Chinese Economics Thread

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The first two months of 2012 saw China's industrial businesses suffer their biggest decrease in profits in three years.

To many, that signaled the country's economy was worsening under the pressure of declines in exports and property prices and that authorities would be more inclined to ease monetary policies.

In the first two months, industrial companies' net income decreased by 5.2 percent from a year before, hitting 606 billion yuan ($96 billion). That came after a relatively strong year in 2011, when their net incomes had increased by 25 percent, according to a statement from the National Bureau of Statistics on Tuesday. During the first two months of that year, their profits increased by 34.3 percent.

The slowdown brought the government under more pressure to loosen monetary policies to stimulate investing and manufacturing, analysts said.

According to the statistics bureau, companies involved in processing ferrous metals saw their profits decrease by 94 percent, the biggest loss among the representatives of 41 industrial sectors that were surveyed.

Meanwhile, the profits of the petrochemical, coking and nuclear-fuel processing industries all declined in the first two months, the statistics bureau said.

Gao Ting, chief China strategist at UBS Securities Co Ltd, said on Tuesday in Beijing that the numbers are a signal that the country's economy continues to grow slowly amid weak demand from overseas markets. He said the country's GDP growth rate may hit its lowest point for the year in the first quarter, dropping to 8.2 percent.

"A direct indicator is the significantly slowing growth of power-generation capacity, which was 7 percent from January to February, compared with 10 percent in the last month of 2011," Gao said.

"The earnings of Chinese non-financial listed companies are expected to decrease by about 10 percent from a year ago in the first quarter."

Qiu Zhiming, president of Beifa Group Co Ltd, a pen maker and exporter in Ningbo, Zhejiang province, said the increase in his company's sales would be slightly smaller this year but still not negligible.

"Our market is abroad, so we are affected by the global economy more than the domestic," he said.

Qiu said it is good news that the economic growth of the US - Beifa's biggest export destination - is recovering faster than expected.

Gao predicted China's GDP would grow by 8.5 percent this year, higher than the government's 7.5 percent target. The country's rate of economic growth is expected to rebound to 8.6 percent in the second quarter, bolstered by a global economic recovery, he said.

"The biggest potential risks are likely to come from the property market, since sales of commercial houses may decrease by 15 percent this year and the government may maintain its tight control of the real estate sector."

A preliminary measure of China's manufacturing activity fell to a four-month low of 48.1 in March from 49.1 in February, suggesting the second largest economy in the world may continue to slow, according to HSBC Holdings Plc. Anything above a 50 on the gauge, which was released last week, indicates an expansion and anything below a 50 indicates a contraction.

"The government needs to cut interest rates and push investment projects in the coming months," Zhang Zhiwei, chief economist for China at the Japan-based financial services company Nomura Holdings Inc, wrote in a research note after the statistics bureau released the data.

Gao said the government's policies are being eased but only in a moderate way. He said the government is unlikely to introduce a large package of stimulus policies this year, a time when authorities are continuing to call for "steady growth".

 

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So what does this all mean? For China and its place in the world.

 

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China Development Bank (CDB) and its BRICS' counterparts will sign agreements on Thursday to formalize cooperation in local currency lending, in a bid to further facilitate trade and investment among the five countries, said chairman of CDB Chen Yuan here on Wednesday.

Under the agreements, namely the Master Agreement for Extending Credit facilities in Local Currency, and the Multilateral Letter of Credit Confirmation Facility Agreement, each country will make its own currency loans available to other four member countries.

"Using our own currencies to issue loans and settle payments can minimize exposure to exchange rate fluctuations, reduce our reliance on third-party currencies, and facilitate trade and investment," said Chen in a financial forum gathering of CDB and its Brazilian, Russian, Indian and South African counterparts.

"Since our last gathering in Sanya, member banks have actively implemented the framework agreement on financial cooperation and established a technical working group on local currency lending," Chen added.

Trade among BRICS countries grew in the past decade. Statistics showed that from 2001 to 2010, inter-BRICS trade soared with an average annual growth of 28 percent. Total trade among the five countries stood at 230 billion U.S. dollars in 2010.

These two agreements will also be important outcome documents for this year's BRICS summit, bearing far reaching significance in deepening financial cooperation, commented Chen while attending a press conference later in the day.

Chen did not provide the amount of lending, but he believed that "the sum will be considerable".

The pacts to be signed have also been applauded by bank leaders of other BRICS countries. "The two agreements will for sure assist us in promoting our bilateral trade and investment and improve the trade facilities which we are extending to each other," Vladimir dmitriev, chairman of Vnesheconombank, told Xinhua after the forum.

"It is important for BRICS countries to trade in an environment that is not volatile, particularly on currencies," Jabulani Moleketi, chairman of Development Bank of Southern Africa, told Xinhua.

The action will reduce the currency risks and increase the trade and investment volume, Moleketi added.

Representatives from the CDB, BNDES of Brazil, Russia's Vnesheconombank, Export-Import Bank of India and the Development Bank of Southern Africa will sign the pacts on Thursday in the presence of the leaders of five countries.

Leaders from the BRICS bloc gathered in New Delhi for a two-day annual summit under the theme of BRICS countries' commitment to the partnership of stability, security and prosperity. It is the fourth annual meeting of this still relative young mechanism.

 

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China’s yuan is becoming increasingly widely used in its neighboring countries to directly buy Chinese goods and invest in yuan-denominated securities and bonds. The offshore yuan market is growing steadily as more and more transactions are settled in yuan at overseas banks.

Hong Kong, Singapore, and London all have a certain amount of international trade settled in yuan, with Hong Kong taking the lead. According to statistics from the Hong Kong Monetary Authority (HKMA), yuan trade settlement in Hong Kong amounted to more than 1.6 trillion yuan in the first 11 months of 2011, or over 80 percent of the total amount of the Chinese mainland’s external trade settled in yuan. Singapore has not released any official data in this regard, but according to local banking industry insiders, yuan trade settlement in Singapore grew several times last year.

Obviously, Hong Kong, Singapore, and London are competing with each other for a bigger slice of the offshore yuan market. Hong Kong has an inseparable bond with the mainland, and thus enjoys a natural advantage. Located in Southeast Asia, Singapore has a close trade relationship with China and a relatively large Chinese-speaking population, which gives it a potential advantage. London relies more on its traditional ties with Hong Kong.

The initial development of the yuan business in the three cities depends on which city will win more policy support from the Chinese government. However, in the long run, they have an equally promising future, which is why Singapore and London are actively developing their yuan business.

At present, Hong Kong is the only offshore yuan business center with the most abundant yuan-denominated products. HKMA data showed that a total of 106 billion yuan worth of dim sum bonds – yuan-denominated bonds issued in Hong Kong, were issued in the city last year. HSBC expects the total value of dim sum bonds issued in 2012 to stand between 260 billion yuan and 310 billion yuan thanks to the huge amount of yuan deposits in the city. The HKMA said that yuan deposits in Hong Kong amounted to 588.5 billion yuan by the end of last year, while the yuan business of Singaporean banks is still mainly limited to trade settlement, according to local banking industry insiders.

Will London surpass Hong Kong in this area? On Jan. 16, the HKMA and U.K. Treasury announced the launch of a joint private-sector forum to enhance cooperation between Hong Kong and London on the development of offshore yuan business. The HKMA is also working to extend the operating hours of the RMB Real Time Gross Settlement system in Hong Kong to give financial institutions in London and other financial centers in the European time zone an extended window to settle offshore yuan payments through the Hong Kong infrastructure.

At the fourth China-U.K. Economic and Financial Dialogue in September 2011, both countries agreed to enhance financial cooperation and support the expansion of each other’s financial institutions. Certain London-based banks are pushing the U.K. central bank to sign a currency swap deal with its Chinese counterpart. In addition, the close cooperation between London and Hong Kong has aroused great concern from Singapore’s financial sector.

Of course, Hong Kong cannot eat the large cake of the internationalization of the yuan alone. Singaporean financial institutions are now eager to obtain a “license” from the People’s Bank of China to set up a yuan clearing bank, so as to bring into full play their geographic advantage, attract more yuan deposits through cross-border trade, and gradually form a yuan capital market. A few years later, a fourth or fifth city may be willing to join the competition, indicating that the climax of the internationalization of the yuan is approaching.

 

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Chinese companies are moving to take over more and more European companies, according to research by Ernst & Young Global Ltd released on Wednesday.

Ernst & Young reported that Japan and China led the pack in making investments in Europe in the first two months of 2012, completing nearly $11 billion in deals. They were followed by South Korea, India and Australia.

Michel Driessen, partner at Ernst & Young, said Asian investors' interest in Europe has increased since 2010 and is likely to become even bigger in 2012.

"It is clear that Asian investors understand the financial backdrop in Europe at present and are keen to take advantage of this situation," Driessen said.

"Pricing, exchange rates and deal dynamics are all working to the benefit of Asian investors at present. It is the right time to acquire for growth in Europe."

The deals pertained to a wide variety of businesses, most of them being in the industrial product, computer service and software, financial service and chemical industries.

According to Ernst & Young, Asian companies should try to expand in Europe because that will allow them to immediately gain loyal customers and quickly increase the size of their market shares.

Europe will also give them a solid means of expanding further into other international markets.

Ernst & Young also said Asian companies hope to enter Germany, Britain and other countries to pursue more research and development and innovation, thereby strengthening their products and improving their ability to conduct research and development in the Asia-Pacific region.

The combination of these influences has driven the Asia-Pacific region to increasingly turn to Europe to make acquisitions.

During the past five years, Australia has become the lead buyer in this area, accounting for 22 percent of the foreign merger and acquisition deals that were completed in Europe. It was followed by India, with 19 percent, China, with 18 percent, and Japan, with 18 percent.

Japan has spent more on mergers and acquisitions in Europe than any other market in the Asia-Pacific region, having invested about $79 billion since 2007.

Driessen said the ongoing financial and economic situation in Europe is giving Asia-Pacific companies opportunities to make interesting purchases at attractive prices.

 

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Once again, a lack of access to refined oil supplies is making news and taking its toll on China's private petroleum companies. As the China Business News reported on March 20, in Fuling city, Chongqing municipality, 51 privately owned gas stations bought 4.2 percent of the total gas supply that entered the city in the first 10 months of 2011, while 36 State-owned stations shared the remaining 95 percent.

Supply shortages have directly led to the closure of many private petroleum companies in previous years. According to the China General Chamber of Commerce's Petroleum Flow Committee, over the past five years, two thirds of the country's 663 petroleum wholesale enterprises have shut down and one third of the 45,000 gas stations have gone into bankruptcy.

The problem is mainly caused by the monopolization of petroleum supplies. Although the government opened the crude and fuel oil wholesale business to the market in 2007, the market is still largely dominated by two State-owned petroleum companies - China National Petroleum Corporation (CNPC) and China Petroleum & Chemical Corporation (Sinopec), who control the right to import crude oil and develop oil fields.

Thus, private wholesalers and retailers have to rely on these two companies for their refined oil supplies. However, as CNPC and Sinopec both have their own large interests in the downstream market, they often sell gas at inflated prices to their privately run competitors.

This monopoly not only hurts private companies but is also bad for the development of the country's petroleum market. Giving freer reign to private enterprises will make the petroleum market more robust by expanding oil imports and improving petroleum exploitation efficiency. In Brazil, for example, output from the country's petroleum industry almost doubled after the country let the market take charge of exploitation, an area formerly dominated by one company.

I suggest the government give private companies more access to petroleum supplies and work to dismantle monopolies by offloading gas stations run by State-owned companies to the private sector.

At the same time, private petroleum companies have to develop their wholesale and exploitation businesses, instead of just focusing on the retail market. Otherwise, they run the risk of repeating the failure of Great United Petroleum Holding Co (GUPC). This private petroleum company opened in 2005 and, within a year, had used up most of its 800 million yuan ($126.87 million) in registered capital when it failed to develop its upstream business, a move which restricted its petroleum supply.

 

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China's State Council announced Wednesday that Wenzhou of East China's Zhejiang province has been approved for a pilot financial reform which will help regulate private financing activities and allow the city's residents to make direct offshore investments.

The long-awaited decision was made at a State Council executive meeting presided over by Premier Wen Jiabao and at a time when underground financing activities in Wenzhou are rampant and have stirred up financial disputes and crime and threatened financial and economic stability.

The pilot project is expected to sort out Wenzhou's problems and make financing serve the real economy and is deemed not only important for the healthy development of Wenzhou, but also of great pioneering significance for financial reform and economic development throughout the nation.

The pilot program will include 12 major tasks, including setting up a file management system for private financing and improvements to the fund monitoring system, encouraging participation of private capital in the reform of local financial institutions, and guiding private funds toward the establishment of venture capital and private equity activities as well as other types of investment bodies.

Also, the government will encourage qualified state-owned banks and share-holding banks to set up special units to deal with credit grants to small enterprises.

The government vowed to encourage the establishment of financial leasing enterprises that serve small and micro enterprises as well as sectors concerning farmers, agriculture and the city's rural areas.

Other steps of the pilot program include measures to standardize and legalize transactions of non-listed companies' shares, technologies and cultural properties, encourage small and micro companies to issue bonds in Wenzhou, set up guarantee mechanisms for small and micro companies, and encourage commercial insurers to participate in the establishment of a social security system.

Earlier this month Wen told a news conference at the National People's Congress that the government needs to guide and permit private capital into the financial arena, standardizing it and bringing it into the open, encouraging its development and strengthening its supervision.

The comments came in response to a question about private fund-raising and the case of Wu Ying, a businesswoman who faces execution for illegally raising 770 million yuan ($123 million). The case is awaiting final review by the Supreme People's Court.

Wenzhou, with a population of over 9 million in east Zhejiang province, is famous for its private businesses.

 

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When asked by reporters on March 15 about how he perceived the huge profits of China's banking industry last year while the private sector was foundering on a shortage of bank loans, Zhou Xiaochuan, governor of People's Bank of China, said he thought banks' staggering profits were a natural result of readjustment of economic cycles.

However, Wu Xiaoling, former deputy governor of PBOC and currently deputy head of the fiscal and economic committee of the National People's Congress, said there are grounds for criticizing banks' enormous earnings, which she said were indeed unjustified.

Whatever the differences between the two seasoned banking regulators, my opinion is that banks' exorbitant profits are overshadowed by mounting risks over worsening bank assets comprised of local debts and home mortgages. Without realizing this fact, we cannot explain the contrasting, following phenomena.

Contrasts

On the one hand, a report issued by the China Banking Regulatory Commission in February said domestic banks generated a net profit of 1.04 trillion yuan (US$120.8 billion) last year, up 36.34 percent from 2010. Banks' daily profits stood at 2.85 billion yuan at the highest.

Moreover, statistics show that 16 listed banks posted a combined profit of 700 billion yuan in the first three quarters of 2011, almost 40 percent of the 1.58 trillion yuan profit of all public firms on the Shanghai and Shenzhen stock exchanges.

On the other hand, amid the prosperity of Chinese banks, China Huijin Investment Ltd, a state-owned investment vehicle, supported the joint bid by the "Big Four" - Industrial and Commercial Bank of China, Construction Bank of China, Bank of China and Agricultural Bank of China - to shed 5 percent of their dividend payout. The company also dramatically increased its holdings of the Big Four's stakes when the stock market was bearish in October. Such fund injections could happen again in the future.

Fundamentally speaking, banks owe their profits to the rapid growth in new assets. For instance, banks extended a credit of 10 trillion yuan to go with the government rescue plan in 2008. Even though local debts and mortgages are now snowballing at a more controllable rate, the considerable capital gains made on loans over the past few years are still growing, in spite of the slowdown in the Chinese economy.

But if we scrutinize banks' asset quality and the inherent liquidity risks, their whopping profits would seem almost negligible. In this sense, limits on high executive bonuses and efforts to force banks to share dividends work quite differently.

Bonus caps are aimed at preventing speculation, which is key to the industry's stability. Bigger dividend payment appears to be a way of equitable distribution of wealth, but it adds to liquidity risks, with possible consequences like a scenario in which medium- and small-sized banks become insolvent.

Given that asset quality is the biggest problem confronting Chinese banks, the government's line on regulating the property market is to stabilize it first and then bring home prices down. As a result, it has implemented a combination of policies.

Avoiding hard landing

On the one hand, to offset the risks of an economic hard landing caused by possible over-regulation, the government has encouraged local banks to lower mortgage rates on first homes.

On the other hand, the authorities are committed to overhauling the real estate sector, in case idle speculative money keeps inflating the bubbles in already astronomical home prices.

Meanwhile, the government is also trying to create more channels of investment through which bank loans can get into the real economy, so as to ensure that the quality of bank assets will improve as the economic recovery deepens. The aforementioned lowered dividend payouts and capital injections can free up some room for banks' liquidity and thus stimulate a new round of growth for non-financial industries.

To change the conflicting reality of banks' ballooning profits yet deteriorating assets, the watchdog might do well to take precautionary measures like boosting banks' capital adequacy ratio and risk provision, so that amid its boom, the sector won't make loans recklessly. Otherwise, the cumulative systemic bubbles will one day boil down to a financial tsunami.

And we must not harbor any illusion in the ability of collaterals to forestall a credit crunch. Japan's "lost 10 years," started by a real estate meltdown and subsequent banking miseries, are a textbook example of the price to pay for entertaining such myths. Besides, even if banks undergo the most conservative of stress tests for risk control, grave stress will still overwhelm them when collateral loans turn bad.

Although openness and competition might dent banks' gains and improve services for depositors, myopic pursuit of short-term benefits will seriously jeopardize banks' assets in an age of prosperity. Therefore, in addition to beefing up precautionary regulation, the watchdog should also speed up the securitization of bank assets to divert worsening systemic risks, a natural byproduct of fast growth.

To be sure, Chinese banks' profit model is also in dire need of reform. But if we miscalculate the best timing and order to do so, we will only reap unanticipated bitter results. This is especially the case in China, where at present the nation's financial resources are concentrated in its banks and disturbance in this sector is far more disastrous than stock market upheavals.

Based on this understanding, the reform of domestic banks may proceed in four steps.

First, strengthen the mechanisms of internal management, including the recruitment of top-notch financial talents and design of an appropriate salary package.

Second, take precautionary supervisory measures but avoid over-regulation that strangles efficiency or loosening regulation in good times and resorting to tightening in bad times.

Third, vigorously promote reforms of interest rate marketization and encourage healthy financial innovation on the basis of safer savings and maturing securities business.

Finally, open up the banking sector to qualified private and foreign investors when time is ripe.

 

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The National Development and Reform Commission (NDRC), China's top economic planner, said Thursday foreign-funded banks in China are allowed to borrow as much as 24 billion U.S. dollars of medium- and long-term external debt this year.

The approval of foreign banks' issuing external debts aims to open up China's banking sector to the outside world and let foreign banks play an active role in attracting foreign investment and helping Chinese enterprises go global, the NDRC said.

HSBC, Deutsche Bank, JPMorgan Chase, Citibank, Sumitomo Mitsui Banking Corporation and the Bank of East Asia are chosen to carry out the pilot scheme to issue external debts.

According to the NDRC, foreign banks must report to the commission about the size, tenure and overseas creditors of yuan-denominated funds whose terms are one year or above.

 

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I recently read in The Guardian an article by enthusiastic orientalist Martin Jacques in which he says that The Economist has just predicted that China’s GDP, measured in nominal dollars, will will be the world’s largest by 2018. Earlier estimates, he says had China becoming the largest economy in the world by 2027. I have always been a little skeptical about the 2027 claim, not that it is implausible, let alone impossible. It is just that given how much we would have to assume about the sustainability of Chinese growth, about the likelihood of current GDP numbers not having been vastly inflated by an over-investment boom, and about the instable range of political outcomes, it seemed to me to be a prediction about as valuable as the world-beating predictions about the USSR in the 1960s or Japan in the 1980s...