Most political press in China or the United States has the predicted blend of pundits calling for a tougher line or more engagement with the other. It is however, both shocking and appalling that the China News Daily, a mouth piece of the Party previously known as Communists, would publish a piece calling the departing US Ambassador Gary Locke a “banana”. (The original in Chinese is here and the New York Times coverage is here). Just yesterday I was told b a senior ranking party member that China has laws that protect “human dignity.” I guess they just don’t apply to departing US ambassadors, members of the press, or people who have dinner. The law protecting human dignity I guess don’t go quite that far. The move to racially attack a departing US ambassador of Chinese ancestry who said such contraversial things like “it’s my view that if the United States and China cooperate there’s almost nothing that we cannot solve” is nothing less than disgusting an appalling. Hopefully this despicable language will be condemned within China and not just outside. That is realistically unlikely because the respect for human dignity doesn’t extend quite as far as some in China like to pretend.
Interpreting Chinese economic and financial data is difficult in the best of times. What Winston Churchill said of Russia is true of Chinese economic data: it is a riddle, wrapped in a mystery, inside an enigma. This is even more true when attempting to understand the discontinuity around major Chinese holidays like Lunar New Year.
A mass of confusing and often contradictory data has come out around the Chinese New Year. For those who have not spent significant time in China, it is difficult for most people to understand this holiday. Not only is the time period longer than most holiday periods in other countries but there is significantly less business, retail excluded, activity for a sustained period of time.
Most of China has very minimal business activity for 2 weeks with at least one additional week where people are either leaving or coming back so that there is a total of 3-4 weeks of significantly reduced business activity around Chinese New Year. One foreign businessman jokingly told me Chinese New Year ruins 6 months of the year: for three months before, people are making excuses about why things can’t get done because of the upcoming holiday; for three months after, people are making excuses about how they just got back from Chinese New Year so things can’t get done. According to him, this left only 6 months of actual working time in China. He was only half joking.
This pattern skews the data. Companies may stock up or they may have a flurry of final activity. The Chinese New Year however can skew the data. Recently, markets were cheered when China reported higher than expected import and export levels. However, it emerged shortly thereafter that many companies appeared to be stockpiling inventory and rushing to fill orders when inventories of key barometers like iron ore hit a 17 month high. This was followed by a concerning drop in the Chinese PMI which roiled markets, despite the fact that it covered the period of lowest business activity due to Chinese New Year. Much of the recent data appears to be significantly impacted by the Chinese New Year holiday.
This matters because it is important to not get moved by week to week or month to month data discontinuities when looking at China. The fundamental problems facing Chinese markets remain unchanged by the New Year holiday. To take one simple example, the steel industry remains an enormous problem and a financial and political risk. Hebei steel mills are polluting Beijing and posing financial risks. One city in Hebei makes more steel that the entire United States, which even rapid growth in China is unable to use entirely. The glut of supply has driven down prices which has prompted people to use steel as collateral for loans increasing inventory rather than consumption. One analyst notes that rapid iron ore import growth coupled with inventory growth indicates “…non-fundamental factors such as financing demand.”
Chinese economic data is difficult enough in the best of times to properly understand. Adding in lumpiness around Chinese New Year and non-traditional behavior for goods such as steel and exports to collateralize debt, only further complicates matters. Chinese New Year causes many businesses to either move forward or delay, shifting, business behavior towards their needs. Don’t worry about individual data points around Chinese New Year. Worry about the big problems that haven’t been addressed.
The South China Morning Post has dropped a bombshell, which if you are an economist in China that does anything less that say how great and wonderful the Chinese economy is, comes as absolutely no shock. According to the SCMP:
“Economic researchers and people working for state-owned media told the South China Morning Post that the central government’s propaganda department had instructed senior editors at major official media outlets to be cautious about whom they invite to talk about China’s economy and what they might say about the problems and challenges it faces after its long run of supercharged growth. “There’s no black list or white list, but it’s clear we are now being encouraged to invite economists and analysts with domestic securities firms and banks to talk about China’s economy, especially on live broadcasts,” said one mainland media source who declined to be named given the sensitive nature of the matter.”
If you are shocked by this, you would probably be just as shocked to learn they speak Chinese in China or that there is gambling in Casablanca. As an economist who has pointed out discrepancies in official data and problems in the banking industry, among other official sins, I can unequivocally state that all this is true and more. Within the past year my office has been broken into, I strongly believe my home has been broken into, there is every indication my phone calls are all listened to, and my computer has been hacked or at the very least targeted.
It began when I wrote a blog post, which has since been taken down due to threats against my personal safety, in which I mentioned some of the activities of a large, powerful, and very influential Chinese company. The information I linked to and wrote about this company was nothing more than public domain information that had already been published by global news organizations. Though embarrassing, I wrote nothing new about this company that was not already in the public domain.
Shortly thereafter, I received word from a senior person at my school that three lawyers and a secretary from this company in Beijing had flown to Shenzhen and made numerous civil and criminal legal threats against me also urging that I be fired immediately. School personnel told me they would do nothing to protect me, strongly advised me to take down the offending post, urged me to make a full apology to the company, but said that they did not see the need to fire me. Though these actions may have been taken in solely by the Chinese firm, I was also told that the actions by this Chinese company were likely taken with the prior knowledge of powerful interests in Singapore.
Nearly immediately my computer was attacked, I believe for different reasons my phone was monitored from that day forward, my home internet has been cut off for extended periods of time despite my neighbors being perfectly fine, and my office was broken into among other intimidation tactics. There have been other small incidents but I have every reason to believe that none of the basic tactics have ceased for nearly 1 year.
I have personally made my peace with what has happened and have chosen to continue to write about what I believe the data says and what companies are doing. It is extremely intimidating to receive the threats, intimidation, and daily reminders that my activities are so closely monitored. I personally know others who have left China because their “safety could not be guaranteed”.
For most academics not in China, it is difficult for them to understand the level of scrutiny and monitoring we face on regular basis. Most professors have students assigned to monitor them and security officials approaching many people to report on our behavior. Our email is widely acknowledged, even by students, as being read. While there are some overt obvious forms of intimidation as I have detailed, much of it is also the “deal you can’t refuse” variety. There are no overt threats but the message is clear.
More than being surprised at what the South China Morning Post is reporting, I am surprised that anyone is surprised by this news. Yu Jie in his new book calls Xi Jinping the Godfather and this is a good model for much of the intimidation and threats. While China has changed enormously in recent years and even in my nearly 5 years here, the repression and intimidation has only worsened.
Economists are targeted because some us choose not paint a rosy picture of the Chinese economy. It should come as no surprise that the People’s Bank of China chose Deutsche Bank economist Ma Jun as its chief economist given he has a 2014 Chinese growth projection a full percentage point higher than the official target.
Like the fable of the emperor’s new clothes, economists who tell those in power what they want to hear are lauded while those of us in China who point out the obvious face threats. Who knew being economist would bring such danger?
The Financial Times has a great piece about the mysterious Chinese trade data which saw imports and exports both rise by more than 10% in the time period leading into Chinese New Year. Given that PMI numbers had been slowing the robust growth of trade figures threw many China watchers for a big surprise. Noted Chinese data skeptic Stephen Green of Standard Chartered joked that “we’re flying blind and nobody knows how to properly adjust this data….we should all just take an extended holiday.”
The problem as has been repeatedly stressed on this blog is that Chinese data does not actually mean anything. It is manipulated and fraudulent. This creates three specific problems. First, people expect and treat Chinese data as if it is an accurate or good faith estimate of reality when in fact it is not. If people begin to treat Chinese as an exercise in futility and adjust accordingly, the data will be more understandable. In other words, adjust for the systematic bias in the data and it will become understandable. Is there anyone that really believes that price inflation in Chinese housing is only 8% since 2000? However, if you treat it as an accurate portrayal of reality, it will always puzzle you.
Second, even when data is reasonably accurate there is an underlying manipulation. For instance, in the middle of 2013 it came to light that fake invoices where Chinese exporters put reminbi accounts in Hong Kong was significantly inflating trade data. In other words, even though official data might have been reporting reasonably accurate data, there was an underlying manipulation that caused the overall picture to be false. Chinese exporters were not healthy but instead making up the data.
Third, the confusion begins when people try to place the discontinuous data trends into a coherent story that explains the Chinese economy. Economic analysis should focus on directions and trends rather than focusing on one data point. However, every Chinese economic variable has a different bias and set of underlying manipulation. Let’s take a simple example. GDP is going to be manipulated upwards, we know that. Most pollution levels should be strongly correlated with GDP but there is a bias to manipulate the pollution data downwards because China wants everyone to believe it is making progress on its environmental record. Not only are GDP and pollution negatively biased (biased in different directions) but the magnitude of the bias is likely to be different. GDP might be biased upwards by 25% but air pollution levels are likely to be biased by a minimum of 50% and probably even more. The underlying result is that making sense of Chinese data is a riddle wrapped within an enigma surrounded by a question.
For the geeks out there, probably the best suggestion for making sense of biased data is to use the geometric mean. Additionally, other research institutions have begun publishing third party data correcting for official Chinese data which has embarrassed Chinese bean counters with some data being incredibly far off.
The basic point being is that if you are an investor trying to make sense of Chinese economic data: take some good advice and take the rest of the week off.
Since global markets are breathing a bit easier since the China Credit Trust bailout of its ill fated wealth management product sold through ICBC, it seems appropriate to conduct a post mortem about what happened and the implications.
- The original loan was a mega-gamble from the outset. The 3 billion reminbi loan was made to a group seeking to buy a Shanxi coal mine with 50 million reminbi in equity. There were additional loans totaling another 4 billion raising their debt to 7 billion rmb using 50 million in equity capital. For those of you keeping score at home that is a debt to equity ratio of 140. To provide some perspective, China Credit Trust and ICBC made a combined 180 million rmb for creating and distributing the product. In other words, they made nearly 4 times what the receivers of the loan put up to fund the deal! Not only was the debt level absolutely astronomical, but once fees were included, the annualized percentage rate topped 14%!(Google translate). I don’t care what country, industry, or economic climate you live in: a company with a debt to equity ratio of 140 paying 14% annually trying to buy another company is extremely high risk.
- The collapse of Shanxi Zhenfu Energy in many ways appears to be a standard case of corporate fraud. While much has been made of coal mine consolidation and drops in commodity prices, the collapse of Zhenfu appears much more straightforward. There are reportedly numerous instances of “related party transactions (Google translate)”. The commonly reported charge of Zhenfu “taking deposits” is really better understood as off balance sheet transactions designed to hide debt. In another instance, one mining asset valued at 445 million rmb ($75 million USD) had 415 million rmb of “intangible assets”. In one deal, Zhenfu transferred one mine to an investment company valued at 754 million rmb or approximately $126 million USD while the origin of the investment company that received the mine remains unknown with one paper speculating it is “loan sharks”. There are also reports of large numbers of missing assets. Many Shanxi based coal companies survived the past few years in fine shape without collapsing in spectacular fashion. While weakness or the consolidation did not help, they did not cause or precipitate the downfall of Zhenfu Energy.
- ICBC’s role was not simply as a distributor of the wealth management product. Though it has been widely reported that ICBC acted only as a distributor of the product originated by CCT, limiting both their financial and legal liability, what has been unreported is that according to the 21st Century Business Herald, they also acted as the trust bank and custodian of funds raised. Furthermore, CCT has stated that the ICBC Shanxi branch actually recommended the client to them and then agreed to distribute the product. Furthermore, given that some estimates for Zhenfu Energy have assets pegged at 500 million rmb and total debt at 5.9 billion rmb, the discrepancies invite questions about third party culpability. If ICBC acted as the custodian bank dispersing funds for bogus assets and related party transactions while also recommending the client to CCT, this invites a wealth of questions about the role ICBC played and whether they bear both ethical and legal liability for the Zhenfu Energy collapse.
- China Credit Trust is not a shadow bank but a state owned company covered with conflicts of interest. Despite the frequent perception that Chinese shadow banking is run by underworld corrupt gangsters (which might still be an appropriate term), China Credit Trust (CCT) is owned by some of the largest and most well connected state owned firms in China. CCT is owned by a consortium of other Chinese state owned enterprises (SOEs). CCT’s largest shareholder is the large state owned insurance company China Peoples Insurance which among other distinctions holds nearly 20% of American International Group (AIG) and is the largest casualty insurer in China. The second largest shareholder Guohua Energy Investment is a subsidiary of the Shenhua Group the “largest coal producing company” in the world. The third, fourth, and sixth largest shareholders are the Yanzhou Coal Mining Group, Yongcheng Coal Holdings, and China National Coal Group which is the third largest coal company in the world. Its remaining shareholders are mostly other coal companies. In other words, CCT is owned by some of the largest and most powerful companies in China with ICBC distributing its products.
- If you noticed a theme among shareholders…. The wealth management product created by CCT and marketed by ICBC was ultimately loaned to an ambitious coal miner. More than 50% of CCT shares are held by coal miners and related companies. However, not only are coal miners the dominant interests in a company making a failed and enormously risky loan to a Shanxi coal miner but the major Shanxi coal miners are shareholders in the company making loans to a Shanxi coal miner. The Shanxi Coking Coal Group and the Shanxi Lu’an Mining Group which also has interests in finance and solar power, are minority owners in CCT. Furthermore, most of the large national coal companies have significant interest in the Shanxi region given its importance to Chinese coal mining. To put this another way: CCT was owned by coal miners and Shanxi coal miners originated a scandalously bad loan to an unknown Shanxi coal miner at 14% apr with a total leverage ratio of 140 while putting the risk on unwitting consumers.
- The clear implication being: this deal just doesn’t pass the smell test.
- Even in the heady days of Chinese financial lending, an unknown company does not walk into a bank and raise $1 billion USD with a leverage ratio of 140 to 1. There had to be a very powerful person or entity behind this deal.
- There are obvious conflicts of interests between the originating institution, its shareholders, and the borrowers. A trust company owned by coal miners making a bad loan to a coal miner where others bear the risk is simply too problematic.
- ICBC clearly needs to answer more questions about its role as the custodian bank for dispersing funds for non-existent assets and related party transactions and whether they recommended the client to CCT. There very well might be a reason that they have reportedly agreed to fund some of the bailout.
- To date, I have been unable to link any of the shareholders of CCT or other vested interests to any of the transactions or assets in question. However, apparently others have had just as much trouble finding people behind the transactions or assets.
There are two final points that needs to be made about this situation. First, while the Chinese government has come under criticism, internally and externally, for deciding to bail out the trust product rather than let market forces and risk prevail, this fails to grasp a basic tenant of the social contract. Having lived in China and talked to people and sat in meetings with senior executives at Chinese and foreign institutions, I have heard the unwavering faith and demands investors and common have in the ability of the Chinese government to manage any situation. The Chinese government clearly understands the ramifications of breaking the social contract with people who expect nothing less that continued economic prosperity promised by state owned banks like ICBC.
Second, the decision to bail out CCT is obviously political, but not for the reasons most people believe. The Chinese government has to bail out as many of these products as possible because there is no greater flash point for the Chinese population that continued and expanding prosperity. An economic downturn or financial crisis has the very real potential to prompt a political crisis which Beijing will not tolerate under any circumstances. They have to bail these products out.
Zhenfu Energy, CCT, and ICBC may have brought a fright to global financial markets, but given the uniqueness of the collapse, it may not be the harbinger of events that many believe. The systematic fraud and misrepresentation on multiple levels by many parties separates it from more standard forms of credit risks that concerns most pundits. While the potential for default was real, it is important to understand the details driving these potential events and their potential spillover.