Xi’s word is your bond

The latest batch of Chinese data for industrial industries was, on the face of it, a cheery sight. Having suffered a YOY plunge of 36.7% in the Lockdown-stricken first quarter, profits for the first two months of the current quarter combined climbed almost 20% above the like period in 2019. Recovery seems assured.

Well, perhaps.

There are more than a few wrinkles in this release, not the least of which is the question of how a firm can report anything meaningful with respect to the profits earned in such a discrete, short period as a month and do so, moreover, less than four weeks after that same month’s end.

The second is that subtle distinction that the report deals with ‘firms above a certain size’ – a definition which automatically winnows out the failures from one period to the next and so systematically biases the sample upwards.

Then there is the simple caveat that reported operating revenues rose 4.4% (not exactly a positive omen for nominal GDP growth) while costs rose 3.8% (a tardier pace partly attributable – as the man from the Ministry took pains to point out – not to improved corporate efficiency, but rather to lowered government imposts and higher subsidies).

That combination means that operating income stood around 8% above that recorded in high summer the previous year. Creditable enough, you might think, but still far short of the growth of final ‘profits’.

Given the extraordinary surge of new credit being pumped into the system, one might have expected an economy freed of the real-side shackles of the pandemic response to have run even hotter. For reference, CNY4.8 trillion in local government bonds have been issued in just the past six months (~US$115bln pcm), almost 60% more than in the year-ago period. Corporates have also taken full advantage of the recent mania to issue Y3.6 trillion in stock and bonds – double their haul in 2019 – while all other forms of credit hit Y11.9 trillion – a good 55% greater than in 2019.

Breaking this down somewhat, households have drawn down Y4.9 trillion in new loans (+23.3% yoy) while non-financial corporates and government entities between them have availed themselves of Y5.6 trillion (+48% yoy). All of this has served to boost M2 by a seasonal record of Y10.6 trillion, an increment more than half as big again as last year.

Circulation Problems

But, for all the impetus this might have been expected to generate, the effects have been inevitably muted , not just by the effects of coronavirus or the nagging problems of the ‘Trade War’, but because millions of acres have been inundated along the Yangtze river basin, thanks to the year’s anomalously high rainfall total: a disaster which has displaced an estimated 55 million people in flooding large swathes of both prime farmland and important industrial and commercial centres.

The agricultural losses thus endured have only added to the toll already taken in recent months by crop and livestock disease and insect pest. Together, these have served to greatly boost prices of food staples (and so reduce the potential for discretionary spending). This has led to a widely-shared unease that China’s state granaries and frozen pork reserves are about to run out – a worry which has only been aggravated by Zhongnanhai’s launch of a loud, public campaign against food waste in restaurants.

The upbeat bulletins do not fit easily either with the spat that has developed between Xi Jinping and Li Keqiang over the latter’s promotion of the ‘stallholder economy’ as a means to alleviate high – but largely officially unrecognised – levels of unemployment. Adding to his boss’s ire, Li also set off something of a media earthquake with his comments that 600 million of his fellow citizens –or some 40% of households – had to make do on less than CNY1,000 a month. Adding to the woe, the Income Distribution Research Institute of Beijing Normal University recently calculated that a further 360 million earn less than CNY2,000 (~US$300).

Scan the local newspapers and you will quickly find talk that rural unemployment has exploded, with some putting the rate as high as 20%. In a report on the issue which seems to offer a certain corroboration, Xinhua revealed that some 30 million migrant workers (around one in nine of the estimated total) have not bothered to travel to the cities as per normal this year, believing the search for work there to be hopeless. It then added the slightly less than reassuring boast that the government had however managed to find work for 17 million of them…

You do the arithmetic!

The SCMP lent further gloss to the plight of these often badly-treated itinerants by describing the parlous state of business in Guangzhou’s usually-bustling rag-trade district. The article in question started by pointing out that the crowds jostling along Qiaonan New Street today are not comprised of the usual eager shoppers, but rather of desperate job-seekers. It then went on to describe the fate of companies such as a Jiangxi-based underwear maker that has shut six of its thirteen production lines in the face of a fall of overseas orders of 40%.

Anecdotal, perhaps, but other data show that newly created urban jobs have fallen by 2 million, or ~20%, year-to-date. Separately, it is estimated that almost three-quarters of the year’s 8 million-plus cohort of new university graduates had not found work this summer – a lack which has prompted government efforts to persuade them either to emigrate to the countryside or set up as ‘online marketing professionals’. The first with ominous echoes of the Cultural Revolution and the second provoking much hilarity at the idea that the prospects for a further army of self-obsessed, social media ‘influencers’ are really all that bright.

Pressure to absorb some of this ‘reserve army’ has already been put on the country’s already inefficient SOE’s – with the banks, in particular, facing the triple-whammy of having to swell their payrolls at the same time that they face the need to make additions to their somewhat scanty loan-loss provisions and as their regulators are insisting they make substantial reductions to their business lending margins, as part of a policy of lowering SME financing costs.

Come into my parlour

The whole of this comes at something of an awkward time for President Xi since the prize of elevating China to the much-vaunted status of ‘moderately prosperous’ economy during his reign seems to be slipping from his grasp – not least because of the economic fall-out from his many foreign policy difficulties.

Faced with the prospect of foreign disinvestment, re-routed supply chains, and the various bans and embargoes to which the likes of Huawei, Tik-Tok, and now SMIC are subject, Xi has lately been pushing therefore the concept of a ‘Dual Circulation Model’. This, when you cut through the Hegelian mumbo-jumbo of the official communiqués, simply seems to mean making a virtue of a necessity by reducing the nation’s reliance on external trade as much as possible by trying to sell more of what is now made at home, not abroad, while simultaneously trying to make more of what is now bought abroad, at home instead.

The first leg of this runs up against the obvious objection that the one billion potential domestic consumers whom we have just noted struggle to earn more than $3,600 a year are not likely to provide an easy substitute for affluent German electronics geeks or credit-maxing Valley Girl shoe-shoppers. The second leg is a little disquieting in that it smacks of the sort of autarky drive that previous states have embarked upon only in preparation for a major war.

Another aspect which has gone largely undetected by those foreign gadflies who have succumbed to Chinese spider’s perilous invitation to enter its parlour – and who are therefore  clamouring to ship money INTO China as fast as they possibly can – is that the authorities have once again been trying to stop as much of it as possible from leaking back OUT, if largely so far at the micro level by putting extra difficulties in the way of the little people trying to conduct business across the border, or hoping splash out on overseas shopping or gambling trips (COVID-19 has provided no mean amount of assistance here, of course).

The problem is not a trivial one for, over the last five years, the identifiable cash flowing into the country amounts to a little more than a trillion-dollars-with-a-capital-T: roughly $800 billion via the current account, $150 billion from net inward fixed investment, and $90 billion in net portfolio flows (stocks and bonds). With $630 billion being shifted off the PBoC’s stockpile of foreign exchange reserves to swell commercial banks’ and others’ external lending, however, that has left a huge, equal-and-opposite, $1 trillion black hole of outflows – listed under the catch-all category, ‘Net Errors & Omissions’ – to balance the books.

‘Net Errors and Omissions’? Red princelings’ purge protection funds? Their rival Youth League members rainy-day hoards, held against a possible (Great) Berlin Wall moment in China? More mundane criminality and corruption? Or just the good ordinary folk, sensibly diversifying their honestly-acquired savings, but having to do it through illicit back channels due to the illiberal nature of the regime under which they live?

A little of each, no doubt. But an ever-present headache for a government anxious to keep all its many wobbling plates spinning for as long as can possibly be.

No wonder, then, that the hierarchy wants to exercise a greater oversight of people’s banking and credit transactions. No wonder ‘shadow banking’ is being throttled and (admittedly often-fraudulent) P2P networks and refinancing schemes are being either closed or subject to much more intense official scrutiny. No wonder there is an unseemly haste to introduce what will be a thoroughly inconvertible ‘central bank digital currency’ as a parallel domestic medium of (highly-circumscribed and fully-monitored) exchange.

Corporate Governance with Chinese Characteristics

All of this gels neatly with Xi’s other recent focus – that of extending the reach of the shadowy United Front Work Department. Although his heavily-advertised pronouncements on matter this came in the context of what seemed outwardly to Xi’s proffering of an olive branch to members of a private business class to which he has previously expressed few sympathies, closer inspection of the text better bore the construction that what was being proposed was more of a bear hug – or a boa constrictor’s suffocating grasp – than a friendly embrace.

Given that Xi has referred to the UFW – an ideological hold-over from the early days of Mao’s CCP – as “an important magic weapon for strengthening the party’s ruling position and realising the China Dream of the Great Rejuvenation of the Chinese Nation” we should not take at all lightly his call for the UFW to co-opt the nation’s entrepreneurs and so ‘encourage’ them to become good Party members, striving to uphold Xi’s doctrines.

That the UFW is being told it should ‘educate and guide’ businessmen and women to ‘unswervingly listen to and follow the footsteps of the party’ and that this obligation should be fulfilled, in part, by having private firms hire, pay, and promote what will in essence be their very own in-house commissars means there will be little let-up in efforts to ensure an unwavering focus on explicit demonstrations of purity of thought and deed.

It seems that the old adage, ‘the public sector advances: the private sector retreats’ is about to go full Blitzkrieg. If that is the case, it should only add to investor caution abroad – though the prospects for an exhibition of cool-headedness from that quarter seem somewhat remote at the moment, so well is China doing the job of selling itself as a solution to people with too much central-bank money burning holes in their pockets.

We know that many of you are slaves to your blessed benchmarks and that therefore the mere addition of Chinese government bonds to the likes of the FTSE Russell World Government Bond index is enough to have you close your eyes and buy what some sell-side firms are touting as up to $320 billion of the things in fairly short order, but do just stop for a moment to think what it is you will be financing.

If the distaste for what we are being told is taking place in Xinjiang, Tibet, and Mongolia is not enough to deter those of you proudly flaunting your ESG credentials; if you do not weep for Hong Kong’s lost freedoms or fear for those of Taiwan; if the dire state of local government finances – or those of the captive regional banks so heavily exposed to them – do not give you pause for thought; if the tottering Leviathan which is Evergrande does not alert you as to how rotten is much of the country’s financial superstructure, then maybe Xi’s ambitions to bring all of the economy more directly under his sway will do the trick.

Yes, the 3%-plus those CGBs currently offer is a good deal more than the plus or minus 50-60 basis points available elsewhere in the Land of NIRP and ZIRP. But before you succumb utterly to your hunger for yield, bear in mind that the fruit so eagerly devoured in such circumstances frequently turns out to be toxic.

Likewise, consider that to sit down at Xi Jinping’s table and to put your investors’ monies readily at his disposal – thus helping him both prop up his Party’s creaking system and further expand his own, already terrifying powers – might be to request an especially poisonous menu from which to choose your meal.

It would therefore be wise, as the old saying goes, to bring a very long spoon with you when you go to your supper with him.