Catalysts for Crisis
1
Conditions for Crisis
• Total indebtedness is about 200% of GDP
– Corporate debt: 130%
– LGFV debt: about 90%
– Government: about 26%
• But these categories overlap
• Meanwhile, industrial production is slowing:
– 2013 power output growth <5%, coal output 2%, steel up
2%, cement flat
• And real credit rates are high, perhaps average 20%.
2
Less Growth from More Credit
3
0
3
6
9
12
15
18
0
1
2
3
4
5
6Nominal Credit Intensity
Real Credit Intensity
Total Social Financing (RHS)
Trend of Real Credit Intensity
Ratio:TSF/Incremental GDP Trillion RMB
Sources: PBoC, NBS, CEIC, The Conference Board
Using Infrastructure Investment to Drive Growth
4
-20
-10
0
10
20
30
40
50
60
70
2007 2008 2009 2010 2011 2012
Fixed Asset Investment (FAI)
Central Government FAI
Infrastructure FAI
Real Estate FAI
Percentgrowth, y-o-y, 3mma
Sources: NBS, CEIC, The Conference Board
Bank lending, total social capital, and money supply
• TSF & M2:Total Social Funding surged as % of
total, eclipsing bank lending. Bank lending was
38% of new lending. M2 money supply exceeded
200% of GDP
• Deleveraging: Substantial deleveraging going on
across China. Severe in benchmark cities such as
Wenzhou, Ordos, Changsha. Ordos has rapid
exodus of wealthy individuals, many leaving
substantial liabilities behind
• Local Government Finance Vehicles (LGFV): Being
privatized and their paper securitized to reduce
the “on balance sheet” debt of local governments
& banks. Local governments now selling future
tax revenue to private investors. Wenzhou is
selling off their Audi fleet
• Control M2 money supply
• Diversify, regulate, and supervise channels of capital to add
transparency and restore confidence
• Maintain stability of RMB value through PBOC and Forex
deployment
Choices facing the Chinese Government
M2 in terms of GDP M2 Growth (%)
M2 Level and Growth Rate
TSF vs. Bank Lending
B
Source: Central Bank of China, IMF
Source: Central Bank of China, Deloitte Analysis
Recoveries Become Briefer and More Shallow
6
44
46
48
50
52
54
56
Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12
PMI: new orders PMI: new export orders
The PMI measure of employment shows a steady fall.
7
46
46.5
47
47.5
48
48.5
49
49.5
50
50.5
51
may-12 jun-12 jul-12 ago-12 sep-12 oct-12 nov-12 dic-12 ene-13
PMI Employment
And the relationship to cash injections is very direct.
8
0%
5%
10%
15%
20%
25%
30%
35%
-80%-80%-80%-80%
-60%-60%-60%-60%
-40%-40%-40%-40%
-20%-20%-20%-20%
0%0%0%0%
20%20%20%20%
40%40%40%40%
60%60%60%60%
80%80%80%80%
Jan-2007 Jul-2007 Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010 Jan-2011 Jul-2011 Jan-2012 Jul-2012
Floor Space of Buildings Under Construction: Residential Buildings: YoY M2: YoY
Why the consumer data is useless
9
-2,000
-1,000
0
1,000
2,000
3,000
4,000
5,000
6,000
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
Q1
Q3
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Retail Sales ofConsumer Goods(NBS)
Difference withHouseholdConsumption figurederived fromExpenditure GDPAccounts
Difference withHouseholdConsumption figureestimated by NBSQuarterly HouseholdSurvey
Seasonal-adjusted real value at 2011 price (bn RMB)
Sources: CEIC, NBS, The Conference Board
But household consumption is shrinking
in each quarter.
10
-5%
0%
5%
10%
15%
20%
25%
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Householdconsumptionfrom expenditureGDP
Householdconsumptionfrom quarterlysurvey
Retail sales ofconsumer goods
Real year-over-year growth rate at 2011 prices
Sources: CEIC, NBS, The Conference Board
The Mechanics of Crisis
• Prices in certain locales increase yearly then monthly then
weekly then daily.
• Speed of financial innovation exceeds regulators’ ability to
control it and investors’ ability to understand the nature of
their investments.
• Velocity of money accelerates.
11
The Mechanics of Crisis
• Early defaults undermine market confidence. Market
participants begin changing their activity to focus on short-
term payback.
• Lenders raise rates and shorten maturities
• Capital flight accelerates.
• Corporates engage in carry trade by borrowing USD and
pledging RMB.
• Forbearance by some key financial institution ends.
12
Some Aspects of the Bubble
• Art prices skyrocketing, even for known fakes.
• Fast growth in sales of luxury watches, luxury cars.
• Speculation in almost anything: garlic hoarding,
$10,000 packets of cigarettes, tea selling for $100,000
an ounce, white spirits for 600,000 per bottle.
• “Land King” projects where prices spiral madly. Beijing
property now selling for 600,000/m2, up by 10x since
last year.
13
The Case of Ordos
• Universal participation in private lending funds.
• Housing prices rising monthly, weekly, daily, then hourly.
• Crash in October 2011. Banks needed bailout in February
2012.
• Property prices now 30-50% of what they were pre-crisis.
• Migrants, wealthy people have left the city. Retailing mostly
closed. Unemployment very high.
• Local government borrowing from state companies to meet its
fiscal needs.
14
New Manhattan: The Plan and the
Reality
15
Meizhou LED Base
16
Taizhou Logistics Port
17
Over-development Everywhere
• No risk associated with over-investment.
• New developments destroy rather than create jobs
• Developments “cash in” dormant land resources and
so expand the money supply before the economy is
capable of absorbing it efficiently. The waste in future
must be recognized as a reduction in GDP.
18
Some other bubbles
• Tulip Mania, The South Sea Scheme, Railway fever, 1929
• Each craze entailed the rapid expansion of credit
• There tend to be defaults then a long period of calm, while
market participants wait to see whether the bubble will burst,
Confidence declines, but people still want to take advantage of
the bubble.
• There will be mini-recoveries but ever briefer
• Credit becomes shorter term and higher-cost
• When one market participant steps down, the circle breaks.
19
Tulips: 1630s
• Booming textiles trade creates major wealth expansion
for the Dutch.
• Syndicates were forming to support voyages. Company
shares were traded.
• As prices rose, the quality of the tulips declined.
• Annual average wage: 200 florins. Emperor Augustus
tulip in 1637: 9,000 florins.
20
Edward Chancellor: “The Devil Take the Hindmost”
Souq al-Manakh, 1982
• Trade in Kuwaiti stock market was conducted using
post-dated personal checks.
• In eight months, the value of the cheques exceeded
$90 billion, and interest rates were 300%. The shares
exchanged were nominally worth $200 million.
• Cheques were due at end of year. But in August, one
speculator asked that a check be cashed early. The
owner defaulted and the market crashed.
21
Edward Chancellor: “The Devil Take the Hindmost”
South Sea Mania, 1720
• The expansion of British trade combined with the
murkiness of investment in colonial expansion to
generate speculation in many traded companies.
• The South Sea Company bought British public debt in
return for shares plus fiscal commitments to pay
interest. Then it traded the shares actively to increase
value.
• Copycat companies emerged. To protect the share
price, the government passed the “Bubble Act” to
curtail them—and this triggered a market sell-off.
22Edward Chancellor: “The Devil Take the Hindmost”
Some Commonalities
• Pre-condition is expansion of the money supply. Money has to
go somewhere.
• Forward delivery stretches out; the object of speculation is not
actually being delivered.
• A confidence jolt is followed by a quiet scramble to recover
value, then a decisive fall.
• There is always some specious argument about why the object
of speculation is actually very valuable—Florida real estate has
an ocean view. The internet will create phenomenal value.
Urbanization will generate 20 years of growth.
23
Two paths to crisis
• Probabilistic
– The system develops multiple areas of instability. Odds are
that some external shock will trigger a panic.
– Types of triggers:
• Large and politically sensitive default
• Bank run
• Pre-paid apartments are not delivered, owners protest publicly
• Significant fall-off in exports or major devaluation by a trading
competitor
• Big default by a debtor nation
24
Two paths to crisis
• Deterministic
– The banking system reaches the end of its ability to kick the
can down the road.
– Types of triggers:
• Term deposits, wealth management products default en masse;
investors lose their principal.
• Cash runs short; banks do not have money to lend. Economic
activity grinds to a halt.
• Government tries to ease cash shortage by printing money and
generating hyper inflation.
25
The Most Vulnerable Regions
• Inner Mongolia
• Zhejiang
• Jiangsu
• Hefei/Bengbu
• Guiyang
• Tianjin
26
Post-Crisis Scenarios
27
Scenario 1: Lost Decade
•Gradual deleveraging and absorption of over-
capacity means that the economy sees very low
growth, under 3% annually, for a very long time.
•Deflation. Consumers hoard cash.
•Growth drops even lower. Unemployment is high.
Scenario 2: Tabula Rasa
•Deflate asset value through high inflation,
significant devaluation of the currency, and
opening of capital account or re-issuance of a
new currency.
•De-legitimate the gray market, rewrite the rules.
•Use aggressive government buying to defend
against attacks on the stock market.
•Freeze deposits, out conditions on their
withdrawal.
• State assets are auctioned off.
Scenario 3: Fragmentation
• Governments, under pressure to find cash for
their own operations, begin freelancing. They
privatize whole functions and farm taxes. They
impose fees on services and unofficial tariffs on
products from other regions. Eventually, some
issue their own currencies.
• Some regional economies improve, some see
negative growth. Investment capital follows the
growth and exacerbates the imbalances.
Scenario 4: Dramatic Reform
• Its back to the wall, the central government
initiates sweeping reforms in financial services,
health, education, and distribution. Unrestricted
private ownership is permitted. Growth in
services sectors over time lifts the banks out of
the crisis and recapitalizes them.
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