kuroda Haruhiko made a bold suggestion: that China should take a step back from its recent reforms and reimpose fuller capital controls to prevent money fleeing the country.

“This is my personal view, and it may not be shared by the Chinese authorities, but in this kind of somewhat contradictory situation capital controls could be useful to manage the exchange rate as regards domestic monetary policy in a consistent and appropriate way,” Kuroda said on Saturday.

The FT agreed. On its editorial page it proclaimed that “capital controls are not a long-term option but, at present, they are the correct step for Beijing to take in a very difficult situation.”

Meanwhile Beijing has been singling out George Soros with a warning that the man that ‘broke the pound’ must not “declare war on the renminbi” (which has lost 5.7% already against the US dollar since August). A prominent article in the People’s Daily on Tuesday declared that “Soros’s war on the renminbi cannot possibly succeed – about this there can be no doubt.”

A government website also posted a comment from Premier Li Keqiang describing as “absurd” those “international voices shorting the Chinese economy”. Who could that possibly mean?

In fact, Tuesday proved an eventful day for two other reasons: first, the A-share market plunged a further 6.4%; then the head of the National Bureau of Statistics was detained for suspected corruption. Only hours earlier Wang Baoan had sounded upbeat, telling a press conference: “The long-term fundamentals of the Chinese economy are improving.”


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