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Thursday, September 26, 2013 2:24 PM

Bulls and Bears Debate China: Property Bubble Expands Again; GDP Growth Picks Up; Economic Recovery Underway? No Says Michael Pettis

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Bulls think China is on the mend. I don't and neither does Michael Pettis at China Financial Markets.

Bullish Arguments

1. Property Prices Rising

The Financial Times reports China house price surge raises prospect of steps to cool market

Prices for new homes in Beijing, Shanghai and Shenzhen – the country’s three largest cities – surged 18-19 per cent year-on-year .

The sharp increase in prices in the biggest cities is the latest evidence of a full recovery in the Chinese property market after it was smothered by several tightening measures this year. A series of land sales have set record prices since August, with real estate developers ramping up their competition for the best plots in the biggest cities.

2. China Rich in Reserves

The South China Post reports US meltdown shadow looms large over China but observers believe Beijing could use its massive foreign reserves to save financial system if shadow banking activity spirals out of control.

Mervyn Davies, a former head of Standard Chartered and British government minister, said: "China is very rich in reserves … At the end of the day, the [Chinese] banks do need recapitalising, which is not a huge challenge to them because the government can recapitalise the banks."

Echoing Davies' view, Hang Seng Bank's executive director Andrew Fung said: "Underlying assets of shadow banking on the mainland are very different from US subprime assets. It is more liquidity risk rather than credit risk. I do not see the risk of a big bank failure in China."

3. Hidden Debt Doesn't Matter

4. China's GDP Growth Picking Up

Pettis Replies ...

Pettis On Property Prices

I expected real estate prices to keep rising as long as credit is so freely available, but it is unclear to me why real estate prices have risen so dramatically in the past couple of months. Part of it may simply be that few Chinese see any real alternative to real estate as a way of saving. Deposit rates are still low and the stock market has been uncooperative.

We are often told that a fall in housing prices won’t affect the real economy in China much because, unlike in the US, the amount of real estate financed by mortgages is quite low. This may well be true, although much of the leverage behind residential real estate consists of borrowing from friends and family and so is not recorded.

With 60% of household wealth consisting of real estate, I find it hard to believe that rising prices have not goosed consumption to levels higher than it otherwise would have been. If this is true, it is hard to imagine that falling prices might not have the opposite effect on household consumption, especially if prices drop anywhere near the same extent that they have dropped after other housing bubbles. It is premature, in other words, to write off the impact of falling housing prices on consumer behavior simply because Chinese housing purchases are not structured in the same way that American or European housing purchases are.
Pettis on Reserves
I disagree very strongly with Mervyn Davies’ claim that because the PBoC is “very rich in reserves” it will not be much of a challenge to recapitalize the banks. China’s reserves only matter to its credit position if China faced a problem of external debt.

It doesn’t, and so the amount of reserves are almost wholly irrelevant, Because this argument seems to be reviving, it makes sense, I think, to repeat why central bank reserves cannot in any way help China resolve the crisis. I will leave aside the problems of whether the reserves are transferred in the form of foreign currency, in which case it does little to satisfy domestic RMB-denominated funding needs, or in RMB, in which case the PBoC must stop buying dollars in order to hold down the value of the RMB and in fact must sell dollars, which would cause the value of the RMB to soar, thereby wiping out the export sector in China.

A much more important objection is that the idea that reserves can be used to clean up the banks (or anything else, for that matter) is based on a misunderstanding about how the reserves were accumulated in the first place. There seems to be a still-widespread perception that PBoC reserves represent a hoard of unencumbered savings that the PBoC has somehow managed to collect.

But of course they are not. The PBoC has been forced to buy the reserves as a function of its intervention to manage the value of the RMB. And as they were forced to buy the reserves, the PBoC had to fund the purchases, which it did by borrowing RMB in the domestic market.

This means that the foreign currency reserves are simply the asset side of a balance sheet against which there are liabilities. What is more, remember that the RMB has appreciated by more than 30% since July, 2005, so that the value of the assets has dropped in RMB terms even as the value of the liabilities has remained the same, and this has been exacerbated by the lower interest rate the PBoC currently earns on its assets than the interest rate it pays on much of its liabilities.

In fact there have been rumors for years that the PBoC would technically be insolvent if its assets and liabilities were correctly marked, but whether or not this is true, any transfer of foreign currency reserves to bail out Chinese banks would simply represent a reduction of PBoC assets with no corresponding reduction in liabilities. The net liabilities of the PBoC, in other words, would rise by exactly the amount of the transfer. Because the liabilities of the PBoC are presumed to be the liabilities of the central government, the net effect of using the reserves to recapitalize the banks is identical to having the central government borrow money to recapitalize the banks.

Bailing out the banks, it turns out, is conceptually no different than transferring debt from the banks to the central government. China can handle bad debts in the banking system, in other words, by transferring the net obligations from the banks to the central government, and the large hoard of reserves held by the PBoC does not make it any easier for China can resolve any future debt problems. In fact if anything it should remind us that when we are trying to calculate the total amount of debt the central government owes, the total should include any net liabilities of the PBoC, and that these net liabilities will increase by 1% of GDP every time the RMB strengthens against the dollar by 2%.
Pettis on Hidden Debt
I want to address another related fallacy that pops up a surprisingly large number of times when I discuss the net liabilities of the central bank. I am often told that because these liabilities are hidden in the central bank books, and so no one really knows how much debt the PBoC adds to the central government’s debt burden, they really shouldn’t matter in our calculations.

Even those who do not understand why this reasoning is incorrect should know that it must obviously be incorrect. If it weren’t, any country could solve all of its debt problems merely by borrowing in a non-transparent way through the central bank. As the Greeks and the Italians most recently showed us, non-transparent borrowing may cause us to recognize a problems later than we otherwise would have, but it cannot solve the problem.

The reason is because in any case debt must either be serviced or the borrower must default. If the assets which were funded by the debt do not create enough wealth with which to service the debt, and if the borrower does not default, then by definition there must have been a transfer from some other entity to cover the difference between the debt servicing cost and the returns on the asset.
Pettis on GDP
Debt always matters because it must always be paid for by someone – even if the borrower defaults, of course, the debt is simply “paid” by the lender. This is why the fact that debt in China seems to be growing much faster than debt-servicing capacity implies slower growth in the future.

And debt is almost certainly rising faster than debt-servicing capacity. This is the message of the most recent third quarter growth numbers. A number of sell-side analysts have taken the recent surge in growth as indicating that Chinese growth has bottomed out and that China is in the process of successfully managing the rebalancing. Many of them have once again raised their growth forecasts, after dropping them in the first and second quarters in response to slowing growth.

This can only indicate that they do not understand the rebalancing process. China can get as much growth as it likes as long as it has borrowing capacity.

There is nothing in the most recent batch of numbers to suggest that anything at all has changed in the Chinese economy. GDP growth is up because credit is up even more, and this is confirmed by reports that the surge on growth has been pretty narrowly limited to heavy industry and the state-led sectors, which tend to have the easiest access to credit and the least concern about the profitability of investment. Until Beijing is truly able to get control over credit expansion, and to tolerate the much slower GDP growth that will inevitably result, growth rates will stay in the 7-8% range and fluctuations within that range will mean very little.
China Shadow Banking Returns as Growth Rebound Adds Risks

Here's a link I picked up from Pettis in his email: China Shadow Banking Returns as Growth Rebound Adds Risks
China’s broadest measure of new credit almost doubled in August from the previous month in a sign leaders are committed to meeting economic goals even at the cost of adding financial risks.

The first pickup in credit growth after an unprecedented four straight declines, the fastest gain in industrial output in 17 months and above-forecast exports signal better odds that Premier Li Keqiang will achieve his 7.5 percent expansion target this year. The data also mark a resurgence in shadow banking that poses risks for the financial system after a record credit boom in the first quarter.

Shadow lending, which allows banks to bypass controls and capital requirements, is flourishing in China because an estimated 97 percent of the nation’s 42 million small businesses can’t get bank loans, according to Citic Securities Co. The industry may be valued at 36 trillion yuan, or 69 percent of gross domestic product, JPMorgan estimated in May.

Bankers’ acceptance bills and entrusted loans, two of the categories within aggregate financing, are “highly correlated with shadow banking activities,” said Hu Yifan, chief economist at Haitong International Securities Group in Hong Kong.

Yesterday’s figures showed entrusted loans of 293.8 billion yuan in August, a record in data going back to 2002, after 192.7 billion yuan in July. Bankers’ acceptance bills were 304.5 billion yuan in August, compared to a 178.3 billion yuan decline in July.
So why is China's GDP growth rising again? The simple answer is shadow banking has revived. Is it sustainable? Of course not.

Debt is growing faster than it can possibly be paid back. In his email Pettis stated that he felt like a broken record, repeating the same story over and over again.

I don't mind, because it's clear that people have not gotten the message, especially in regards to using alleged reserves. Please re-read that section until you understand it.

One further point that Pettis has mentioned in the past but did not this time is that even if China could use reserves to stockpile things like copper, it would be horrendous pro-cyclical policy.

Balancing requires a slowdown in State-Owned-Enterprises as well as a slowdown in housing, roads, airports, many of which are empty or unused.  Stockpiling goods when China's infrastructure is massively overbuilt, and driving up the price all the while, would not be a smart thing to do.

The Great Rebalancing

Michael Pettis taught me much I know about global trade.

I highly recommend Michael Pettis' his book "The Great Rebalancing".

The book covers global trade issues with a focus on current events in Asia, Europe, the United States, and the commodity producing nations.

Read the book and you will see that much of the "common wisdom" espoused by others on global trade issues is not "wisdom" at all.

In a chapter called "The Exorbitant Burden", Pettis debunks the nearly universal misconception that the United States receives a great benefit from having the world's reserve currency. That chapter alone, is well worth the price of many books.

Mike "Mish" Shedlock

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