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Due Like Yesterday’s Bills

March 25, 2014
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Contributor: Louis Gave, Gavekal Research Limited (Published with Permission)

Following the 2008 global financial shock, almost every major government deployed massive fiscal and monetary firepower to prevent another Great Depression. One government, China (which was also still recovering from the devastating Gansu/Sichuan earthquake) did so more than most, compressing a five-year plan worth of rail, canal and motorway construction into just a couple of years. Of course, sending a large amount of public money down a fairly narrow pipe meant that quite a few banknotes leaked into the “wrong pockets.” Signs of leakage could be seen in the rising price of Bordeaux wines, the cuts at the Macau Baccarat tables, the price of gold, etc. (See: Corruption And Party Control). And it was not just the “greasing of the wheels” money that was misallocated; responding to a massive expansion in cheap credit, many local authorities, provincial governments and real estate companies adopted a “build it and they will come” mentality.

The fact that money was misallocated is hardly in question. Instead, the real question is whether China can pull off the same trick it has so many times in the past: namely grow out of its bad-debt problems? This is quandary facing Chinese equity investors today.

As most of GaveKal Research readers know, Shanghai is the only major equity market trading roughly at its 2008 crisis lows. Meanwhile, it is hard to open a financial newspaper without reading warnings about the coming implosion of the Chinese financial system. How this will happen in a country with capital controls, trillions in reserves, and huge trade surpluses is never clearly explained. If nothing else, the contrarian/value investor’s interest should be piqued.

Unfortunately, because of the debt splurge of 2009 – 2010, Chinese banks are quite incapable of adding much liquidity to the system. The average commercial banker at ICBC or BoCom is probably spending more of his day dealing with the loans made in 2009 than going out and looking for new industrialists, entrepreneurs or developers to lend to. Which brings us to the recent declaration by China’s leaders that the economy will expand by 7.5% in 2014; an extremely bullish call to make given that all recent data points to growth being closer to 7%, and heading lower (witness this morning’s weak HSBC flash PMI for China). Why would the government put its credibility on the line with a target that, right now, it looks highly unlikely to reach? Perhaps: –

  • The Chinese government is delusional. Frankly, that seems unlikely. Or at the very least, it would be an important departure from the recent track record.
  • The Chinese government is planning to cook the books in order to “keep the spirits up.” Undeniably, this has been done before (most notably in 1998 – 1999) but in this day and age, with so many eyes focused on China, attempting such a reputation-damaging trick could prove self-defeating.
  • The Chinese government will do something in the coming months to get bank lending going again, whether a bank recap, or easing of reserve requirements, etc.

It is this last possibility which should have investors most intrigued, especially following the March 21st announcement by the China Securities Regulatory Commission that the constituents of the Shanghai 50 Index (banks account for roughly 35% of that index) will henceforth be allowed to issue preferred shares. Moreover, companies will also be allowed to use preferred shares to pay for mergers and acquisitions. All of a sudden, a door opens for a) accelerated industry consolidation and b) the recapitalization of banks without any immediate dilution of common shareholders.

There may be a parallel here with the euro crisis of 2011 – 2012. To some extent, one could say that the European stock market malaise ended with the recapitalization of the Spanish and Italian banks in mid-to late-2012. Could the same thing happen in China? Today, successful Chinese equity investors are basically long the richly valued internet and gaming stocks, and short/underweight the banks, utilities and energy companies. This is a trade which has worked wonders, and the better it has felt, the more investors have piled in. But trees don’t grow to the sky, and large nationalized energy or utility monopolies rarely go to zero either. What the market is waiting for to reverse that trade is an acknowledgement from the Chinese government that something needs to be done to help out the banks, credit and economic growth in general.

It is probably too early to say that this is what occurred on Friday, March 21st when Shanghai shares jumped amid talk of policy easing. But it bears watching. For with President Xi Jinping having now consolidated his power, and put pressure on all the guys he does not like (either through corruption accusations or by cutting off the easy money spigots), some supportive government action vis-a-vis the undervalued/oversold/heavily shorted Chinese banks is due like yesterday’s bills.

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