Phisix: A Bull Trap and the Switch to a Global Risk OFF Mode?

Know how to listen, and you will profit even from those who talk badly-Plutarch

I was supposed to write about Japan as one of the potential triggers for the Black Swan event in 2014 and on the US shopping mall bust as this week’s topic but an unscheduled family event have forced me to truncate and alter my outlook for the week.

To add, another reason for this outlook is due to flash developments that have transpired in the global markets during the last two days. This may signal a change in the complexion of the markets.

Local bulls have been delighted by the apparent rekindling of the animal spirits as the Phisix roared anew for the second straight week.

As one would note, the Phisix outsprinted her neighbors with a 3.41% jump (see blue square). The gains during the past two weeks at 5.88% have accrued to yield a 5.12% return year to date.

We can expect the mainstream Pollyannas to say, “you see the bull market is still alive. “Fundamentals” rule the day and that those bears are being “irrational”.

Of course “irrationality” applies to both the base instincts of fear and greed. And of course, whatever fundamentals these commentators will refer to are statistics that have been cherry picked to justify the current stock price surges.

In reality the impassioned rally by the embattled ASEAN stock markets, has been led by Indonesia (JCI-green) that has spilled over to Thailand (SET-red) and the Phisix (PCOMP-gold). The Phisix and the SET only picked up steam only during the last two weeks.

The story of Indonesia I will continue later as well as the late Risk OFF mode by European and US stocks (red ellipse in first chart)

Three Against One, Who will Prevail?

Now back to the Phisix.

There is big hole in the supposed Risk ON mode for the Phisix: it is called Divergence.

First of all, the Phisix rally has not been shared by the domestic currency, the Philippine peso. It is an irony to see that considering the modest net foreign buying in the Philippine Stock Exchange for the week, the peso’s decline has been accelerating. Who is doing all the selling, the locals? Why? Have they not been bullish the economy?

Second, in spite of the tightly held and controlled domestic bond markets by the banking system and the government, there have been little signs of improvement across the curve.

In fact during this week, yields have gained at varying degrees through the curve.

Yields of one month and 6 month Philippine peso denominated treasuries remains elevated despite inflation being “manageable” and “within target” story as trotted out by the BSP.

The one month yield has been up 50 basis points from December, the 6 month has also been up by more than 100 bps.

Yields of one year and 5 year treasuries have been up about 100 bps and 120 bps respectively.

Meanwhile yields of the longer 10 year and 20 year has risen modestly compared to the shorter yields by about 80-90 bps from the lows of last year

Rising yields means that there has been selling pressure on the local bond markets. Have banks and financial institutions been selling out signs of inflation or from signs of credit strains?

Are these signs of cracks in the stranglehold by banks and the government on the local bond markets?

How much of an increase in interest rates can the Philippine financial system withstand?

The third factor has been that the price to insure debt via annual probability of default from CDS spreads has been rising for the Philippines.

Increasing CDS spreads means heightened concern over the credit quality of Philippine debt.

Again from the above are several concerns. How will the lower peso affect the financing cost of companies whose debts have been priced in foreign exchange? While there may be some companies who may benefit from weaker peso, to what extent will higher revenues from a weak peso offset rising input prices/operating costs? As for the local companies, how will higher consumer price inflation affect real demand? How will higher price inflation affect the cost of doing business, thereby profits? And how does growing concerns over quality of debt become a plus for stocks, especially for companies with substantial debt exposures?

These three factors, namely tanking peso, slumping bond prices (higher yields) and higher CDS spreads (concerns over credit quality) point to the opposite direction of the rose colored performance of the Phisix.

Obviously the current relationship isn’t sustainable. The question is who will fold? Will it be the Phisix or the latter three?

The Intensifying Emerging Market Turmoil

This brings us back to the Indonesian inspired ASEAN equity market rally.

At the start of the year I pointed out that the Indonesian government successful raised US $4 billion from global bond markets. This has prompted for a full risk ON mode for Indonesia’s financial markets as shown last week whether seen in bonds, stocks or the rupiah.

But it appears that the global bond magic, which seems to be eroding, has a very short life cycle.

Yields of Indonesian 10 year rupiah denominated bonds have skyrocketed anew to approach the former highs. The latest weakness in her bond markets seems to be reflected on the diminishing momentum of the stock market bulls in Indonesia.

I would add that the selling pressure in emerging markets financial markets have been accelerating, as this Bloomberg article entitled “Contagion Spreads in Emerging Markets as Crises Grow” notes

The worst selloff in emerging-market currencies in five years is beginning to reveal the extent of the fallout from the Federal Reserve’s tapering of monetary stimulus, compounded by political and financial instability.

The Turkish lira plunged to a record and South Africa’s rand fell yesterday to a level weaker than 11 per dollar for the first time since 2008. Argentine policy makers devalued the peso by reducing support in the foreign-exchange market, allowing the currency to drop the most in 12 years to an unprecedented low.

Two issues of concern, as the article duly highlights. The concern over emerging markets is about growing risks “crises”. Since crises is plural then this means that it is not just one but many emerging markets are at risks of a crisis. Emerging markets account for 38% share of the global growth according to the Standard Chartered. A big share of EM economies hit by crises will have a negative effect on global growth.

Second, Indonesia’s first successful offering at the start of the year represents the initial tranche of the “record IDR 357.96 trillion (USD $29 billion)” bond sales it plans to conduct “from both international and local debt capital markets in 2014”.

The question is what if the current emerging market turmoil spreads to ASEAN, will the Indonesian government be able to raise money from her targeted bond sales? If yes, at what level of rates? If not will she resort to bigger taxes or more inflation by her central bank? Yet how much increase in coupon yields in the bond markets can the Indonesia’s government afford to finance the new round of debt? How will higher rates impact the political and the economic landscape?

These are stock market bullish?

Interesting no?

From the Periphery to the Core Dynamic

This leads us to the third issue. The Phisix ignored the Thursday’s selloff in US markets.

Unfortunately, instead of recovering from Thursday’s setback, the US and European stocks fell off the cliff from record highs on Friday.

The Dow Jones Industrial plummeted 1.96% or 318.24 points last Friday. Ironically the US stock market tremblor comes in the face of record optimism on the global economy.

Notes the Bloomberg:

International investors are the most upbeat about the global economy than at any time in almost five years, buoyed by the U.S.-led revival of industrial nations, according to the Bloomberg Global Poll.

I will show again the first graph above. Heavy two day losses from record high US and European markets have cumulated to losses from anywhere above 2-4% for this week (see red ellipse). 

Yet based on the futures markets Friday’s losses in US and European markets may be sustained next week.

And Asian markets are expected to open on Monday deep in red territory. 

The question is, have the selling pressure in US and European equities merely been a temporary profit taking shakeout or has this been the initial portent of a possible major inflection point that could lead to a Black Swan event?

The spiking yen have appears to have prompted an unwind in yen carry trades that seem to have escalated the plunge in equities of US (S&P), Europe (Stox 50) and the Nikkei.

Should selling pressures persist, will the Phisix and ASEAN markets be immune to such adverse developments?

Lastly the fear of financial instability has led China’s PBOC to infuse 255 billion yuan into the system. This has prompted for a rally in China’s stocks. How long will this band-aid treatment last?

Yet reports over anxieties on credit conditions in various parts of China continue to surface. As the Zero Hedge notes, “depositors in some of Yancheng City's largest farmers' co-operative mutual fund societies ("banks") have been unable to withdraw "hundreds of millions" in deposits in the last few weeks”.

Amidst signs of credit crunch, China’s runaway housing bubble reportedly reached record $1.1 trillion in new home sales in 2013

The Chinese will be celebrating their Spring Festival or New Year by the end of the month which is next week, for one week. It will be interesting to see how China’s financial markets will react to the escalating risk OFF mode prior to the holidays.

A bull trap according to Investopedia.com is a false signal indicating that a declining trend in a stock or index has reversed and is heading upwards when, in fact, the security will continue to decline

Has the bullish consensus been right about the revival of the bull market? Or have many of these “greater fools” been suckered into a bull trap?

Will central bankers get into the picture? Will they be able to kick more cans? Yet in so far as central banks actions are concerned, Turkey’s central bank’s efforts to create a “shock and awe effect” to stop her hemorrhaging currency, the lira, has failed miserably. Certainly not a good sign.

We should expect sharp volatility in the global financial markets (stocks, bonds, commodities and currencies) in the coming sessions. The volatility may likely be in both directions but with a downside bias.

Oh don’t forget as I have been repeatedly saying, denial rallies tend to be dramatic. But they have consistently failed especially in the historical account of the PSE since 1980. 

Will this time be different? Or will history rhyme?

Quote of the Day: The vision of the left is a vision of themselves

The vision of the left is not just a vision of the world. For many, it is also a vision of themselves -- a very flattering vision of people trying to save the planet, rescue the exploited, create "social justice" and otherwise be on the side of the angels. This is an exalting vision that few are ready to give up, or to risk on a roll of the dice, which is what submitting it to the test of factual evidence amounts to. Maybe that is why there are so many fact-free arguments on the left, whether on gun control, minimum wages, or innumerable other issues -- and why they react so viscerally to those who challenge their vision

This is from economist, author and political philosopher Thomas Sowell at the Townhall.com. 

Quote of the Day: Why you don't need equations to understand economics

Stripped of his numbers an economist would have to resort to the old home truths about how the world works: If you tax something you get less of it; as a general rule an individual manages his own affairs better than his neighbor can; it's rude to be bossy; the number of problems that resolve themselves if only you wait long enough is far larger than the number of problems solved by mucking around in them. And the cure is often worse than the disease:

In the long run, the aggregate of the decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is likely to do less harm than the centralized decisions of a Government; and certainly the harm is likely to be counteracted faster.

Somehow the most successful practical economist of the twentieth century knew this was true, and he didn't have to work out a single equation.

This is from Weekly Standard’s Senior Editor Andrew Ferguson published at the Wall Street Journal Notable & Quotable section. (hat tip Prof John Cochran at the Mises Blog)

Mr. Ferguson proposes that the Federal Chairman Janet Yellen adapt a John Cowperthwaite paradigm. Mr. Cowperthwaite has been largely credited for the economic success story of Hong Kong via free markets.

The point of the above isn’t entirely to shun or scorn statistics but to know of its fundamental limitations and the perils of relying on them to solve social problems. Obsessing over statistics has mostly been the handiwork of scheming interventionists, as well as, knowledge pretenders in pursuit of the social desirability bias

Infographics: Prison Inc. USA

Some numbers on the US Prison industry (hat tip zero hedge)

 

Source: Online-Paralegal-Degree.org

Let me add: Half of the federal prison population have been due to the war on drugs. The Prison population constitutes the bottom one percent. Read more on US incarceration rate here.

Thailand's political nightmare exposes her financial fragilities

Following an escalation of political violence, Thailand’s government declared a 60 day emergency rule yesterday

The New York Times reports

The embattled government of Prime Minister Yingluck Shinawatra declared the imposition of emergency rule in Bangkok and surrounding areas on Tuesday, suggesting a more aggressive posture toward protesters who have occupied parts of the city during the past two months and are seeking to overthrow the government.

But officials said they had no plans to crack down on protesters, who have escalated their campaign over the past week by blocking government offices, taking over major intersections and staging daily marches across Bangkok. The emergency decree enacted Tuesday gives the government the power to invoke curfews, censor the news media, disperse gatherings and use military force to “secure order.”…

Protesters have been attacked by unknown assailants in recent days. Three grenade attacks left one person dead and dozens injured. The government and the protesters have blamed each other for those attacks.

The emergency decree, which is valid for 60 days, was passed under the same law that a different government used in 2010 to start a military crackdown that left dozens of people dead. Underlining the seesaw power struggle that has gripped Thailand for the better part of the past eight years, the man responsible for the crackdown four years ago, Suthep Thaugsuban, a former deputy prime minister, is now leading the antigovernment protests.

A video of the man who threw a grenade that wounded 28 protesters captured here

Yet it’s rather odd, if not contradictory, for the Thai government to impose an emergency rule but claim “they had no plans to crack down on protesters”.  So what’s the emergency rule for?

Anyway, the aggravation of political violence headed towards election day in February 2, has led to increasing anxiety in Thai’s credit markets.  Default probability from Thailand’s 5 year CDS spread surged to September highs.

But the angst over Thailand’s politics has had mixed responses on her financial markets so far. Such has been partly due to the recent rally in US Treasuries, expectations for the Bank of Thailand to cut rates and the People’s Bank of China’s recent liquidity injections.

As a side note: to the surprise of the consensus, the Bank of Thailand kept rates on hold. It is bizarre, if not absurd, for pundits to expect that manipulation of interest rates to function like a magic wand that would solve real world economic problems. The economy is a micro dynamic. For instance, we shouldn’t expect interest rates to solve Thai’s political impasse that affects investor sentiment. Investors will be concerned about the sanctity of property rights that may be affected political turmoil, rather than by low interest rates. The Bank of Thailand surprisingly cut interest rates last November, yet the political nightmare and slowing economic growth continues. [note: the last sentence is an add on]

Thailand’s stocks (via the SETI) have recovered most of the New Year’s day crash but the rally appears to be faltering again.

Yields of Thailand’s 10 year local currency bonds have likewise recovered but like the stock market, pressures appear to have re-emerged.

Importantly, the US dollar-Thai baht is at a 3 year in spite of the recent decline.

Foreign investors were reported to have pulled $4 billion from stocks and bonds since October 2013

It would be easy to dismiss the effect of politics on the financial markets, but as I have been pointing out, Thailand has a credit bubble

Loans to the private sector ballooned by more than 20% over the last 2 years that has fueled a property bubble.

The credit bubble has been manifested in her monetary aggregate M3 which has swelled over the same period.

Thailand’s external debt which inflated by about 75% from 2010 will likewise be under pressure as the baht continues to weaken.

This will further impact Thailand’s once vaunted foreign exchange reserve cover which appears to be rapidly dwindling.

As you can see, political instability will only magnify Thailand’s fragile financial and economic conditions.

As I pointed at the start of the year, there are many potential flashpoints for a Black Swan event to occur. ASEAN may be one of them or if not would be vulnerable to a contagion.

Things are turning out to be very interesting.

Quote of the Day: Colonial Nationalism and Anti Colonial Nationalism

If nationalism inspired two incompatible movements, how should we evaluate it?  You might just call it a wash: Nationalism giveth, and nationalism taketh away.  But this shoulder shrug overlooks two mountains of bodies.  The first mountain: All the people killed to establish colonial rule.  The second mountain: All the people killed to overthrow colonial rule.  It is perfectly fair to blame nationalism for both"transition costs." 

Surprising implication: Regardless of the relative merits of colonial versus indigenous rule, the history of colonialism makes nationalism look very bad indeed.  Why?  Because colonial rule didn't last!  So if you're pro-colonial, nationalism led to a high transition cost, followed by ephemeral wonders, followed by another high transition cost.  And if you're anti-colonial, nationalism led to a high transition cost, followed by ephemeral horrors, followed by another high transition cost.  Two dreadful deals, however you slice it.

But don't you either have to be pro-colonial or anti-colonial?  No.  You can take the cynical view that foreign and native rule are about equally bad.  You can take the pacifist view that the difference between foreign and native rule isn't worth a war.  Or, like me, you can merge these positions into cynical pacifism.  On this view, fighting wars to start colonial rule was one monstrous crime - and fighting wars to end colonial rule was another.  Nationalism is intellectually guilty on both counts, because it is nationalism that convinced people around the world that squares of multi-colored cloth are worth killing for.

(italics original)

This is from economics professor,  prolific blogger and author Bryan Caplan at the Library of Economics and Liberty

PBoC Injects 255 Yuan to Calm Debt Jitters, Asian Stock Market Celebrate

China’s financial markets “hooked” on liquidity injections, got another shot in the arm with 255 billion yuan of reverse-repurchase agreements by the People’s Bank of China to to large commercial banks

From Bloomberg:

China’s benchmark money-market rate fell while stocks rebounded as the central bank added more than 255 billion yuan ($42 billion) to the financial system and expanded a loan facility to meet Lunar New Year demand for cash.

The seven-day repurchase rate, a gauge of interbank funding availability, dropped 88 basis points to 5.44 percent in Shanghai, according to a daily fixing compiled by the National Interbank Funding Center.

China’s 7 day repo rate (china money.com) has declined on PBoC’s injection (green ellipse). 

Media says that this measure will “reduce risk in the interbank market and help restore confidence as concern mounts about potential defaults” and that “Money-market rates typically spike before the new year break, a period in which cash gifts are made and families get together for celebratory feasts”

The above picture tells of a vastly different story. Those blue arrows on top reveal of the episodes of “major” short term liquidity squeezes over the past year. The (blue) trend line also reveals of a seeming increase in repo rates since the last quarter of 2013. 

Rising frequency of incidences of liquidity turmoil and the seeming gradual build up in the magnitude (expressed via rising trend of repo rates) seem like mounting pressures looking for an outlet valve to ventilate. They seem hardly about celebratory feasts, instead they seem as writing on the wall for a Black Swan.

Curiously despite the action by the PBoC, yields of China’s 10 year bonds remain in a consolidation mode at recent highs.

China’s stock market investors nevertheless cheer the same theme of more "bad news is good news" [I see this as an oversold bounce].  And so with the ASEAN counterparts.

Yet the PBoC’s liquidity injection and declining yields of US treasury notes appear to have hardly calmed ASEAN bond markets which continues to show weakness via higher yields (yes Philippine treasury yields seem as rising today from 1 year through 20 year curve. 10 year at 4.3%). Such has also been expressed via their respective currencies (the USD-Philippine peso is 45.2+ from Friday's 45). Rising stocks amidst rising treasury yields and falling currency represents a widening of unsustainable divergences. 

Well, stock market investors see none of these as risks: again symptoms of what I call as the Aldous Huxley “Facts do not cease to exist because they are ignored” syndrome.

Cayman Islands: Success Story and the Coming Risk from Revenue Starved Governments

At the Lew Rockwell.com, historian Eric Margolis describes the success story of Cayman Islands.

Two things happened to change Cayman from insect hell to the world’s second most important tax haven after Switzerland, and the fifth largest banking center.

First, an intense mosquito control campaign and swamp drainage killed most of the island’s insects. Second, the British Crown colony adopted a no tax policy and removed any restraints on the flow of funds.

The New York and London principals of the West Indies port, land and shipping group for which I was working at the time sent me to Cayman to open up banks. I chartered three, including my favorite brainchild, the German-Atlantic Bank.

Would that I had stayed in the banking business. My principals had remarkable foresight. Forty-four years later, Cayman hosts almost 300 banks, insurance firms of every type, and over 10,000 hedge funds managing some $36 billion in funds, as well as registries for ships and aircraft.

The population has grown to 56,000, nearly a third of whom are expatriate financial executives. The inflow of bank business has allowed life without personal taxes and a per capita income of $47,000, giving Cayman the highest living standard in the West Indies. Over 50% of government revenue comes from the finance industry.

With its azure waters, beautiful beaches, fine hotels, well-regarded restaurants, highly developed communications and public infrastructure, Cayman is a paradise for tourists and finance.

Now the coming risk:

By contrast, tax collectors everywhere hate Cayman.

The island’s ultra discreet banks are awash with hot money, particularly from Russia. In fact, almost every major business deal in Russia is run through either Cayman, Switzerland, or Cyprus (though it’s gone bust). This island is a world center for legitimate business but also financial hanky-panky and shielding money from taxes, angry ex-wives and lawsuits.

What makes Cayman so attractive is that it remains a British colony, meaning no revolutions or coups by wild-eyed fanatics. The island offers still largely impenetrable secrecy and a safe place for money. And, to quote Somerset Maugham’s wonderful description of Monaco, “a sunny place for shady people.”…

But Cayman, like other tax havens, is now under heavy fire from abroad. Last year, President Barack Obama singled out Cayman as a major financial malefactor. Revenue hungry governments across the globe are closing in on Cayman.

See the complete article here

If "revenue hungry government across the globe" have been intensifying their leeching of their captive taxpayers, think of what may likely happen when a Black Swan event occurs.

Quote of the Day: Trade is Not a Scoreboard

We need to do better a job explaining how trade does not lend itself to sports metaphors. Exports are not our “points.” Imports are not “their” points. The trade account is not a scoreboard. It is not Team America against the world. Trade is about mutually beneficial exchange between individuals in different political jurisdictions, and to the extent that those kinds of transactions are subject to the whims of politicians, more and more resources will be diverted from economic to political ends.

This is from Cato Institute director Daniel Ikenson debunking mercantilist myths

Will China Trigger the Black Swan Event in 2014?

The ongoing financial tremors in China appears to be absent in the eyes of the mainstream

Instability in China’s Credit Markets

Yields of China’s 10 year local currency bond remains at 2008 levels.

As of Friday, China’s money market rates leapt to the highest level in a month as banks have reportedly been hoarding funds in order to meet withdrawals before the Spring Festival (New Year) holidays and concerns over “first trust-product default”.

The seven-day repurchase rate, reports the Bloomberg[1], surged 81 basis points, the most since Dec. 20, to 5.17 percent in Shanghai, according to a weighted average from the National Interbank Funding Center. That was the highest level since Dec. 31. It climbed 114 basis points this week.

The Chinese government attempted to ferret out her shadow banking system by withdrawing liquidity last June only to discover that the vehemence of market reactions[2].

For the Chinese government market instability would run the risk of upsetting political goals of generating statistical economic target which may have political repercussions. This forced the People’s Bank of China to inject funds and abort the mission. 

But artificial treatments have led China’s debt disease to rear her ugly head. Not only has interest rates soared, but the credit pressures have become apparent anew as China’s annual probability of default based on 5 year credit default swaps have risen.

Ballooning Debt Levels

Runaway credit growth underpinning China’s property bubble plus growing complexity from deepening politicization of the banking sector via credit allocation has prompted for a dramatic evolution of credit activities in China over the past few years.

Local government debt has reportedly reached 17.89 trillion yuan or about US $ 3 trillion. Lending restrictions by the central government on the local government has forced the latter to migrate and tap shadow banks consisting of trust securities, insurance and leasing companies, and other non-bank financial institutions, which accounted for 27.8% of new debt. Aside from shadow banks the local government has resorted to other financial engineering instruments too, they have used IOUs and shifted the use of local government financing vehicles (LGFV) into using State Owned Enterprises (SOE) who acquired loans in their behalf (backed by illicit guarantees by the borrowing local government).[3]

Mainstream media wants to put the blame financial liberalization on the explosive growth of lending, but as one would note from the above, credit growth has largely been from the local governments camouflaged through the private sector, via LGFVs, or through the Shadow banks. All these avalanche of debt financed spending on mostly property projects has spurred a massive property bubble. Although  these has mostly been contrived to produce statistical growth which has been meant to get the blessings of the higher ups in order to ensure the political tenure and to fulfil the political ambitions of the officials of local governments.

A lot of the supposed private sector entities appear to be either wards or crony arms of local and state governments. And all these collective attempts to generate statistical “growth” have led to China’s dire pollution problems where smog has reached dangerous levels[4].

Meanwhile Chinese credit expansion has also been in a product of the PBoC’s printing of yuan in exchange for foreign currency. Although much of the proceeds of foreign exchange transactions end up with the banking system and subsequently converted into loans. China’s money supply growth has soared past the US[5]

China’s foreign exchange reserves have now reached new records at $3.82 trillion at the end of December. Importantly, China’s vendor financing scheme with the US has led to record holdings of US treasuries. China now has $ 1.317 trillion worth of USTs[6]. This record holding of US contradicts the PBoC’s earlier claim where they will not increase acquiring of USTs last November[7]. This also shows how China continues to implicitly finance the US military via UST purchases, which for me, represents a Dr. Jekyll and Mr. Hyde or an inconsistency in terms of the brinkmanship geopolitics of territorial disputes.

Emergent Signs of Credit Stress

Yet despite the huge reserves, the Chinese government appears to be a bind. They would like to put a curb on the shadow banks, but they fret that doing so might impair the credit channels via the banks, which may harm credit conditions, undermine the economy and imperil the already fragile political conditions.

An example can be seen in a reported infighting between banking regulators: the People’s Bank of China (PBoC), whom has been finding ways to “move loans off their books” and China’s banking regulator, the China Banking Regulatory Commission (CBRC), whom has supposedly “watered down” regulations to accommodate the requests of the banking system[8].

A proposed new rule by the CBRC known as Regulation 9 has been designed to restrict off banking sheet lending activities that would limit backdoor activities, but lobbying from the banking industry allegedly pushed the CBRC to dilute the essence of the regulation.

Nonetheless a record 2.6 trillion yuan ($427 billion) of interest and principal on securities issued by non-financial companies have reportedly been due this year[9]. This has brought about growing concerns over credit risks.

There have already been signs of emerging credit stress. 74 of about 800 Peer-to-peer online lending companies which came online in 2013[10] with outstanding loans of 26.8 billion yuan ($4.4 billion) have either shut down or have been unable to facilitate cash withdrawals to its users.

Importantly at the start of the article I noted that rising money market rates have reportedly been due to banks hoarding funds in anticipation of the “first trust-product default”.

The world’s largest bank (in terms of assets[11]), the Industrial & Commercial Bank of China Ltd., which is state owned bank, has reportedly rejected calls to bailout a 3 billion-yuan ($495 million) shadow banking trust product which it had distributed[12]. The company reportedly invested in a coal mine venture, Shanxi Zhenfu Energy Group, which recently collapsed. 

A default on the investment product, according to a report from Bloomberg, which comes due Jan. 31, may shake investors’ faith in the implicit guarantees offered by trust companies to lure funds from wealthy people. Assets managed by China’s 67 trusts soared 60 percent to $1.67 trillion in the 12 months ended September even as policy makers sought to curb money flow outside the formal banking system.

A China Triggered Global Black Swan Event?

This is interesting because the Chinese government embarked on a massive stimulus program in 2008 to the tune of 4 Trillion RMB US$ 586 billion[13] to shield her from the global crisis. Apparently the Chinese government got hooked on such political measures from which stimulus spending have now become a standard and stealthily implemented via state and local governments.

And yet the government may have already drained the people’s savings and has thus used debt to attain statistical growth. And as noted above, most of today’s economic growth model comes with heavy reliance on leveraging which results to the loss of productivity making them vulnerable to bursting bubbles.

Applied to China, billionaire, market guru and crony capitalist George Soros appears to share the same insight. In a recent article, Mr Soros writes[14] that China’s “model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing.”

Mr. Soros continues “There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008. But there is a significant difference, too. In the US, financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.”

And while many including Mr. Soros points to China’s Third Plenum as being an optimistic factor, as I recently noted[15],

implementation will mark the difference from rhetoric

Yet the Chinese political economy and her financial markets will have to face vast immediate or short term challenges first. And the ultimate  challenge is how to deal with her overleveraged economy.

I recall that in late November, as companies borrowing costs spiked, China’s state newspapers warned about a “limited debt crisis”[16]. 

China’s Shanghai Index seems to share the same worries and has been down 5.25% year to date as of Friday’s close

2014 will probably answer the following questions:

Will the year of the horse usher in a series of defaults for the China’s overleveraged system? Will such defaults be contained (perhaps by her record reserves)? Will the Chinese government resort to bailouts? Or will it cause a domino effect that may spread through the financial system? Will there be a global contagion?

Has the proverbial chicken come home to roost for China’s credit and property bubbles?

Will economic and financial troubles prompt China into a military showdown with her neighbors over territorial disputes?

Will China trigger the Black Swan Event in 2014?

---

[1] Bloomberg.com China Money Rate Surges on Cash Demand Amid Trust-Product Risks January 17, 2014

[2] See China’s PBOC: From Tapering to Easing? June 21, 2013

[3] Wall Street Journal Real Times Economics Blog A Micro Reading of China’s Local Government Audit January 9, 2013

[4] Australia New Network Dangerous pollution hits the Chinese capital as index hits top of the scale January 17, 2014

[5] New York Times With China Awash in Money, Leaders Start to Weigh Raising the Floodgates, January 15, 2014

[6] Bloomberg.com China’s Treasury Holdings Climb to Record in Government Data January 16, 2014

[7] Bloomberg.com PBOC Says No Longer in China’s Interest to Increase Reserves November 21, 2013

[8] Wall Street Journal Regulators at Odds on Reining In China's Shadow Lending January 14, 2014

[9] Bloomberg.com First China Default Seen as Record $427 Billion Debt Due December 9, 2014

[10] Bloomberg.com China Peer-to-Peer Loan Sites Fail as Fraud Climbs, Xinhua Says January 13, 2014

[11] Global Finance Magazine World’s Biggest Banks 2013 October 2013

[12] Bloomberg.com ICBC Won’t Repay Troubled China Trust Product, Official Says January 17, 2014

[13] Wikipedia.org Chinese economic stimulus program

[14] George Soros The World Economy’s Shifting Challenges Project Syndicate January 2, 2014

[15] See China’s Stock Market Soars on ‘Leaked’ Reform Documents as Bond Markets Seize Up November 16, 2013

[16] Bloomberg.com Record Spread Blowout Sparks Mini-Crisis Warning: China Credit November 27, 2014