Enzio's Clock

Background

1. RMB News

This Monday, Peoples’ Bank of China, their Central Bank, and the Hong Kong Monetary Authority announced two policy moves:

• Hong Kong companies may use the RMB to settle their trade accounts with Mainland counter-parties, and
• Hong Kong banks may use the RMB in order to facilitate trade finance

These policy moves are more limited than they appear to be. Crucially, such business can be conducted only by

• Companies that have registered with the authorities, and
• Companies that are located in five Chinese cities: Shanghai, Guangzhou, Shenzhen, Dongguan and Zhuhai. The latter four cities are all located in the Guangdong Province, which neighbours Hong Kong.

This is the first time that the will  be used to conduct business with in  Hong Kong herself.

Why?

Over the few years,  the RMB will be tied to a basket of currencies.  It will be tied to a basket of currencies (not unlike, for instance, the Singapore dollar) because China is leery of the ever-weakening dollar.   So the authorities will want to keep the RMB aligned to more than just the dollar, as it currently is. Having said this, the dollar will be part of that new RMB basket – precisely because Beijing will not want its own currency  to appreciate too rapidly and thus stunt the competitiveness of many of China’s very price-sensitive exports.

 3. Lending news

So much for the good news. The bad news is that banks simply are lending too much and too fast. Indeed, the government wanted banks to lend RMB 5 trillion for the full year; however,  they already have issued RMB 5.17 trillion within the first four months.  Within the first half of this year, such “stimulus lending” will exceed RMB 6 trillion – the highest amount ever since China’s founding in 1949.

We wonder just how much of such loans are going where they are supposed to – the creation of jobs – and how much is going into non-productive projects such as the stock market…

 4. Lending implications

In any instance, a bubble is being built because “…the growth rate became excessively high, credit was over-extended, and the scale of national infrastructure construction was too great. As a result, prices rose even faster.” This not a new observation; in fact, this is lifted from Zhao Zhiyang’s recent memoirs, Prisoner of the State (Simon and Schuster, New York, 2009, p. 127: Zhao was describing what was happening during the first quarter of 1984, i.e. over 25 years ago! Contrary to the slam on the brakes when something similar occurred in 1981, Zhao engineered a “soft landing” by adopting a gradualist approach. All of this worked well from 1985 - 1987.  

But then in 1988, another price bubble was created; this time, it was because – according to the same source – Zhao opted for an “all-at-once” idea (instead of  1984’s gradualism) of merging   free market prices with the existing  two-track price system. Under this system, “The same commodity, whose price was set by the government within the planned sector’s quote might then be sold in the market at an open price. ibid., p. 130.  Commenting on his “all at once” mistake, Zhao notes that “This was not the correct way to carry out price reform, because ultimately it was not a shift from price controls to market mechanisms. It was using planning methods o adjust prices.”  The media got hold of this mistake, reported it, and panic buying set in.

While we are not forecasting re-runs of the inflation bubbles of 1981, 1984 and 1988, we are warning that the very strong credit creation is going to fan the proverbial “too much money chasing too few goods” later on. That is the implication of such virulent lending.

Indeed, even the Central Bank, the Peoples’ Bank of China, already has started warning of such consequences.

Next to inflation, however, the even scarier proposition is that people withdraw their  money from banks – as they did in the bank runs of 1981, 1984 and  1988. Then, it was because people feared that inflation would eat up their savings. This time, they won’t trust the viability of banks – a little like we have seen recently in the West.

The problem with China’s  current stimulus lending orgy is that according to the Wall Street Journal Asia of 30^th June, p. 3, “Chinese banks have lent freely to state-owned enterprises and local government, partly on expectations that the central government will ultimately underwrite the risk…”  But that is a little easy. In fact,  Ultimately it is the local authorities – and not the central government - that must guarantee the loan repayments. Banks have been forced to lend to local authorities, but they don’t have solid information about the financial health of such authorities whom they have lent to. Indeed, on Monday a Communist Party newspaper carried an article in which was written that “Lenders’ asset quality will suffer if local government later find themselves in financial trouble.” (ibid., p. 3).

Thus, lending risks have become a social problem: bank defaults can fan social unrest.  This is the last thing that China wants, what with her current issues concerning the urban-rural income divide…

How to Save/Make Money Off This Idea

1. Always consult your financial adviser first.
2. I got China all wrong.Sincere apologies.  My Economic Clock® foretold an excess supply of money, but I forgot my structural analysis and disregarded the obvious fact that lending is booming in China. I should have stuck with this excess supply of money view.
3. This view, however,  is contrary to the West, where lending keeps contracting, and I thus (incorrectly, too?) have labeled the Economic Time® in the West as one characterized by an excess demand for money.
4. Forget decoupling: if Wall Street tumbles, everyone else's’ psychology goes “herd” and people sell, too. This is currently what is starting to happen. But with China’s Economic Clock® revealing an excess supply of money, buy into the market once it has fallen enough.
5. Going forward, however, beware being too long of the market and owning particularly too many banks: at some point, Beijing will have to reign-in lending. If she does so gradually (as in 1984): no problem. But if she slams on the brakes 1988), then caveat emptor!