Friday 21 March 2014

Chinese Reforms Update

Life has kept me away from the blog here but what a few weeks it's been.

China's Rorschach Reforms

Announcement after announcement, data point after data point, all providing 'evidence' for arguments as diametrically opposed as reform success to a hard landing (and everything in between).

Here are a few of the highlights:

Broadening the Yuan trading bound: The People's Bank of China (PBoC) has always set the rate at which Yuan can be exchanged for USD.  Until 2005 they maintained a hard peg (the rate is x and only x). Accepting a trading band of +/- 0.3% doesn't sound like a huge move but that 2005 action allowed some flexibility for the market to at least indicate the desired rate direction. 2007 brought the band to 0.5% and 2012 to 1%. Also, during this period, the Chinese currency appreciated significantly (graph below). The announcement this March was a doubling of the bound to 2%.

You can see that the Yuan/USD has largely been a one sided trade, meaning that the market almost by consensus believed that the Yuan was undervalued at 2005. 2014 and the 2% band marked an interesting occurrence, the markets pushed the Yuan value lower.

Directions aside, the liberalization of the Yuan is a key piece of the re-balancing reform we've heard so much about. While the appreciation since 2005 has eaten into the financial repression that has aided domestic producers to sell their excess production or domestic investment abroad (a below equilibrium exchange rate would result higher then socially optimal production levels). The undervalued Yuan also ate into domestic consumers purchasing power.

Notice that this imbalance encourages over investment and under consumption. Key items that the re-balance need to address. With the recent depreciation, the market is suggesting that perhaps the government won't get a free re-balancing lift from exchange rate liberalization but having the market find the right level will encourage help ensure that external balances don't encourage internal imbalances. This alone makes is encouraging.

Bankruptcies: With over investment embedded in the Chinese economy (via financial repression) it's quite reasonable to expect that the re-balance reform will render firms on the frontier of economic viability, insolvent. So for me, perhaps the most interesting reform development to watch will be how the Chinese economy handles unwinding these firms. Or put another way, how does Chinese internalize all of the uneconomic investment.

That Li Keqiang understands that bankruptcies are inevitable, and recognizes the magnitude of the problem is encouraging. However, the scale of this problem is yet to be revealed. Because of China's very low level of capital stock at the beginning of this growth phase it seems logical that despite the presence of financial repression high investment levels of investment, despite being sub-optimal in the current period were easily internalized and became economic with growth. However, at some point the marginal returns of this over-investment tipped into the uneconomic territory.

When did this happen? Has this happened? In which industries has it occurred? In which industries will it occur in the future?  These are the billion Yuan questions that reforms should answer for us. They are also the questions that will impact the effectiveness of reforms, and determine how the reforms should evolve going forward.

Capital Market Liberalization: China has unveiled a pilot program that should facilitate the issuance of preferred shares by certain market segments. From Reuters:
Analysts have widely predicted the first preferred shares to be included in the trial will be shares in Chinese banks. Sources told Reuters last week that major state-owned banks, which are among China's biggest index heavyweights, have already prepared share tenders. 
The second group of listed firms include those which intend to acquire or absorb their counterparts by issuing preferred shares, while the third group covers those which aim to use preferred shares to replace existing ordinary shares, the CSRC said in the statement published on its microblog.
Again, pushing market influence. Again, stopping well short of 'ideal' (which gives the critics ample room to wonder: why not extend this to x industry? why not offer x channels to debt?) but a clear first step in the direction indicated by the Chinese government in their reform outlines and a move consistent with the consumption/investment re-balance plot line.

The market allocation of resources, in my opinion, is by definition socially optimal in the vast majority of cases (particularly in determining consumption and investment habits). Thus, to my eye, this is by definition a step in the right direction (I accept that there is plenty of room for disagreement on this point). Increasing the market's influence on what is deemed a good investment, and what is 'over-investment' is a positive. That this reform seems to be incentivizing consolidation is a bit troubling. But, if this helps internalize the over-investment described above, then it might still be net positive.

Perhaps the more important benefit is that this is a positive step towards giving households access to a wider range of investment opportunities. I'm having a hell of a time finding data on the composition of household savings but this article from the Epoch Times cites a PBoC report, "Surveys conducted by The People’s Bank of China show that Chinese residents prefer saving their money in banks rather than investing in stocks, bonds, and real estate." I'd really love to read through this report but I'm having a hell of a time finding it or any more information on how households are allocating their savings.

If this is correct, and it does line up anecdotaly with the little bit of knowledge I have on the subject. But Chinese households are largely under invested in the stock market and as liberalization allows increasing numbers of companies to tap into debt markets, and an increasing number of financial institutes are able to fund these companies, and as an increasing number of products are offered to households to give them exposure to this type of equity, then I think they'll you'll see a serious shift to equities.

How far away is that? Again with the billion Yuan questions, but this does appear to be consistent with that direction.

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