Sharp Slowdown in China’s Factory Activity Amplifies the China Uncertainty Factor

A sharp decline in China’s factory indicator last month amplifies the uncertainty over China’s economic (as well as political) conditions. The larger than expected slowdown has coincided with the recent slump of China’s demand for commodities and thus signals an adverse development.

The Reuters reports,

China's factories took a hit in May as export orders fell sharply, a private sector survey showed on Thursday, suggesting surprise weakness in April's hard economic data persists even as policymakers seek to shore up growth.

The HSBC Flash Purchasing Managers Index, the earliest indicator of China's industrial activity, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh consecutive month that the HSBC PMI has been below 50, indicating contraction.

A sub-index measuring output rose to a seven-month high, following a rebound in new orders in April. But other figures in May's figures were less rosy.

The new orders sub-index fell in May, reflecting an even sharper fall in the new export orders sub-index to 47.8 from April's final figure of 50.2 - pushing it back to within a whisker of March's 47.7 - data from Markit Economics Research, which publishes the index, showed.

Unexpectedly weak economic data for April released earlier this month was followed quickly by the central bank's third cut since November in the amount of cash that banks must keep in reserve, to allow more credit to flow into the economy.

This week Beijing has signalled its biggest push since joining the World Trade Organisation to boost private investment into areas previously reserved for the state sector, like rail, hospitals and energy transmission.

It also intends to fast track infrastructure investment to combat the slowdown, state media reported.

So the China’s markets await actions from the Chinese government: one, through liberalization of some formerly restricted sectors (which should be something to cheer about) and from more stimulus (which is likely to offset any gains from liberalization).

The liberalization aspect of reforms accentuates the growing influence of entrepreneurs on China’s politics as earlier discussed.

Yet the slowdown of China’s factory index highlights risks of what the mainstream has been ignoring: an imploding bubble or a financial crisis. Professor Patrick Chovanec of Tsinghua University takes into perspective such risks (hat tip Bob Wenzel) [bold emphasis mine]

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital. “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system. If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans. State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy. Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default. Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make). In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

Now putting aside what happened at Zhongdan for a moment, let’s just consider what this means. Like any insurance scheme, this arrangement only “works” if the risks are not correlated. If you insure 100 people in 100 different towns against a tornado striking, you collect premiums and then, when a tornado strikes one of those towns, you make the payout to one claimant and the premiums from the rest cover it. If you insure 100 people in the same town against a tornado, you collect premiums for a while at no cost — it looks like a fantastic business. But if a tornado finally does strike that one town, you have to pay everybody at once and you’re wiped out. That’s exactly what happened to AIG when it sold credit default swaps on mortgage-backed CDOs. As long as the housing market didn’t collapse, all they did was collect premiums. When it did collapse, they went under. Or rather, they had to be bailed out so that all the banks and other customers who had bought insurance from them — who thought they were insured — wouldn’t go bust when AIG couldn’t pay up.

The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry. The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing. In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured. (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks. I suspect these loans are considered loss-proof, because they are “insured.”)

In laying out plans for action, the Chinese government has only been engaging in “signaling channel'”, viz., talk up the markets, to boost the market’s confidence.

But with the scale of the slowdown becoming more apparent, many are expecting huge moves from the Chinese government. Yet, from the political perspective, this would seem unclear.

This means that until concrete actions will be taken, the China uncertainty factor seems like the proverbial sword of Damocles hanging over the head of the global financial markets. Caveat emptor.