China's market Leninism turns dangerous for the world

Global markets have swung overnight from a mystical faith in Communist competence to near revulsion. But this August storm may yet blow over

By Ambrose Evans-Pritchard


The sudden loss of confidence in the anchor economy of East Asia has struck before the West is fully back on its feet 
 
 
The world financial system is at a dangerous juncture. Markets no longer believe that China’s Communist leaders are in full control of the country’s $27 trillion debt bubble, or know how to manage fast-moving events beyond their ken.

This sudden loss of confidence in the anchor economy of East Asia has struck before the West is fully back on its feet after its own debacle seven years ago.
 
Interest rates are still near zero in the US, the eurozone, Britain and Japan. Fiscal deficits are at unsafe levels. Debt is 30 percentage points of GDP higher than it was at the onset of the Lehman crisis. The safety buffers are largely exhausted.
 
“This could be the early stage of a very serious situation,” said Larry Summers, the former US Treasury Secretary. He compared it to the two spasms of the Asian crisis in the summer of 1997 and again in August 1998.
 
Ominously, he also compared it to the "heart attack" of August 2007, when credit markets seized up on both sides of the Atlantic and three-month US Treasury yields plummeted to zero.

That proved to be a false alarm, but it was an early warning of the accumulating stress that would bring down Western finance a year later.
 
Full-blown contagion is now ripping through the international system. The main equity indexes in Europe and the US have all sliced through key levels of technical support.

Once the S&P 500 index on Wall Street broke below its 200-day and 50-week moving averages last week, it was extremely vulnerable to any bad news. This came last Friday with yet more grim manufacturing data from China.


JP Morgan says the Caixin PMI indicator that so alarmed markets is skewed to the weakest segment of the Chinese economy and overstates the trouble, but such subtleties are lost in a panic.

It turned into a global rout after the Shanghai composite index crashed 8.5pc on China’s “Black Monday”, pulverizing its July lows after the central bank (PBOC) - oddly passive - refused to come to the rescue as expected with a cut in the reserve requirement ratio for banks.

Beijing’s botched efforts to prop up the country’s stock markets have collapsed. An estimated $300bn of state-orchestrated buying achieved nothing, overwhelmed by an avalanche of selling by investors forced to cover margin debt.

Professor Christopher Balding from Peking University wrote on FT Alphaville that China is lurching from one incoherent policy to another, shedding credibility and its aura of omnipotence at every stage. “There is a very real risk that Beijing is losing control of the story,” he said.

The speed with which this episode has now engulfed US markets - trading at 50pc above their historic average on the long-term Shiller price/earnings ratio, and primed for trouble – suggests that events could all too easily metastasize into a self-perpetuating crisis of confidence. The Dow may have rebounded after a record 1,090-point drop at the opening bell, but such tremors cannot be ignored.

“Circuit-breakers are needed, given how quickly markets have moved. Crises are highly non-linear events and ruling them out isn’t wise,” said Manoj Pradhan from Morgan Stanley.

The question is whether China’s economy will itself prove to be the circuit-breaker by confounding the predictions of economic meltdown. There are signs that growth is poised to pick up after a deep slump in the first half of the year, caused by a combined monetary and fiscal crunch.

Spending contracted 19.9pc in January as local government reform went horribly wrong. It did not recover fully until May and June, when the new bond market took off. The fiscal stimulus will feed through over the next six months.


Simon Ward from Henderson Global Investors says his measure of China’s money supply – “true M1” – turned negative late last year for the first time this century. It has since recovered briskly and is growing at a 10pc rate, implying a recovery of sorts a few months later.

The Shanghai equity collapse has been spectacular, but the number of shares in private hands amounts to just 30pc of GDP, compared to 81pc on Wall Street in 1929 and 183pc in 2000.

The wealth effects are limited. “Only one in 30 Chinese owns equities. We think the authorities should just let the chips fall where they may,” said Mark Williams, chief Asia strategist for Capital Economics.

Property is far more important. Home ownership rates are almost 80pc in China and the housing market is recovering, with prices rising 6.5pc in the big Tier 1 cities over the past year and finally bottoming out in the regions.



Yet what began two weeks ago as a technical move by the PBOC to end China’s dollar exchange peg, and switch to a managed float, has set off a global crisis with a life of its own that cannot easily be reeled in.

The PBOC’s move was widely seen to be the start of a devaluation push that would transmit a deflationary shock through East Asia and the rest of the world.

China is burning through foreign reserves at a blistering pace to stabilize the yuan and offset capital flight estimated at $35bn a week. This is automatically tightening monetary policy, squeezing liquidity, and risks holding back the very recovery in China needed to quell doubts.

Whether or not China’s economy is as weak as feared, the crisis is feeding a global chain-reaction through the entire nexus of emerging markets (EM), now half the global economy and therefore a greater threat than in the previous EM crises of the early 1980s and the late 1990s.

“We are seeing the worst of all storms for emerging market currencies,” said Bernd Berg from Societe Generale.

“This crisis has the potential to become worse than the Asian crisis in 1997/98 as it is spreading globally. Panic selling is triggering a bloodbath among EM currencies,” he said.

The 1998 Asian crisis did not lead to a global recession. The US and European economies brushed it off in the end. Markets raced on for another two years.



Yet it felt deeply threatening at the time. The Russian default triggered the collapse of the huge US hedge fund Long Term Capital Management, forcing the New York Fed to intervene to avert a systemic meltdown. The US slashed interest rates.

The Fed cannot cut rates this time, but it can issue a clear signal that it plans to delay rate rises.

The futures markets are already pricing this in, slashing the chance of a rise in September to just 24pc, down from 50pc on Thursday.

The dollar is already weakening against the euro and the yen. Once the dust settles, this should take some of the sting out of the EM crisis, deferring the day of reckoning for companies in Latin America, Turkey, China, and other emerging regions holding an estimated $4.5 trillion of US dollar debt.


From BIS


The violent moves over recent days may prove to be no more than an August squall. “Liquidity has dried up over the summer and that has exaggerated the moves,” said Marc Ostwald from ADM.

“The consensus trades are getting blown up and we are seeing an unwinding of carry trades as people get stopped out of positions. But credit stress is not that high by historical standards,” he said.

The economies in Europe and the US are lacklustre but recovering gradually. China may, in reality, be on the cusp of another upward mini-cycle, the latest in a string of stop-go episodes.

What is clear is that the world is no longer willing to give the economic benefit of the doubt to Chinese leaders. The pretensions of market Leninism have been shattered by one policy blunder after another over the past year.

Global markets have swung almost overnight from a mystical faith in the competence of the Communist Party to near revulsion, doubting everything until proven. From now on, Beijing is on probation.


China to Flood Economy With Cash as Global Markets Lose Faith

By Lingling Wei and Mark Magnier


BEIJING—The selloff in Chinese stocks accelerated Monday, adding pressure on Beijing, which is planning to flood its banking system with new liquidity to offset effects of its recent surprise currency devaluation, according to Chinese officials and advisers to the central bank.

Stocks fell sharply in morning trading, with the Shanghai Composite Index down about 8%, bringing its losses since its mid-June peak to roughly 37%. Stock markets also were down Monday morning in Japan and South Korea.

The expected move to free up more funds for lending—by reducing the deposits banks must hold in reserve—is directly aimed at countering the effects of a weaker currency, which could send more funds away from Beijing’s shores. The moves reflect an economy increasingly failing to cooperate with Chinese leaders’ playbook to control the world’s No. 2 economy.

Beijing’s struggles this summer have spooked many investors into viewing China as a threat to, rather than a rescuer of, global growth. During the financial crisis of 2008 and early 2009, China, with a colossal stimulus plan, acted as a shock absorber. Lately, it is China that is providing the shocks.

Over the past week, it has grown clear how dependent a growth-starved world is on China, which accounts for 15% of global output but has contributed up to half of global growth in recent years.

Given this dependency, one reason markets have been so unnerved is that China’s economy remains something of a black box. For starters, analysts have long wondered about the accuracy of government economic statistics. And levers pulled by Chinese policy makers can be unconventional.

This is seen in Beijing’s desire to micromanage the yuan’s value, which undercuts its ability to pursue an independent monetary policy because of spillover effects on domestic liquidity.

The cut in bank reserves, which could come as early as this week, would follow several others this year and four interest-rate cuts since November that have failed to juice growth and channel bank lending to the so-called real economy.

A key problem is that risk-averse banks continue to favor state-owned companies, eschewing private enterprises with less-traditional collateral and balance sheets. This often leaves entrepreneurs with higher growth potential to fall back on high-interest nonbank financing or go without. Meanwhile, many state-owned companies, already awash in cheap capital, are reluctant to borrow because of overcapacity in various industries.

High-tech entrepreneurs say they are having even more difficulty securing financing since the steep Chinese stock-market fall that started in June, as investors grow more cautious. Zhong Shaofeng, founder of a venture-capital firm in Shenzhen called Zhijin VC, said that instead of asking wealthy individuals to commit large sums for his latest startup investment fund, he has created a new fund that invests small amounts in specific projects. In this climate, “it’s easier to ask more people for small amounts of money,” he said.

The People’s Bank of China’s latest planned move, which could come before the end of this month or early next month, would involve a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing 678 billion yuan ($106.2 billion) in funds for banks to make loans.

One option being considered at the PBOC is to aim the planned reserve-requirement cut only at banks that lend significantly to small and private businesses, the ones deemed key to the country’s future growth. Such strategies, however, haven’t proved effective in the past in channeling credit to particular borrowers.

On Friday, a long stream of bleak economic news from China appeared to reach critical mass.

When a private survey showed manufacturing sentiment as the worst in six years, markets around the world tanked. U.S. stocks suffered their worst one-day loss in four years, oil futures hit multiyear lows and emerging-market currencies gyrated on devaluation fears.

“Views about China’s economic prospects appear to be shifting from serious concern to near panic,” said Eswar Prasad, a Cornell University professor and former China head for the International Monetary Fund.

China’s economy is still growing at a fast clip compared with Western nations. And China has a vast $3.7 trillion in foreign-exchange reserves to help it weather shocks.
 
But its current target of 7% growth this year would be China’s slowest in about a quarter-century, and Beijing clearly doesn’t have the same control over its economy as it has demonstrated in past years, such as during the financial crisis.

Earlier in 2015, Beijing hoped to use a rallying stock market to channel funds to indebted companies. But when stocks fell in June and July, a flurry of interventions to prop up the market just exacerbated the impression of leaders losing control.

Then, after China devalued the yuan earlier this month, surprised markets drove the yuan down more than Beijing expected, prompting the central bank to intervene again.

Also this month, the government’s slow response to a chemical disaster in Tianjin added to a perception of wobbly crisis management.

“The world is starting to realize China is not nearly as competent as thought, especially in the economic sphere where everyone gave it good grades,” said Fraser Howie, co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise.”

Some of the tools China has traditionally relied on to support growth are losing effectiveness as their repeated use runs up against structural inefficiencies and a larger economy. China’s $10.3 trillion economy in 2014 is five times its size a decade ago.

“The room for fiscal expansion is rather limited,” said a senior economic adviser to China’s leadership, adding that policy is less effective as the economy gets bigger. “In the past, you would only need one yuan of investment to achieve a certain growth rate, but now it probably would require twice that amount,” the adviser said.

At just-completed summer talks at the northern seaside town of Beidaihe, China’s senior officials were divided over how to stimulate the economy, according to people familiar with the matter.

It wasn’t a disagreement over whether to accept slower growth, one of the people said. “The question is more about what to do to reach the 7% growth target for this year,” said this person, who added: “The government has a much tougher job of maintaining growth now compared to seven years ago.”
 
The old recipe, relying on state investment and exports, is losing effectiveness faster than expected. Exports fell 8.3% year-over-year in July, factory orders are down, and construction starts fell 16.8% over the first seven months of 2015 from a year earlier.

Even China’s car factories are feeling the squeeze, with General Motors Co. and Volkswagen AG now running their plants in China below full capacity for the first time.
New would-be drivers of the economy—high technology and entrepreneurship—aren’t filling the gap quickly enough.

In southern China, Shenzhen’s Nanshan district is buzzing with activity from hundreds of technology firms, from Internet giant Tencent Holdings Ltd. to tiny startups confident of continued growth in the Internet sector. But despite double-digit growth rates, the sector’s size isn’t enough to replace the old economy any time soon.

Chinese Internet-search company Baidu Inc., for example, has roughly the same stock-market value as CRRC Corp.—a company formed this year from the merger of China’s two largest railway-equipment makers—but has half the revenue and only one quarter the staff.

And some big-name Chinese technology companies are reporting softening markets.

Electronics maker Lenovo Group Ltd. called the past quarter “perhaps the toughest market environment in recent years.”

Phone maker Xiaomi Corp., which had ridden the wave of first-time smartphone buying in China to rack up triple-digit growth in recent years, now has to look for such growth elsewhere.

For the first time in six years, China’s smartphone sales are declining.

The lights are dimming for some old-economy industries. In an energy sector that for decades scrambled to keep up with demand from China’s factories, companies such as state-controlled power producer Huadian Power International Corp. are reporting sharply falling production as manufacturers close.

In an industrial suburb of Chengdu, Huang Mingjian’s income from a laundry service he opened 17 years ago has fallen by a third as the main source of his livelihood, a nearby steel plant, is preparing to close. “I’ve been feeling the business pressure for months,” Mr. Huang said.

As some factories close and construction projects stand idle, the flow of migrant workers to cities is starting to reverse, particularly in China’s northeast, according to labor activists.

A construction worker who gave his name as Bao said he left Shenyang, the capital of Liaoning province, to return to his hometown about two months ago. “Things started to get worse from the middle of last year. Many construction projects were halted, and those that continued paid workers less,” said the 34-year-old Mr. Bao. “Many of my friends have left as well.”

China’s government says that nationwide, employment is holding up well. Still, according to China Labour Bulletin, a Hong Kong-based watchdog, the number of worker protests and strikes more than doubled in the second quarter from a year earlier.

As various levels of government in China are struggling to repay debt, fiscal problems are especially acute in Liaoning. The province’s revenue plunged 23% in the first half of this year.

Within the PBOC, doubts remain about the effectiveness of more bank-reserves cuts, according to Chinese officials and advisers to the central bank. “The central bank would have preferred not to flood the market again with liquidity, if only it had a choice,” said an official close to the central bank.

Beijing’s desire to control the yuan’s value means that unlike the U.S. Federal Reserve and other central banks, the PBOC still lacks the ability to conduct an independent monetary policy. Buying or selling the yuan to influence its exchange rate affects domestic liquidity, causing the central bank to have to adjust its monetary policy as a result. “We call it ‘Zhou Xiaochuan’s dilemma,’” said Wang Jian, an analyst at Orient Securities, referring to the PBOC’s long-serving governor.

Beijing is even having trouble getting some people and institutions beholden to it to follow its directives.

In April, Premier Li Keqiang lashed out at inactive “local functionaries” for not investing fast enough. Last week, a commentary on the website of state broadcaster CCTV said that reforms were facing “unbelievably” fierce resistance and cited the need to “reconfigure the lifeblood of this enormous economy, making it healthier. The scale of the resistance is beyond what could have been imagined.”

On Friday, China’s banking regulator and its top planning organization called on policy banks to lend more in support of government projects, citing funding shortfalls as the main cause of slowing investment growth.

Han Zhifeng, head of the National Development and Reform Commission’s investment department, told reporters at a briefing that China Development Bank, a state policy bank, promised to issue 1.16 trillion yuan ($181.4 billion) for 11 key investment projects rolled out by the government this year, but has issued only 71.9 billion yuan so far. Another policy bank, Agricultural Development Bank of China, promised to provide 46.2 billion yuan for these projects but has issued only 2.8 billion yuan of loans, he added.

Some economists say global markets may be overreacting. They point to bright spots: Property sales in major Chinese markets are starting to recover, while high down-payment requirements reduce the systemic risk of default. And growth in retail spending has remained above 10%, with shifts to online shopping and services not fully captured in official statistics.

The transition, albeit a slow one, to a more labor-intensive service economy will help protect employment, economists say.

For many Chinese, in fact, it is business as usual.

“My job is still stable and my income is the same as it has been,” said Liu Yang, a 36-year-old engineer at an auto company in China’s northeast city of Changchun, who says he still shops, buys clothes and eats out as before.

In March, Premier Li said China still has several tools to use if the job market weakens significantly or growth slows to the lower band of the reasonable range. He didn’t elaborate.

Some economists say China’s best near-term option is to continue ramping up fiscal and monetary stimulus to meet growth targets. “Now they need to double down on stimulus,” said ING economist Tim Condon.




Markets Insight

We borrow too much from the future at our peril

Peter Fisher

Central banks seem concerned about liquidity, but it is not the issue

Janet Yellen, chair of the U.S. Federal Reserve, center, talks to Mario Draghi, president of the European Central Bank (ECB), before the IMF governors' group photo at the International Monetary Fund (IMF) and World Bank Group Spring Meetings in Washington, D.C., U.S., on Saturday, April 18, 2015. IMF Managing Director Christine Lagarde warned this week that she wouldn't let Greece skip a debt payment to the lender, shutting down a potential avenue to buy the Greek government some financial leeway. Photographer: Andrew Harrer/Bloomberg *** Local Caption *** Janet Yellen; Mario Draghi©Bloomberg
Janet Yellen, chair of the US federal reserve, center, talks to Mario Draghi, president of the European Central Bank
 

Why are central bankers so concerned with liquidity? Is this sympathy for the plight of the hard-working bond trader? It is more likely they wonder if the lofty asset prices they have engineered with quantitative easing can be sustained.

By liquidity we mean our ability to sell an asset without material loss. In this sense, individual transactions can be liquid and some of us can find liquidity for some of our assets some of the time. But we cannot all withdraw our deposits from the bank the same day nor sell all our bonds and stocks at the same time.
 
In financial markets when we rush for the exits the doors get smaller. The system rests on a liquidity illusion. Keynes derided the idea that liquidity was a virtue, calling it an antisocial fetish that “forgets that there is no such thing as liquidity of investment for the community as a whole”.
 
Although central banks were invented to backstop our liquidity illusion, today’s central bankers are somewhat embarrassed by their origin as liquidity providers and lenders of last resort. Not satisfied with merely stabilising the value of money, they have committed themselves to ensuring good macroeconomic outcomes.
 
This commitment is today expressed by the powerful idea that if the supply of labour and other resources exceeds the demand then interest rates must be too high. The only acknowledged constraints to this imperative are inflation and financial stability concerns.

But from whence do low interest rates conjure additional demand?

By lowering interest rates we can weaken our exchange rate and take demand from our trading partners. We can also take demand from the future by inducing more borrowing against future income and also by a “wealth effect” when lowering interest rates makes future cash flows appear more valuable. So we can steal demand from foreigners, induce people to borrow more than they otherwise would, or make rich people appear richer. That’s it.

Foreigners can defend themselves but the future is defenceless. It is at risk if we borrow too little and also if we borrow too much. Thought of in this way, we can integrate financial stability concerns and monetary policy objectives.

A virtue of finance capitalism is that we can convert our future income into current investment and consumption while creating savings vehicles for others. If we borrow too little from the future we risk underperforming our economic potential.

We all recognise the risk that we might borrow too much if, by increasing indebtedness, we bring too much demand from the future into the present and create inflationary pressures. But there are other risks.

We might “over-invest” and borrow too much investment from the future, creating too much output compared with demand, contributing to deflationary forces. We might borrow too much compared with our future income and constrain our propensity to consume, weakening future demand.

We might incur debt greater than our ability to repay and undermine the value of financial assets.

Borrowing from the future via a wealth effect is a trick that can work but once which must push us closer to uncertainty about the sustainable level of asset prices and, thus, to the risk of financial instability.

A pernicious consequence of borrowing too much results if we borrow beyond our probable income against the collateral of unsustainably elevated asset prices. This creates a balance sheet mismatch that can lead to a debt deflation and, hence, to conditions of chronically weak demand.

The inter-temporal trade-off of borrowing from the future might make us better off both now and in the future but there is no guarantee. Those who ignore the risk of a negative trade-off put financial stability and macroeconomic outcomes in jeopardy.

Central banks have pumped up financial conditions in the hope of creating a good equilibrium between the supply and demand for resources. It is unlikely they have simultaneously engineered an enduring equilibrium in asset prices. Liquidity is not the issue.
 
 
Peter Fisher teaches at the Tuck School of Business at Dartmouth; he previously served as under secretary of the US Treasury for domestic finance and head of fixed income at BlackRock

U.S. Lacks Ammo for Next Economic Crisis

Policy makers worry fiscal and monetary tools to battle a recession are in short supply

By Jon Hilsenrath and Nick Timiraos
     
 


Record capital flight from China as industrial slump drags on

China's state media decries "unimaginably fierce resistance" to economic reforms, a sign that president Xi Jinping is becoming furious with incompetent party officials

By Ambrose Evans-Pritchard

8:00PM BST 21 Aug 2015

China's Vice President Xi Jinping casts his ballot during the closing session of the 18th National Congress of the CPC at the Great Hall of the People in Beijing...China's Vice President Xi Jinping casts his ballot during the closing session of the 18th National Congress of the Communist Party of China (CPC) at the Great Hall of the People in Beijing, in this November 14, 2012 photo released by China's official Xinhua News Agency. The congress started its closing session on Wednesday morning, at which a new CPC Central Committee and a new Central Commission for Discipline Inspection will be elected.     REUTERS/Xinhua/Li Xueren (CHINA - Tags: POLITICS ELECTIONS TPX IMAGES OF THE DAY) NO SALES. NO ARCHIVES. FOR EDITORIAL USE ONLY. NOT FOR SALE FOR MARKETING OR ADVERTISING CAMPAIGNS. THIS IMAGE HAS BEEN SUPPLIED BY A THIRD PARTY. IT IS DISTRIBUTED, EXACTLY AS RECEIVED BY REUTERS, AS A SERVICE TO CLIENTS. CHINA OUT. NO COMMERCIAL OR EDITORIAL SALES IN CHINA. YES

China's Vice President Xi Jinping  
 
Capital outflows from China have surged to $190bn over the last seven weeks, forcing the authorities to intervene on an unprecedented scale to defend the Chinese currency.
 
The exodus of funds is draining liquidity from interbank markets and has pushed up overnight Shibor rates by 30 basis points in the last ten trading days, a sign of market stress.
 
Yang Zhao from Nomura said $90bn left the country in July. The pace has accelerated since the central bank (PBOC) shocked the markets by ditching its currency peg to the US dollar.
 
Capital flight for the first three weeks of August is already close to $100bn, despite draconian use of anti-terrorism and money-laundering laws to curb illicit flows.
 


Overnight Shibor rates Mr Zhao said the PBOC had intervened “very aggressively” to stabilise the currency and prevent the devaluation getting out of hand, but this automatically tightens monetary policy.
 
The central bank will almost certainly have to cut the reserve requirement ratio (RRR) for banks to offset the loss of liquidity, with some analysts expecting action as soon as this weekend.
 
The PBOC’s latest report calls for “monetary easing”, dropping the usual caveat that measures should be targeted. It is a sign that Beijing is preparing blanket stimulus, despite worries that this could lead to a repeat of the credit excesses that have haunted China since the post-Lehman boom.

The PBOC has already injected $160bn into the China Development Bank for projects.

Hopes that China is at last shaking off a recession in the first half of the year – caused by a combined monetary and fiscal crunch - have once again been dashed by grim manufacturing data.

The Caixin PMI survey slumped to 47.1, far below the boom-bust line of 50 and the lowest since March 2009. New export orders slid further to 46.0 while inventories are rising, a nasty cocktail.

Caixin Insight said the bad figures reflect the tail-end of a downturn that has largely run its course as stimulus kicks in. "The economy could be in the process of bottoming out and may start to rebound within the next few months," it said.

The ructions in China come at a moment when markets are already bracing for the first interest rate rise by the US Federal Reserve in eight years, a move that threatens to tighten the noose further on over-stretched emerging markets (EM) and the commodity nexus.

Danske Bank said the latest rout is worse than the “taper tantrum” in 2013 when the Fed first hinted at tightening, and is quickly turning into a “perfect storm” as the Turkish lira, Brazilian real, Malaysian ringgit, and Russian rouble all go into free-fall.


Capital outflows from emerging markets have reached $940bn since June 2014, according to NN Investment Partners. The damage from the EM crisis is ricocheting back into the US. High-yield bonds spreads have surged to three-year highs, rising to bankruptcy levels of 1100 basis points for energy companies.

It is unclear where China’s political system is now heading. The country is gripped by an anonymous article published in the state newspapers warning that the reform process faces “unimaginably fierce resistance”

Jonathan Fenby from Trusted Sources said the article is a sign that a furious President Xi Jinping is losing faith in his officials after a secret conclave of the party leadership in August.

“Behind the confident front which he presents to China and the rest of the world, factionalism is still alive within the senior ranks,” he said.

The botched handling of the Shanghai equity crash has raised serious doubts about the competence of the Chinese leadership. The conclave report urged “drastic and pragmatic reform” of the state-owned enterprises, fiscal policies, finance, and the judicial system.

There is little doubt that the party committed grave policy errors over the winter months, culminating in the so-called “fiscal cliff” as a botched reform of local government finance caused spending to collapse. The question is whether the worst is over as the authorities launch another stop-go cycle.

Credit growth rose to a 31-month high in July, though a chunk of this is simply rolling over old debts to keep the game going.

Fiscal spending is picking up sharply as the new bond market finally comes on stream. Local governments issued almost $200bn of securities in June and July, a blistering catch-up pace.
S
imon Ward from Henderson Global Investors says his measure of the money supply – “true M1” – has recovered after turning negative late last year for the first time this century.



It has been rising at an annual pace of 10pc over the last six months and is accelerating, pointing to a lift-off in growth later this year. His measure includes household demand deposits.

Yet capital flight greatly complicates the picture. It comes at a time when the Shanghai composite index of stocks has dropped back to 3,507, retesting the post-crash lows of early July.

There is a pervasive fear that the crisis may be deeper than admitted so far by the Communist Party.

The PBOC has clearly been caught off-guard by the violent reaction of the markets to its new exchange rate regime, widely suspected to be a disguised move to devalue the yuan and rescue struggling exporters. It has had to step in to stabilise the currency near 6.40 to the dollar, containing the devaluation at 3pc.


Shanghai Composite

Nomura said these conspiracy theories are misguided. The PBOC had to act to bring exchange rate policy into line with other reforms of China’s capital account or face mounting complications. It is a healthy development.

The PBOC was faced with the “Impossible Trinity”, a textbook case in economics where you cannot control capital flows, monetary policy, and the currency, all at the same time. One has to give.

“Unless they opened up the exchange rate, they were going to lose monetary policy independence. It was quite urgent,” said the bank.

Michael Kurtz, Nomura’s Asian equity strategist, said markets have misread what is happening on the ground in China, pricing in a doom scenario that is unlikely to happen. “This represents a buying opportunity. We think stocks will end materially higher at the end of the year,” he said.

The ugly PMI figures overstate the weakness of the economy. Premier Li Keqiang is deliberately shifting resources away from the old industrial sectors. The “trade-intensity” of Chinese growth is plummeting as the country matures.

The Chinese people have hardly felt the effects of their slowdown so far. The pain has been exported to Brazil, South Africa, Australia, and other countries that live off China’s commodity demand.

Bo Zhuang from Trusted Sources said the stability of the jobs market is the “ultimate bottom line for the Chinese leadership”. Employment is so far holding up well. A net 7.2m jobs were created in first half of the year, enough to meet the annual target of 10m.


However, the ratio of vacancies to applicants peaked at 1.15 late last year and has since dropped to 1.06, the steepest fall since the Lehman crisis. One of the weakest components of Friday’s PMI survey was employment, so the ratio is likely to fall further.

The Chinese authorities have manoeuvred themselves into a corner. With hindsight they liberalised the exchange regime too soon, before the fiscal recovery had fed through and before it was clear that the recession was safely over.

They have now to contend with accelerating capital outflows that they themselves provoked, and that make it even harder to manage the downturn. Xi Jinping has every reason to be exasperated.


Corporate Debt - Road To Oblivion In A Bear Market

 

By: The Burning Platform

 

Any article that starts with a quote from Jim Grant is guaranteed to be a fact based, common sense, reasoned analysis of our warped, debt saturated, over-valued, Federal Reserve rigged financial markets. John Hussman starts his weekly letter with this quote from Jim Grant:
"The way to wealth in a bull market is debt. The way to oblivion in a bear market is also debt, and nobody rings a bell." - James Grant
We've been in a Fed QE and ZIRP induced six year bull market that has been sputtering since QE 3 ended in October 2014. Leveraging yourself to the hilt and piling into the stock market has been the road to riches for six years, just as leveraging to the hilt in real estate was the road to riches from 2002 through 2007, and leveraging to the hilt in internet stocks was the road to riches from 1998 through 2000. Of course, the dot.com and housing road to riches detoured into ditches that wiped out trillions of phantom wealth, just as the current road is leading to a grand canyon size ditch.
Thelma's flying 1966 Thunderbird convertible
Total credit market debt has reached all-time highs. The de-leveraging of consumers, liquidation of insolvent Wall Street banks, and bankruptcies of zombie retailers, real estate developers, and mall owners was postponed by Federal Reserve intervention, changing accounting rules to hide bad debt, political shenanigans, and taxpayers paying for the extreme risk taking by bankers and corporate CEOs. Total credit market debt sits at $59 trillion, up from $52 trillion in 2009 at the depths of the recession. This increase has been entirely driven by a $5.3 trillion increase in government debt and a $1.6 trillion increase in corporate debt. The propaganda about corporations flush with cash is bold faced lie. Corporations have increased their debt load by 25% since 2009.
As Dr. Hussman points out, the Fed has encouraged this behavior by the biggest corporations on the planet with their suppression of market interest rates and their gift of $3 trillion to the Wall Street banks. Corporate CEOs are supposed to be the smartest guys in the room, but they haven't been able to grow their businesses through innovation, creativity, new products, or new investments in plant and equipment. Their entire playbook consists of outsourcing jobs to foreign countries, keeping wages below the level of inflation, and borrowing cheaply from Wall Street banks to buyback their stock and boost earnings per share, so their stock price will go higher, enriching themselves.
The opposite of a debt-equity swap, of course, is a debt-financed stock repurchase, which leverages up the claims of existing shareholders. One of the more troubling aspects of the Federal Reserve's suppression of interest rates is the speculation it has encouraged, by giving companies access to enormously cheap funding on a 5-7 year horizon. Though nominal economic growth has been tepid, revenue growth has turned negative, and profits as a share of GDP have been falling for more than a year, companies have scampered to boost their per-share earnings by taking out debt to repurchase and reduce the number of shares outstanding. This leveraging has been done at market valuations that are near the highest levels in history on historically reliable measures.
These Ivy League educated CEO titans are nothing but greedy lemmings, following the guidance of corrupt Wall Street bankers by buying back their stock at all-time high valuations. They did it from 2005 through 2008 and paid the price shortly thereafter. It appears some one taught them the "buy low, sell high" concept backwards. They bought no stock at the 2009 lows.
See, the timing of buybacks at an aggregate level has nothing to do with value. As Albert Edwards at SocGen has often observed, not only do buybacks increase at rich market valuations and dry up in depressed markets, they are also typically financed by issuing debt. What drives buyback activity is not value, but the availability of cheap, speculative capital at points in the business cycle where profit margins are temporarily elevated and make the increased debt burden seem easy to handle. The chart below showed the developing situation a few years ago...

They are presently buying back their own stock at a pace never before seen in market history.

Every valuation metric known to mankind is flashing red and showing the market to be as overvalued as any time in history, but corporate CEO's are borrowing like madmen and buying their own stock. Where is the prudence, risk management, and responsibility for the long-term financial viability of these corporations from the executives running these companies? Does only next quarter's EPS matter?
... and the chart below shows the frantic pace that repurchases have reached - at what are now the most extreme levels of valuation in U.S. history outside of a few months surrounding the 2000 market peak.
Weekly Announced Buybacks: S&P 500
Hussman, inconveniently for the Wall Street huckster crowd and CNBC cheerleaders, points out that corporate profits peaked two quarters ago and are headed downward. Revenue growth is non-existent and corporate debt yields are rising. The high yield financed shale oil boom is imploding, zombie retailers are struggling, and marginal players are seeing interest rates rise. Borrowing to buy back stock as a recession takes hold becomes untenable, even for delusional greedy CEOs. Stockholders are going to wish these CEO's hadn't levered their balance sheets just before Depression 2.0 hit.
One emerging problem here is that credit spreads in corporate debt have begun to widen considerably, increasing the cost of debt, while profit margins continue (predictably) to come under pressure. Corporations tend to press their luck when it comes to buybacks, largely because profit margins tend to be deceptively high at major market peaks, but it's difficult to maintain a high pace of repurchases when fading revenue growth and narrowing profit margins are joined by wider credit spreads.
The larger problem with repurchases is that debt-financed buybacks effectively put investors on margin. As corporations have borrowed in order to aggressively buy back their stock near the highest market valuations in history, existing stockholders have quietly become heavily leveraged, without even realizing it.
You can thank Janet, Ben and their merry band of central bankers for this epic level of malinvestment. Their ongoing ZIRP has left pensions plans, life insurance companies, and other large institutional investors with no yields. The Fed is a perpetual bubble machine and the latest bubble is in debt financed corporate equity purchases. It will end the same way all Fed bubbles end, with a financial crisis, trillions in losses, bankruptcies, and soaring unemployment. The unwind of these excesses will be epic.
So not only is the equity market at the second most overvalued point in U.S. history, it is also more leveraged against probable long-term corporate cash flows than at any previous point in history. As we observed during the housing bubble, yield-seeking by investors opens the door to every form of malinvestment. The best way to create a debt-financed wave of speculative and unproductive activity is to starve investors of safe return. In 2000 that wave of speculation focused on technology. The next Fed-induced wave of speculation focused on mortgage securities, which financed a housing bubble. In our view, the primary avenue of speculation in the current cycle has been debt-financed corporate equity purchases.
Over the completion of this cycle, we fully expect that many companies and private-equity firms will be forced to reverse this activity through involuntary debt-equity swaps, with a corresponding dilution in the ownership stakes of existing shareholders. Indeed, the group that led the largest leveraged buyout in the oil and gas sector in 2011 announced last week that its ownership stake would be handed over to lenders. Back in 2011, profit margins were elevated in the energy sector, making the new debt burdens seem easy to handle. But part of the signature of an emerging global economic slowdown has been pressure on energy and industrial commodity prices (see the February 2, 2015 comment, Market Action Suggests an Abrupt Slowing in Global Economic Activity). The grandiose leveraged buy-outs of 2011, now facing Chapter 11, are the canaries in the global economic coal mine. In the words of Bad Company, "It ain't the first time baby... baby it won't be the last."
The market was down 275 points last Wednesday and finished flat on the day. The market was down 135 points today and reversed by 200 points in a matter of minutes. In these low volume markets, large corporations are propping up their stocks and the market by wading in and buying back their stock. The savvy investors have been selling hand over foot, while the lemming CEO crowd keeps wasting their cash on their over-priced stocks. They call this adding value.
Chart: BofAML Client net buys by client type
As usual, Dr. Hussman provides a succinct, factual, and dire warning to anyone invested in this market. The current overvalued market conditions have only been present 8% of the time over the last century. Market crashes have only occurred when the current conditions existed in the past. The ghosts of 1929, 2000 and 2007 are warning you to beware. Ignore the warnings at your own peril.
The current set of conditions has been observed in only about 8% of market history, and that 8% of history captures the only set of conditions that we associate with expected and severe market losses. It's the 8% of history that matches current conditions where most market crashes have occurred.

A New Approach to Eurozone Sovereign Debt
 Yanis Varoufakis. MP Panagiotis Lafazanis and Yanis Varoufakis

 
 
ATHENS – Greece’s public debt has been put back on Europe’s agenda. Indeed, this was perhaps the Greek government’s main achievement during its agonizing five-month standoff with its creditors. After years of “extend and pretend,” today almost everyone agrees that debt restructuring is essential. Most important, this is true not just for Greece.
 
In February, I presented to the Eurogroup (which convenes the finance ministers of eurozone member states) a menu of options, including GDP-indexed bonds, which Charles Goodhart recently endorsed in the Financial Times, perpetual bonds to settle the legacy debt on the European Central Bank’s books, and so forth. One hopes that the ground is now better prepared for such proposals to take root, before Greece sinks further into the quicksand of insolvency.
 
But the more interesting question is what all of this means for the eurozone as a whole. The prescient calls from Joseph Stiglitz, Jeffrey Sachs, and many others for a different approach to sovereign debt in general need to be modified to fit the particular characteristics of the eurozone’s crisis.
 
The eurozone is unique among currency areas: Its central bank lacks a state to support its decisions, while its member states lack a central bank to support them in difficult times. Europe’s leaders have tried to fill this institutional lacuna with complex, non-credible rules that often fail to bind, and that, despite this failure, end up suffocating member states in need.
 
One such rule is the Maastricht Treaty’s cap on member states’ public debt at 60% of GDP. Another is the treaty’s “no bailout” clause. Most member states, including Germany, have violated the first rule, surreptitiously or not, while for several the second rule has been overwhelmed by expensive financing packages.
 
The problem with debt restructuring in the eurozone is that it is essential and, at the same time, inconsistent with the implicit constitution underpinning the monetary union. When economics clashes with an institution’s rules, policymakers must either find creative ways to amend the rules or watch their creation collapse.
 
Here, then, is an idea (part of A Modest Proposal for Resolving the Euro Crisis, co-authored by Stuart Holland, and James K. Galbraith) aimed at re-calibrating the rules, enhancing their spirit, and addressing the underlying economic problem.
 
In brief, the ECB could announce tomorrow morning that, henceforth, it will undertake a debt-conversion program for any member state that wishes to participate. The ECB will service (as opposed to purchase) a portion of every maturing government bond corresponding to the percentage of the member state’s public debt that is allowed by the Maastricht rules. Thus, in the case of member states with debt-to-GDP ratios of, say, 120% and 90%, the ECB would service, respectively, 50% and 66.7% of every maturing government bond.
 
To fund these redemptions on behalf of some member states, the ECB would issue bonds in its own name, guaranteed solely by the ECB, but repaid, in full, by the member state. Upon the issue of such an ECB bond, the ECB would simultaneously open a debit account for the member state on whose behalf it issued the bond.
 
The member state would then be legally obliged to make deposits into that account to cover the ECB bonds’ coupons and principal. Moreover, the member state’s liability to the ECB would enjoy super-seniority status and be insured by the European Stability Mechanism against the risk of a hard default.
 
Such a debt-conversion program would offer five benefits. For starters, unlike the ECB’s current quantitative easing, it would involve no debt monetization. Thus, it would run no risk of inflating asset price bubbles.
 
Second, the program would cause a large drop in the eurozone’s aggregate interest payments. The Maastricht-compliant part of its members’ sovereign debt would be restructured with longer maturities (equal to the maturity of the ECB bonds) and at the ultra-low interest rates that only the ECB can fetch in international capital markets.
 
Third, Germany’s long-term interest rates would be unaffected, because Germany would neither be guaranteeing the debt-conversion scheme nor backing the ECB’s bond issues.
 
Fourth, the spirit of the Maastricht rule on public debt would be reinforced, and moral hazard would be reduced. After all, the program would boost significantly the interest-rate spread between Maastricht-compliant debt and the debt that remains in the member states’ hands (which they previously were not permitted to accumulate).
 
Finally, GDP-indexed bonds and other tools for dealing sensibly with unsustainable debt could be applied exclusively to member states’ debt not covered by the program and in line with international best practices for sovereign-debt management.
 
The obvious solution to the euro crisis would be a federal solution. But federation has been made less, not more, likely by a crisis that tragically set one proud nation against another.
 
Indeed, any political union that the Eurogroup would endorse today would be disciplinarian and ineffective. Meanwhile, the debt restructuring for which the eurozone – not just Greece – is crying out is unlikely to be politically acceptable in the current climate.
 
But there are ways in which debt could be sensibly restructured without any cost to taxpayers and in a manner that brings Europeans closer together. One such step is the debt-conversion program proposed here. Taking it would help to heal Europe’s wounds and clear the ground for the debate that the European Union needs about the kind of political union that Europeans deserve.