As Chinese Developers’ Debt to Equity Soar, Hope Becomes Part of the PBoC Strategy

Interesting ironies developing in the Chinese economy.

First, credit woes has been spreading to reflect on slackening demand for properties.

From Bloomberg’s Chart of the Day: (bold mine)

China’s largest property developers risk missing their full-year sales targets as tighter credit and an economic slowdown cut demand for real estate, fueling concern the industry will struggle to repay debt.

The CHART OF THE DAY shows the 13 biggest developers that provided full-year sales targets achieved 49 percent of those goals by the end of July, the weakest level in at least two years, according to data compiled by Bloomberg. The ratio of debt to equity on a Bloomberg Industry gauge of 84 Chinese property companies has climbed to 128 percent, the highest since at least 2005 and almost double the Bloomberg World Real Estate Index’s 76 percent.

New-home prices fell in July in almost all cities that the government tracks, while sales of residential units slumped 28 percent from the previous month, as China’s broadest measure of new credit sank to the lowest since the global financial crisis. Moody’s Investors Service and Standard & Poor’s said this month some smaller Chinese developers may default in the second half amid falling sales and shrinking access to credit.

So slumping property demand expressed through falling prices has begun to impair on the balance sheets of property developers. This should amplify credit risks as debt servicing burden increases in the face of falling sales compounded by tightening access to credit.

In another Bloomberg article, the Chinese central bank, the People’s Bank of China has reportedly been challenged by the current predicament. (bold mine)

Rising stress in China’s $6 trillion shadow banking industry is testing central bank Governor Zhou Xiaochuan’s resolve to limit monetary easing as risks to the government’s growth target climb.

In the past three months at least 10 trusts backed by assets spanning coal mines in Shanxi to forests in Fujian have struggled to meet payments, sparking protests by investors outside banks that distributed their products. A slump in new credit in July underscored strains on the industry that funded as much as half of China’s recent growth, presenting Zhou with a choice: ease policy to avert a slowdown, or hold the line…

Apparently, the PBoC toes the same line with her contemporaries who has assumed the de facto policy guidepost on bubbles: “We recognize the addiction problem but a withdrawal syndrome would be more catastrophic”. 

So PBoC launched ah ‘targeted easing’ stimulus…

While the People’s Bank of China hasn’t changed its benchmark lending and deposit rates for the past two years, local media reported last month it had extended a 1 trillion yuan ($163 billion), three-year loan to a state development bank to support the funding of government-backed housing projects. It recently granted a 20 billion yuan re-lending quota to some regional bank branches to support agriculture, according to a statement on its website yesterday.

And as an offshoot to their previous undertakings of stimulus and other interventions, the consequences are now the PBoC’s headache:

Local-currency bank loans’ share of aggregate financing -- which includes bank lending, off-balance sheet loans, and bond and stock sales -- fell from 70 percent in 2008 to 51 percent in 2012 as shadow banking surged along with government-led efforts to stimulate the economy.

In the first seven months of 2014, the share of bank loans recovered to 56.7 percent, according to calculations based on PBOC data. In July, bank loans exceeded aggregate financing as other forms of credit shrank.

China’s debt-to-gross-domestic-product ratio was about 250 percent at the end of June, up from about 150 percent before the government rolled out its stimulus campaign in 2008, according to research by economists at Standard Chartered Plc.

And because of too much partying (debt financed asset boom), signs of hangover has emerged:

Shadow-banking assets jumped more than 30 percent in 2013 to 38.8 trillion yuan, according to Barclays estimates.

Trust defaults have escalated in recent months as the economy’s momentum stalled. At least 15 trust products have been reported to have repayment difficulties this year, according to UBS AG, citing media accounts and company disclosures. Local governments are working to avoid defaults, brokering deals between corporates and banks and leaning on lenders to provide bridge loans or take over shadow credit, Wang Tao, chief China economist at UBS, wrote in a July 10 note.

China Credit Trust Co. last month delayed payments on a 1.3 billion-yuan high-yield trust product backed by coal-mining assets in Shanxi after the borrower failed to raise funds to repay investors, according to a company statement. That triggered protests outside the Shanghai branch of the Industrial & Commercial Bank of China Ltd., which sold the product, according to local media reports.

Chinese debt woes hasn’t just been from the context of statistics, these are symptoms of a much larger disease, misallocation of capital. Therefore, working to avoid defaults by shifting productive capital to survive zombie companies simply will add to the present dilemma which means it won’t last.

And clearly hope has become part of the PBoC strategy. 

The hangover effects appears to have even spread to the mutual fund sector

From the South China Morning Post (bold mine)

The mainland's shadow banking woes have spread to the mutual fund sector, fuelling fears that defaults and frauds could spread in waves despite Beijing's efforts to deleverage an economy facing the risk of a hard landing.

Two recent scandals were fresh signs that nearly 1.5 trillion yuan (HK$1.89 trillion) of capital raised by the subsidiaries of mutual fund houses is exposed to risks due to the absence of an efficient monitoring system.

Earlier this month, Shanghai Goldstate Brilliance Asset Management, an alternative investment arm of Value Partners Goldstate, announced a 600 million yuan real estate fund would not be able to pay interest to investors, indicating the product would fail amid a weakened property market.

At the same time, Wanjia Win-Win, a subsidiary of Wanjia Asset Management, said it had uncovered fraudulent actions by a partner, Shenzhen Jingtai Fund Management, in the operations of a real estate fund started in June…

About 70 alternative investment companies have been set up by mainland mutual fund houses, with total assets under management of about 1.5 trillion yuan.

And because of the constrained access to credit, credit starved entities has been loading up from foreign sources

From the Wall Street Journal Real Time Economic Blog (bold mine)

Both disclosures offer insight into a recent surge in foreign lending to China as tighter lending conditions there and low global interest rates push more Chinese companies to borrow offshore. According to the latest data from the Bank for International Settlements, outstanding foreign loans to China rose 38% on year in the first quarter of 2014 to a record $795.7 billion, a fourfold increase since 2010.

Of the 25 countries whose banks report lending data to BIS, the biggest surge in new loans in the year ended March 31 — $50 billion — came from banks based in the United Kingdom, a group that includes HSBC and Standard Chartered, both British-domiciled banks with most of their assets in Asia. French banks were the second-largest source of new credit, extending $20.6 billion in new loans to China. Japanese banks were third, raising their exposure by $15.8 billion over the same period.

The rapid growth in credit to China left British banks as China’s largest foreign lenders, with a record $221.2 billion in outstanding loans to China. U.S. banks were second with a record $86.5 billion and Japanese banks third, with a record $77.4 billion.

So ‘misery loves company’ has been transmitted through foreign financial institutions. Aside from PBoC stimulus, Chinese (private and hybrid) firms continue to survive because of access through the global chase for yields. Yet this underscores the elevated risks of contagion

And of course, junctures in the credit markets will filter down into the real economy which will have a feedback mechanism: credit problems will hurt the real economy and the real economy will aggravate on credit woes.

And the stimulus have yet to weave its magic as shown in the above chart. According to the WSJ Real Economic Blog

The latest figures out of China indicate recent stimulus attempts have yet to relieve distress in lending and real estate markets.

So how should stocks respond to a slowing economy, to a decline in earnings and rising credit risks?

In the case of the Chinese stocks, since the targeted easing last June PLUS the recent massaging of IPOs the Chinese equity benchmark has been significantly been UP!

So are stocks about fundamentals as textbook says? The answer is it depends on the type of fundamentals. Post Lehman crisis, "fundamentals' have been determined largely by central bank subsidies to financial markets and secondarily government policies.

The Pre-Lehman crisis world illustrates the disconnect between stocks and the real economy or what has been a parallel universe!

Don't worry, risks have all vanished, central banks has assured that stocks have been bound to rise forever!

China Bubble: No Money Down Housing Proliferates, Echoes US Subprime Loans

In desperation to sell an oversupply of properties, Chinese developers have evaded regulations to offer "no money down" housing loans which the Bloomberg associates with the risks of US subprime loans

China’s home buyers are being offered no-money-down purchases in an echo of the subprime lending that triggered a U.S. economic meltdown and the global financial crisis.

Deals skirting government requirements for minimum 30 percent down payments have emerged this year from Guangzhou and Shenzhen in the south to Beijing in the north as real-estate sales slump, according to state media and statements by government agencies and developers.

Loosening down-payment requirements could erode China’s financial stability by adding to risks for property companies, lenders and an economy already heading for the weakest growth in 24 years. Government warnings to consumers indicate that officials will strive to limit such arrangements, a sign of stress in a property market with a glut of homes.

Well, this has not just been an exclusive Chinese affair, Sovereign Man’s Simon Black points to the same financially destabilizing risks of NO money loans down in the Philippines.

Going back to China, the earlier stimulus of “additional spending on railways, upgraded housing for low-income households and tax relief for struggling small businesses” plus the central bank, the PBOC’s calls for “nation’s biggest lenders to accelerate the granting of mortgages” or the political way to solve debt problems with even more debt, appears to have delayed an economic meltdown as banking loans and money supply growth recovered in May.

From another Bloomberg article: (bold mine)

Local-currency loans were 870.8 billion yuan ($140 billion), the People’s Bank of China said on its website yesterday, higher than 42 out of 43 analyst estimates in a Bloomberg News survey. M2, the broadest measure of money supply, rose 13.4 percent, compared with a median projection for 13.1 percent…

Aggregate financing, China’s broadest measure of new credit was 1.4 trillion yuan in May, matching the median analyst estimate in a Bloomberg News survey. The figure, which includes bank lending, corporate bond issuance and shadow-banking products like entrusted loans, compared with 1.55 trillion yuan in April and 1.19 trillion yuan in May last year. 

New yuan loans accounted for 62.2 percent of aggregate financing in May, up from 50 percent in April and 56.1 percent a year earlier, central bank data show.

Chart of China’s M2 and New Loans can be seen here.

Despite the rhetoric to control the shadow banks, the Chinese government continues to flush the system with liquidity. In mid-May, the PBoC injected 44 billion yuan ($7.1 billion). Yesterday the central bank added 104 billion to the interbank system for the 5th consecutive net weekly injection. This is a sign of how worried authorities are with the financial-economic system

While favoring the formal banking system, growth in May loans reveals that credit activities in shadow banks continue to swell.

So obviously all these measures have been meant to buy time. 

Today, Chinese equity markets as represented by the Shanghai Composite Index had been jubilant—as they have been up by about 1% (specifically .93%) on reported economic improvements.

From Bloomberg:

China’s industrial output rose 8.8 percent in May from a year earlier and retail sales gained 12.5 percent, the National Bureau of Statistics said on its website today.

Fixed-asset investment excluding rural households increased 17.2 percent in the first five months of the year, the Beijing-based agency said.

What you see depends on where you stand.

Fixed Asset investment has still been declining but yielded better than expected ‘forecast’

Industrial Production remains stagnant 

It's only retail sales that has shown slight improvement

Except for retail sales which looks like a dead cat’s bounce, both industrial production and fixed investment hardly points to a ‘recovery’. Recovery has been more a wishful thinking.

Nonetheless, in today’s credit addicted world, governments aim to keep the unsustainable party going by spiking the punch bowl with even more toxic credit, China's political response has been no exception.

China’s Central Bank Launches Targeted Easing

Earlier today, I pointed to the plummeting real estate activities and to the spreading commodity rehypothecation financing woes. Here I mentioned: 

So how will the Chinese government deal with hissing credit bubble? Well, in the same way almost every government deals with the addiction problem: give them more of the substance which they have been addicted to: credit

From CCTV.com

The Chinese government’s central bank, the PBOC officially announced ‘targeted’ easing directed at institutions lending to the rural economy

China’s central bank is easing monetary policy for lenders focused on small firms and the farming economy. The PBOC is cutting the reserve requirement ratio by 50 basis points for some lenders, effective from June 16th.

The triple R cut applies to banks whose new loans to the farm sector last year exceeded 50 percent of total new lending. An additional requirement says that outstanding loans to the farming sector must be more than 30 percent of total outstanding loans.

This means the targeted RRR cut covers around two thirds of city commercial banks, 80% of rural commercial banks and 90% of rural credit cooperatives. The RRR cut will also apply to financial services companies like leasing firms and auto financing firms to lift domestic consumption.

The problem with so-called targeted easing is that once money has been released into the system no one can know or control where it flows. This has been the reason why China’s shadow banking has ballooned. Government controls on local government lending produced offspring called Local government financing vehicles (LGFV) and eventually to illicit loans by State Owned Enterprises in behalf of local governments.

Shadow banks really signifies a regulatory arbitrage response to the highly regulated banking and finance system dominated by the state or State Owned Enterprises and most importantly to the credit boom initiated by the PBOC and from the Chinese government’s 2008 stimulus program ($586 billion). 

The likely scenario from this rural based loans will be that credit issued by accredited banks will end up again in the shadow banking sector. Such will most likely signify attempts to prop up zombie companies. 

So more resources will likely end up with non-productive activities that will persist to drain on the economy’s real savings.

Because of this China’s Shanghai index jumped 1.08% today

Oh by the way, despite tumbling property markets, China’s official inflation rates jumped in May.

From CTV.news.ca

Higher food prices have pushed China's inflation to a five-month high of 2.5 per cent.

Data released Tuesday showed consumer inflation in May picked up from the previous month's 1.8 per cent. The increase was driven by a 4.1 per cent rise in food prices.

Inflation still is well below the ruling Communist Party's 3.5 per cent target for the year, leaving room for interest rate cuts or other measures to stimulate the slowing economy if needed.

The above chart shows that May’s inflation increase has been a four month high.

This also reveals of the developing deadly cocktail mix of stagflation and bubble bust at work.

Today’s rescue also shows how the Chinese government will try to resist a collapse (kick the can) which exposes on the government’s priority which is that of political convenience first and social welfare last. Thus, goodbye reforms.

And this also shows how stock markets have been addicted to stimulus

Note to email subscribers. If I am not mistaken this blog’s Feed Burner services delivers only a maximum 3 blog post per day. Since I made six posting for today you are likely to receive only the latest three. Anyway here are the links for today’s post

Graphic of the Day: The Militarization of the US Local Police

Venezuelan Hyperinflation: Prostitutes as Currency Traders

China Bubble Bust: Land sales in a free fall, Rehypothecation Woes Spread

Quote of the Day: The IMF Gets It Wrong (again)

CNN Money: Market Emotion Now Registers EXTREME GREED

More Signs of Cracks in China’s Massive Bubble: Bond Auction Failure, Rising NPLs, More Defaults

Aside from this week’s slump in external trade where both China’s export and imports fell in March y-o-y by 6.6% and 11.3% indicative of an intensifying economic slowdown, reports also say that property developers have substantially scaled back in raising money through the shadow banking system via trust sales

From Businessweek/Bloomberg:

Chinese developers raised 49 percent less through trusts in the first quarter as the collapse of Zhejiang Xingrun Real Estate Co. highlighted default risks.

Issuance of property-related trusts, which target wealthy investors, slid to 50.7 billion yuan ($8.16 billion) from 99.7 billion yuan in the fourth quarter, data compiled by Use Trust show. The yield on AA rated five-year bonds has climbed 175 basis points in the past year to 7.23 percent, according to Chinabond. That compares with a2.74 percent on corporate securities globally, Bank of America Merrill Lynch indexes show…

New property trust offerings accounted for 30 percent of total trust sales in the first quarter, down from 33 percent in the last three months last year, according to data compiled by Use Trust. Figures from the research firm are for collective products only, which are sold to more than one investor.

And even more signs of debt delinquency or risks of debt default…

Companies with other kinds of building projects are also facing repayment concerns. A unit of China Sports Industry Group Co. (600158) failed to repay 144 million yuan of principal on a 600 million yuan trust loan for a sports center development, according to a statement from the company to Shanghai’s stock exchange dated April 4.

And the exposure on trust products, which are part of the shadow banking system, have been sizeable.

Outstanding property trust products, including collective and single, totaled 1.03 trillion yuan as of the end of last year, accounting for 10 percent of all types of trusts, according to data posted on the website of China Trustee Association.

And as more delinquent companies surface, these have been reflected on Non-Performing Loans (NPL) of banks.

Here is an update from Marketwatch/Caixin:

Bad loans have sharply increased for many Chinese banks as more companies struggle to make repayments, data from recent bank annual reports show.

The total value of non-performing loans at 12 major banks was 467 billion yuan on Dec. 31, an increase of 76.3 billion yuan ($12.3 billion), or 19.5%, from the beginning of 2013.

And in jeopardy are big state owned companies and their subsidiaries involving steel producers and traders and the coal mining industry.

Among the defaulters were subsidiaries of big state-owned enterprises (SOEs), which banks normally view as safe clients, a loan officer at a joint-stock bank said. In many cases, he added, the parent SOEs did not save their subsidiaries, mostly because they were in deep trouble themselves.

In addition, importers have been defaulting too. From Reuters/Chicago Tribune

Chinese importers have defaulted on at least 500,000 tons of U.S. and Brazilian soybean cargoes worth around $300 million, the biggest in a decade, as buyers struggle to get credit amid losses in processing beans.

Three companies in the eastern province of Shandong had defaulted on payments for shipments as they were unable to open letters of credit with banks, trade sources said on Thursday.

The same report cites that along with commodity firms, semiconductor and software companies are among the most at risk of credit defaults

Many defaults seem to be surfacing in many corners of the Chinese economy almost simultaneously.

But as rising incidences of defaults emerge, in desperation Chinese investors have shunned private sector debt and have gravitated into the riskier local government debt in hopes that the latter will be supported by the national government. This despite warnings from authorities.

From another Bloomberg report:

China’s first default is prompting investors to discriminate against privately-owned companies, boosting demand for local government bonds even as the central bank warns of the dangers of a $2.9 trillion pile of debt…

Premier Li Keqiang said last month that failures of financial products are “unavoidable,” a week after a solar company whose controlling shareholder is the chairman became the first Chinese issuer to default on its onshore notes. Risks of nonpayment have climbed as economic growth slows after a five-year credit binge. Li said there would be no “regional financial risks,” prompting investors to bet the state would stand behind local-government financing vehicles.

So despite the Premier Li’s  pronouncement last week that there will be "no major stimulus—"We will not take, in response to momentary fluctuations in economic growth, short-term and forceful stimulus measures…We will instead focus more on medium- to long-term healthy development"—assurances of containment from debt woes has provided investors the incentive to shift towards LGY debt. 

The Chinese government has announced at the start of April of a 'minor' stimulus program consisting of “additional spending on railways, upgraded housing for low-income households and tax relief for struggling small businesses”, as discussed here.  Importantly the formal declaration had been “short on specifics”.

This shows that in the world of politics, communications are meant to be opaque, and promises are meant to be broken. While the conflicting position by the government gives her leeway or the flexibility adjust, unfortunately this has also been aggravating the risk environment.

And as the same report indicates, many of the private sector debt exposure signify as offspring of the local government. 

Regional authorities, which aren’t allowed to sell debt directly, have set up thousands of financing vehicles to raise funds to build subways, highways and sewage works. Local governments are responsible for 80 percent of spending while they get only about 40 percent of tax revenue, the legacy of a 1994 tax-sharing system, according to the World Bank.

A 2008 stimulus package deployed amid the financial crisis and funded with off-balance sheet lending added to the debt burden for local governments. Their liabilities rose to 17.9 trillion yuan as of June 2013 from 10.7 trillion yuan at the end of 2010, according to National Audit Office data.

LGFVs were among the three riskiest types of debt highlighted by the People’s Bank of China in its fourth-quarter policy report. Their debt is headed for a “mini crisis” because defaults will be needed for restructuring, Li Daokui, a former adviser to the central bank, said March 25.

In other words, many Chinese local governments have been circumventing rules set by the national government as previously noted here which has been a potential source of China’s Black Swan. The above also serves as a showcase of deep conflicts within governments. 

And speaking of internal conflicts, in the face of intensifying debt concerns, the friction between Chinese financial regulators particularly the central bank, the People’s Bank of China (PBoC) and China Banking Regulatory Commission (CBRC) has likewise been deepening. According to the Financial Times, the PBoC accuses the CBRC of being “too close to the state banks” or regulatory capture while the latter blames the former for creating the current conditions and “promoting financial innovation” or “regulatory arbitrage”. The report also says that the CBRC warned of such risks from the stimulus launched in 2008.

All these seeming state of confusion has brought about even more risks and uncertainties. Yet these are indications that current adjustments to the China's debt burden would most likely be disorderly.

Finally, last week the Chinese government also suffered her first bond auction failure since June of last year.

From another Bloomberg article:

China’s Ministry of Finance failed to sell all of the bonds offered at an auction today for the first time in 10 months amid speculation short-term interest rates will climb as corporate tax payments tie up funds.

The ministry sold 20.7 billion yuan ($3.3 billion) of one-year debt today, less than the planned issuance of 28 billion yuan, according to a statement on its website. The average yield of 3.63 percent compared with the median estimate of 3.4 percent in a Bloomberg News survey yesterday, when the yield on similar-maturity existing notes was 3.32 percent.

The credit crunch has now been spreading from the private sector, to the local government and now to the national government: such is the periphery-to-core dynamics in motion.

And my impression is that 'tax payments' serve as smoke screen to the real dynamic—which as shown from the compilation of reports above, are signs of the widening fracture of China’s bubble.

The USD-Yuan and yields of 10 year lcy sovereign debt closed the week almost unchanged. 

Nonetheless despite all the above, China’s stock market bulls pushed the Shanghai index nearly to February highs after this week’s 3.48% run. 

Maybe the stock market sees a world differently from that of the real economy.

China’s First Default and Export Collapse; Russia’s Financial Meltdown

China’s First Default and Export Crash

A few hours after the close of the Friday’s trading session in Asia, news announced of the first China onshore default on bonds[1]. While the manic US stock markets seem to have shrugged this off, it is unclear if Asian markets will also disregard this. 

Even worse, after the close of the trading hours in US, the Chinese government announced[2] of a steep 18.1% decline in exports!!! I would say that 18% EIGHTEEN PERCENT represents a collapse and not just an ignorable drop.

The export crash has brought about China’s trade balance into a massive deficit. Yet both the degree of export volume breakdown and the scale of deficits matches or has even been larger than during the global crisis of 2008 (see red ellipses). Whether this represents an anomaly or signs of the deepening and acceleration in the deterioration of China’s economy has yet to be established. But I suspect the latter.

Why?

Because as I have been pointing out, such is how the bubble cycle unfolds.

The first stage; financial market disruption. Then, liquidity squeeze. Lastly, either a financial crisis that brings about an economic crisis or vice versa. The Chinese markets had her financial market disruption episode in June 2013. Then the attendant spike in interest rates underscored on the liquidity squeeze which the Chinese central bank has been intensely firefighting with liquidity administration[3].

Now the real world contagion.

In 2014, we seem to be witnessing the combination of financial market disruption and real world economic problems, particularly, the first trust bailout[4] in late January, the unreported January quasi-‘bank run’ on three cooperatives which just surfaced last week[5], the reversal of the one way yuan trade[6] and now both the first default and export meltdown. In barely three months, accounts of financial-economic convulsion appear to be increasing in frequency and intensity.

Remember, Chinese ‘zombie’ non-financial companies with debt-to-equity ratio exceeding 200% have reportedly jumped from 57% to 256 from 163 in 2007 according to a report from Bloomberg[7]. This implies of the potential scale of the risks of defaults, not to mention the risks from $3 trillion of local government debt and China’s shadow banking industry estimated[8] between $7.5 trillion (JP Morgan) and $15 trillion (Fitch’s controversial Charlene Chu)

So aside from higher cost of funding which results to dislocations in economic operations and subsequently engenders an economic slowdown, a feedback loop of slowing economic growth magnifies on the debt problem by aggravating access to funding which translate to higher costs of financing.

This is why the first default has been analogized by some mainstream pundits as China’s ‘Bear Stearns moment’ as climbing rates and the risks of payment delinquency will pose as major roadblocks to interbank lending that increases default risks. 

And it is important to point out that in contrast to the external account talisman that the mainstream uses to justify their worship of bubbles, in China’s case surpluses dramatically morphed into deficits. In addition, China’s record forex reserves hardly serve as an adequate shield to a DEBT problem issue.

As I have projected at the start of the year, China’s unwieldy debt conditions may trigger a Global Black Swan event[9].

Evolving events have been indicative towards such direction.

Russian Financial Markets Meltdown

And this has not just been a China affair. Financial strains in emerging markets have been sporadically spreading. While ASEAN’s pressures may seem to have eased (I say temporarily), Russia suffered a financial market meltdown last week.

It would be misguided to treat or impute Russia’s problems to entirely the Ukraine standoff. As I pointed out earlier, in contrast to mainstream understanding which views the weakening Russian ruble as foreign money instigated[10], this has been mostly a resident capital flight phenomenon[11]. The falling ruble existed even prior to Russia’s troop build up in Crimea.

The intervention by the Russian government has only aggravated such conditions. And in trying to preempt the outflows from a deepening corrosion of sentiment, Russia’s central bank Bank Rossii hiked interest rates by 150 basis points. The result has been a horrific (12%) one day crash in stock market, bond markets and even the ruble[12]. All the stock market gains accumulated from June of 2013 vanished in just one day. Russia’s stocks as measured by the MICEX closed the week down 7.29% which means about 40% of the losses have been recovered. Dead cat’s bounce, perhaps?

And all it takes is for political maelstrom to expose on the real issues: DEBT.

And again despite the huge forex reserves of both China and Russia, worsening credit conditions have overwhelmed or negated any so-called advantages.

And to put into perspective from the heavily biased reporting seen in most of mainstream media about the geopolitical impasse between the US and Russia, under the previous terms and agreement by Ukraine and Russia, Russian troops “has been allowed to keep up to 25,000 troops on the Crimean Peninsula”[13]. Now whether troops operating outside the bases are legitimate or not is subject to anyone’s interpretation.

But so does interpretative conundrum apply to the historical attachment of Crimea with Russia. Crimea had been a part of the Russian empire in 1783 way until the General Secretary of the Communist Party in Soviet Union ‘Ukrainian’ Nikita Khrushchev transferred in 1954 “the Crimean Oblast from the Russian Soviet Federative Socialist Republic to the Ukrainian Soviet Socialist Republic” notes the Wikipeida.org[14]. Ukraine became independent[15] from the Soviet Union following the latter’s dissolution in 1991.

So the Crimean political crisis is a complex issue being oversimplified by media.

I would like to also further note intervention has been a two party affair. Early February news leaked of the hacked phone conversation between US Assistant Secretary of State Victoria Nuland and US Ambassador to Ukraine Geoffrey Pyatt in actively plotting over the ouster of the previous Ukraine leadership[16] and of the prospective instalment of their candidates.

And Ms. Nuland also reportedly confirmed according to UK’s Guardian “that the US had invested in total "over $5 billion" to "ensure a secure and prosperous and democratic Ukraine" - she specifically congratulated the "Euromaidan" movement[17].”

So the pot calls the kettle black.

The Contagion Link

 

Going back to economics, in terms of trading linkage, ASEAN represents the fourth largest trading partner of China[18] (left window). The EU has been both the largest trading source for China and Russia. China is the second biggest trading partner of Russia[19] (right window). So a China and a Russian economic downturn imply that the biggest damage will be on the EU.

And that’s just the context of trade and doesn’t cover capital flows.

The implication of China’s export meltdown is that the global economy may have taken a sharp downturn in February. This will be reinforced by Russia and all other Emerging Markets (Turkey, Brazil, India, ASEAN and etc…) recently hit by the yield spread disorderly adjustments.

And as of December 2013, according to the Philippine National Statistics office, China has been the largest source of Philippine imports[20] and the second largest export market[21].

And as I previously mentioned US and European banks have intensely increased bank lending to emerging markets[22].

So should China and or Russia’s financial-economic turmoil escalate, the idea that the ASEAN or the Philippines will be immune from this will just seem utterly delusional. Or the fugazi.

---

[1] See China’s First Onshore Default! March 7, 2014

[2] Bloomberg.com China’s Feb. Exports Unexpectedly Decline in Blow to Confidence March 9, 2014

[3] See PBoC Injects 255 Yuan to Calm Debt Jitters, Asian Stock Market Celebrate January 22, 2014

[4] See China Rescues Troubled Trust Product January 28, 2014

[5] See China’s Bear Stearns Moment? First Bond Default Looms March 6, 2014

[6] See Has the Falling Yuan and Tumbling Chinese Stocks Been Signs of Capital Flight? March 3, 2014

[7] Bloomberg.com Zombies Spreading Shows Chaori Default Just Start: China Credit March 7, 2014

[8] See Global Markets: How Sustainable is the Recent Risk ON? February 17, 2014

[9] See Will China Trigger the Black Swan Event in 2014? January 20, 14

[10] See Behind Russia’s Central Bank’s “Unlimited Intervention” January 31, 2014

[11] See Emerging Market Turmoil: The Fallacy of Foreign Currency Reserves as Talisman February 3, 2013

[12] See EM Crisis Over? Explaining the Meltdown in Russian Financial Markets March 4, 2014

[13] Voice of America Russian Forces in Crimea: Who Are They, Where Did They Come From? March 5, 2014

[14] Wikipedia.org Crimea Early History, Independent Ukraine

[15] Wikipedia.org Ukraine independence

[16] Euronews.com US embarrassed by apparent hacked phone call dismissing EU on Ukraine February 7, 2014

[17] The Guardian Ukraine crisis is about Great Power oil, gas pipeline rivalry March 6, 2014

[18] Wikipedia.org List of the largest trading partners of China

[19] Wall Street Journal Lawmakers Pass Russia Trade Bill November 16, 2012

[20] Philippine National Statistics Office External Trade Performance: December 2013

[21] Philippine National Statistics Office Merchandise Export Performance : December 2013

[22] See Emerging Markets: Why Adjustments For Relative Yield Spreads has been Disorderly February 17, 2014

Phisix: The BSP’s Self Imposed Hobson’s Choice

Because of pressures applied by some influential groups on the Philippine government over the risks of property bubbles, officials of the Philippine central bank, the Bangko Sentral ng Pilipinas (BSP), proposes to establish a “residential property-price index” index to monitor “asset bubble risks” in the property sector at the first half of the year. 

Overheating is a Sign of a Maturing Inflationary Boom

Yet while the government including the President rabidly denies the “overheating” of the economy, a private company Colliers International notes that “February projected property prices in Manila’s financial district Makati, which climbed to a record last year will rise a further 8 percent in 2014.”[1]

The tautology of “economic overheating” is what I had predicted would become the catchphrase for the mainstream[2],

Eventually, the current boom will get out of hand, which will be manifested through rising interest rates, which the mainstream vernacular will call “economic overheating” …

Of course, record property prices on itself are hardly sufficient representative of an escalating bubble, as record property prices are merely symptoms.

The question what has financed property prices to reach such record levels?

The answer as I have been pointing out here has been intensifying asset speculation financed by debt.

The article further notes that “property loans and investments rose 6.8 percent to a record 900.1 billion pesos ($20 billion) in the second quarter of 2013 from the previous three-month period, the central bank reported in November. Property made up 22 percent of the total loan portfolio at banks.” (bold mine)

Record property prices backed by record debt. Record debt spending as expressed by a 30++% jump in money supply.

The fundamental problem with the mainstream’s heavy dependence to look at ‘select’ statistics in measuring economic activities has been at the risks of isolating economic variables which are really entwined or interrelated

As the great Austrian economist Ludwig von Mises reminds us[3].

Economics does not allow any breaking up into special branches. It invariably deals with the interconnectedness of all phenomena of acting and economizing. All economic facts mutually condition one another. Each of the various economic problems must be dealt with in the frame of a comprehensive system assigning its due place and weight to every aspect of human wants and desires.

And this is why overheating hasn’t just been as “property” problem. Measuring property and property related credit alone will tend to diminish the size and scale of risks. 

Bubbles operate like a vortex, they draw in associated industries which piggybacks on the main beneficiaries of the credit boom.

Think of it, will shopping mall operators continue with their wild expansion plans if they don’t project a sustained demand for their retail outlets? Will hotel developers also be in an expansion spree if they don’t foresee a sustained boom for their services from both resident and non-resident tourists? Will office building developers continue to expand if they don’t expect to see their units bought or leased out at profitable rates?

This is why the Philippine property bubble incorporates the shopping mall, hotel and restaurants and vertical non-residential edifices, as well as, the trade industry. 

The banking and other financial intermediaries and the capital markets (stocks and bonds) which have all served as the property sector’s financial conduits or agents are also considered as bubble beneficiaries or appendages. 

Statistics which signifies history of specific variable/s in numbers will not tell you this, it is economic deductive causal-realist logic that does.

This also means the BSP will gravely underestimate on their assessment of bubble risks by solely looking at “residential property-price index” while ignoring the other dimensions of the property sectors that have also been scampering to chase yields financed by debt.

As one would note, aside from record property prices, and the revival of the credit inspired mania in domestic stocks, the peso has been falling despite the this week’s region driven rebound and yields of Philippine treasuries remain stubbornly above 2013 levels while price inflation, despite so called .1% pullback from 4.2% to 4.1% this February[4] remains at the high end of the government estimates. All these come in the face of money supply growth going berserk.

And all these converge to depict that the statistical economy has been ‘overheating’ regardless of the official denial.

As a side note; speaking of the domestic currency, the USD-peso has sharply fallen Friday to close the year almost unchanged. The two week rally in Emerging Asian currencies signifies a regional phenomenon brought about by “resistance-to-change” outlook in the attempt again to resuscitate regional bubbles.

For instance Indonesia’s rupiah has massively rallied over the past 2 weeks, even when there has only been marginal improvement in the so-called current account and balance of trade deficits. Indonesia’s external debt swelled by about 5% in 2013. Meanwhile the Philippine peso has seesawed from big rallies to big losses. Friday monster rally seems part of the recent sharp volatility swings. We will see how rallying ASEAN currencies will react to the crash in China’s exports.

Why the BSP seems Trapped

Going back to BSP’s proposed anti-bubble measures, and this seems why the BSP-Philippine government appears to be trapped.

An asset bubble thermometer has already been in existence. There is an extant 20% cap on bank lending to the property sector. But as early as May 2013, the cap or the quota has been breached[5]. Now property sector lending has swelled by over 10% or 22% of the threshold. In short, the BSP, despite the self-imposed legal proscription, has been tolerant of the breach.

While it may be partly true that banks have been tightening lending standards for the commercial property sector “for the sixth consecutive quarter in the three months through December”, there has been a vast discrepancy between reports framed from the government’s perspective and what the stock market has been cheering about.

I have noted last week that the expected expansion on capital spending for real estate and allied industries will reach a very conservative Php 250 billion[6]. Most of the companies have declared borrowing as the source of finance for such expansion.

In terms of proportionality, 250 billion pesos amidst a record 900.1 billion pesos in property loans and investments in the banking system for 2013 will extrapolate to a 27.8% jump in credit! As a share of overall banking loans based on 2013 data, real estate loans will balloon to 26.5%. That’s if all these will be sourced from the banks.

Yet if the BSP stringently enforces the cap, there are many implications on these.

Property firms may circumvent the cap through camouflaged borrowing which is borrowing, coursed through other industries from which these property firms have exposure to. Say for instance, if a company’s portfolio includes energy or manufacturing or other non-real estate industries, the sister companies may secure borrowing from banks then execute intercompany loans.

This has been the case in the 2011 Bangladesh stock market crash. Lending caps on the banking system were dodged when loans were acquired through industrial companies and then diverted into the stock market. When the government tightened by raising bank reserves requirements, these loans came under pressure that led to the stock market collapse[7].

A second scenario is related to the first. This for current banks to do what has become one of the alternative main avenues for local government financing in China; the use loopholes via the establishment of non-property companies that serve as intermediaries to acquire and re-channel loans to the intended firms hobbled by such regulations. This is known as the Shadow Banks[8].

The Philippines have already existing shadow banks, according to the World Bank[9]. But one of the current main forms of shadow banks has been to finance buyers of property from the informal economy.

Nonetheless a strict enforcement of banking property loan quota by the BSP will impel for innovative ways to get around such regulations

A third way to go around the restrictions will be through deepening access of the domestic bond and international bond markets. Many companies have already expressed the former option.

Yet a ceiling on debt means reduced availability of funds from domestic sources which implies of HIGHER domestic interest rates. Should domestic interest rates rise faster than foreign based rates then these property companies may resort to more offshoring borrowings. Such may also include borrowing from offshore banks.

Again the Chinese experience can be instructive. In the face of relatively faster rising rates, US dollar loans by Chinese property companies have raised $40 billion over the past 2 years[10].

Of course expectations of currency conditions will play a big role in determining sourcing of credit for these companies. Then, the yuan had been a one way trade, so Chinese property companies underestimated on the currency risks by borrowing US dollar loans

The fourth setting will be for the industry to vastly reduce or even desist from expansions. But this will be devastating for the incumbent government who has been starved out of funds to finance their burgeoning boondoggles.

Bubble Revenues in Support of Government Spending Bubble

Easy access to finance would mean to impress upon to the creditors of the salutary state of financial conditions of the debtors. As such, in terms of the Philippine political economy, confidence has to be established by the impression of a booming economy.

And real estate has been a key anchor to the statistical boom. For instance, construction and Real Estate accounted for 18.18% of statistical GDP growth for the Philippines in 2013 based in the industry origins at current prices. If we should include trade and financial intermediation, the share of exposure of the said credit driven frothy industries balloon to 43.66%. In other words, tighten credit (either via interest rates or strict imposition of banking loan ceiling cap) and your “fastest economy in Asia” crumbles. 

Notice: Credit tightening doesn’t mean that the entire 43.66% will collapse. It means that big overleveraged participants in the sector, which when affected, will drag down many entities of the related sectors and even to the non-related sectors. Yet ironically some [debt free] companies from the same sector may benefit from the problems of their colleagues. The latter could be buyers of problematic assets at fire sale (market clearing) prices.

Also remember access to the formal banking and credit system has been very limited (2-3 out of 10 households), which means all these so-called growth has concentrated. Alternatively this means risks have also been concentrated.

On a side but related note, one has to just ask why is it that the Philippines, an agricultural country, have essentially no commodity spot and futures markets and have been left behind by her neighbors[11]. The benefits from commodity markets should have been the purge or reduction of the role of the middleman, diminished transaction costs, to empower and enrich the agricultural and commodity producers, generate pricing efficiency, spread risks and expand access to credit by allowing the informal sector to migrate to the formal sector. And yet the public blathers about the sins of rice smuggling[12], duh! 

This is also related to why the PSE dithers (or refuses) to integrate her bourses with region[13].

And this is also why there has been a growing divergence in sentiment between the informal and the formal sectors[14].

Also such divergence has brought about the mainstream’s perplexity on why the so-called boom has not been translating into more jobs. Paradoxically, highly paid experts have offered little but to associate joblessness with poverty rates[15].

As I have been pointing out numerous times, real economic growth can’t happen when there is a huge formal-informal system divide. As one can see from the above chart[16], the degree of shadow economies has been tightly associated with degree of wealth conditions. Naturally any informal economy includes informal or shadow banking too.

The informal economy which is a product of economic and financial repression[17] extrapolates to high transaction costs, high cost of capital and equally inefficient means to accumulate real savings and capital[18]. This also means limited growth because substantial growth postulates migration to the formal economy which poses as a disincentive for many in the informal economy.

So the mainstream can continue to prattle about growth statistics but by ignoring the informal economy they will tend to miss out on the real conditions of the economy, that’s because the informal sector constitutes a huge share of the population.

This brings us back to issue of easy access to credit. The Philippine government missed her tax collection target by a slight 2.95% in 2013, albeit overall collections grew by 15% year on year. While this is good news so far as for the statistical concentrated economy, the bad news is that aside from stagflation, taxes will even grow at a faster rate this year.

The BIR, which accounts for 70% of the government’s total revenues, expects a 16.16% increase in her 2014 target[19]. That’s because national government budget will expand by 13% to Php 2.265 trillion in 2014[20]. So government spending will grow about twice the statistical economy.

This explains why in spite of the so-called boom, the BIR has been tightening on the noose of practicing doctors[21], where the latter have pushed backed, and even on the ‘lechon’ or roast pork vendors[22]. As one would note, the government has been waging war on the informal economy. So one can’t expect real growth to occur when government tries to restrict commercial activities.

Oh by the way the Philippine national government has so far done well in containing budget deficit. As of November 2013, annualized deficit (Php 111.464 billion) has been sharply lower, down by 54% compared to the yearend of 2012 (Php 242.827 billion). That’s the good news. The bad news is that the good upkeep depends on revenues from an unsustainable bubble blowing economy.

All these means that the incumbent government will have to increasingly rely on a sustained credit financed boom of assets in the formal economy in order to fund her fast expanding spendthrift appetite, as well as, to maintain zero bound rates or negative real rates (bluntly financial repression) to keep her debt burden manageable.

So the supposed boom in statistical formal economy translates to a boom in government spending financed by a boom in taxes derived from bubbles

Aside from the government, the other beneficiaries of BSP subsidies are the asset holders and formal economy debtors, which come at the expense of savers, non-asset holders and peso holders (outside the beneficiaries whose assets offset the loss in purchasing power).

Yet the only way to neutralize the negative effects of excessive money supply growth is through productivity growth.

But blowing bubbles and taxes diverts resources from high value productive uses to non-productive consumption activities. Thus a statistical boom can occur in the face of a loss of productivity. Yet this isn’t real growth, but that’s how bubbles operate

Think of it, if the BSP rigidly imposes banking caps, a tightening would result to a market meltdown and which will most likely get transmitted to the real economy via a significant slowdown or even a contraction, if not a crisis. This will not only undermine the leadership’s political goals but also bring to the surface the economic and political imbalances that have been built to promote access to easy credit via populist politics. And economic strains will likely bring about a more intense popular demand for the scrutiny of political malfeasances.

So the Philippine government together with the BSP has been trapped. They will need to keep the musical chairs going by continuing to inflate on asset bubbles and hope that such bubbles won’t pop under their terms. Thus this explains two factors: one the Pollyannaish declarations by the officialdom, which has been bought hook, line and sinker by media and industry participants benefiting from the phony boom. Second, the public denials and the superficial measures announced by authorities supposedly to contain the risks of financial instability via asset bubbles.

Yet everything will depend on the bond vigilantes. If interest rates as expressed by bond yields continue to climb, then what is politically hoped for may not be attained, they may even backfire.

As John Adams US founding father and 2nd US President in his defense at the Boston Massacre Trial said,

Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence.

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[1] Bloomberg.com Philippine Index to Monitor the Risk of Property Bubble March 4, 2014

[2] See What to Expect in 2013 January 7, 2013

[3] Ludwig von Mises, The Why of Human Action, Economic Freedom and Interventionism

[4] Wall Street Journal Slower Inflation Gives Philippine Central Bank Reprieve March 6, 2014

[5] Bangko Sentral ng Pilipinas BSP Releases Results of Expanded Real Estate Exposure Monitoring, May 10, 2013

[6] See Phisix: Why Tomorrow’s Fundamentals will be Distinct from Yesterday, March 3, 2014

[7] See Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets January 11, 2011

[8] See Will China Trigger the Black Swan Event in 2014? January 20, 2014

[9] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20, 2013

[10] Reuters.com Renminbi swings shake Chinese developers March 6, 2014

[11] See A Prospective Boom in Philippine Agriculture! February 25, 2008

[12] Wall Street Journal Crackdown on Rice Smuggling Blamed for Price Jump February 26, 2014

[13] See Phisix 7,200: Up, up and away! The Illusions of Comfort May 6, 2013

[14] See Phisix: Stagflation is here, Expect a Weaker Peso February 17, 2014

[15] Wall Street Journal Few Good Jobs In Fast-Growing Philippines, March 4, 2014

[16] Zero Hedge JPMorgan's Biggest Concern Is That Bitcoin Will Succeed March 7, 2014

[17] See Does The Government Deserve Credit Over Philippine Economic Growth? May 31, 2010

[18] See Phisix: Global Financial Volatility Intensifies February 10, 2014

[19] Malaya BIR MISSES 2013 TARGET BY 3% February 20, 14

[20] Rappler.com Aquino signs P2.265-T 2014 budget December 20, 2013

[21] Inquirer.net Doctors slam BIR ad: We’re not tax cheats March 4, 2014

[22] Manila Standard Taxman roasts lechon traders January 9, 2014