Catalysts for Crisis - ?· Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 ... control it and…

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  • Catalysts for Crisis

    1

  • Conditions for Crisis

    Total indebtedness is about 200% of GDP

    Corporate debt: 130%

    LGFV debt: about 90%

    Government: about 26%

    But these categories overlap

    Meanwhile, industrial production is slowing:

    2013 power output growth

  • Less Growth from More Credit

    3

    0

    3

    6

    9

    12

    15

    18

    0

    1

    2

    3

    4

    5

    6Nominal Credit Intensity

    Real Credit Intensity

    Total Social Financing (RHS)

    Trend of Real Credit Intensity

    Ratio:TSF/Incremental GDP Trillion RMB

    Sources: PBoC, NBS, CEIC, The Conference Board

  • Using Infrastructure Investment to Drive Growth

    4

    -20

    -10

    0

    10

    20

    30

    40

    50

    60

    70

    2007 2008 2009 2010 2011 2012

    Fixed Asset Investment (FAI)

    Central Government FAI

    Infrastructure FAI

    Real Estate FAI

    Percentgrowth, y-o-y, 3mma

    Sources: NBS, CEIC, The Conference Board

  • Bank lending, total social capital, and money supply

    TSF & M2:Total Social Funding surged as % of

    total, eclipsing bank lending. Bank lending was

    38% of new lending. M2 money supply exceeded

    200% of GDP

    Deleveraging: Substantial deleveraging going on

    across China. Severe in benchmark cities such as

    Wenzhou, Ordos, Changsha. Ordos has rapid

    exodus of wealthy individuals, many leaving

    substantial liabilities behind

    Local Government Finance Vehicles (LGFV): Being

    privatized and their paper securitized to reduce

    the on balance sheet debt of local governments

    & banks. Local governments now selling future

    tax revenue to private investors. Wenzhou is

    selling off their Audi fleet

    Control M2 money supply

    Diversify, regulate, and supervise channels of capital to add

    transparency and restore confidence

    Maintain stability of RMB value through PBOC and Forex

    deployment

    Choices facing the Chinese Government

    M2 in terms of GDP M2 Growth (%)

    M2 Level and Growth Rate

    TSF vs. Bank Lending

    B

    Source: Central Bank of China, IMF

    Source: Central Bank of China, Deloitte Analysis

  • Recoveries Become Briefer and More Shallow

    6

    44

    46

    48

    50

    52

    54

    56

    Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12

    PMI: new orders PMI: new export orders

  • The PMI measure of employment shows a steady fall.

    7

    46

    46.5

    47

    47.5

    48

    48.5

    49

    49.5

    50

    50.5

    51

    may-12 jun-12 jul-12 ago-12 sep-12 oct-12 nov-12 dic-12 ene-13

    PMI Employment

  • And the relationship to cash injections is very direct.

    8

    0%

    5%

    10%

    15%

    20%

    25%

    30%

    35%

    -80%-80%-80%-80%

    -60%-60%-60%-60%

    -40%-40%-40%-40%

    -20%-20%-20%-20%

    0%0%0%0%

    20%20%20%20%

    40%40%40%40%

    60%60%60%60%

    80%80%80%80%

    Jan-2007 Jul-2007 Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010 Jan-2011 Jul-2011 Jan-2012 Jul-2012

    Floor Space of Buildings Under Construction: Residential Buildings: YoY M2: YoY

  • Why the consumer data is useless

    9

    -2,000

    -1,000

    0

    1,000

    2,000

    3,000

    4,000

    5,000

    6,000

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    Q1

    Q3

    2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

    Retail Sales ofConsumer Goods(NBS)

    Difference withHouseholdConsumption figurederived fromExpenditure GDPAccounts

    Difference withHouseholdConsumption figureestimated by NBSQuarterly HouseholdSurvey

    Seasonal-adjusted real value at 2011 price (bn RMB)

    Sources: CEIC, NBS, The Conference Board

  • But household consumption is shrinking

    in each quarter.

    10

    -5%

    0%

    5%

    10%

    15%

    20%

    25%

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    Q3

    Q4

    Q1

    Q2

    2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

    Householdconsumptionfrom expenditureGDP

    Householdconsumptionfrom quarterlysurvey

    Retail sales ofconsumer goods

    Real year-over-year growth rate at 2011 prices

    Sources: CEIC, NBS, The Conference Board

  • The Mechanics of Crisis

    Prices in certain locales increase yearly then monthly then

    weekly then daily.

    Speed of financial innovation exceeds regulators ability to

    control it and investors ability to understand the nature of

    their investments.

    Velocity of money accelerates.

    11

  • The Mechanics of Crisis

    Early defaults undermine market confidence. Market

    participants begin changing their activity to focus on short-

    term payback.

    Lenders raise rates and shorten maturities

    Capital flight accelerates.

    Corporates engage in carry trade by borrowing USD and

    pledging RMB.

    Forbearance by some key financial institution ends.

    12

  • Some Aspects of the Bubble

    Art prices skyrocketing, even for known fakes.

    Fast growth in sales of luxury watches, luxury cars.

    Speculation in almost anything: garlic hoarding,

    $10,000 packets of cigarettes, tea selling for $100,000

    an ounce, white spirits for 600,000 per bottle.

    Land King projects where prices spiral madly. Beijing

    property now selling for 600,000/m2, up by 10x since

    last year.

    13

  • The Case of Ordos

    Universal participation in private lending funds.

    Housing prices rising monthly, weekly, daily, then hourly.

    Crash in October 2011. Banks needed bailout in February

    2012.

    Property prices now 30-50% of what they were pre-crisis.

    Migrants, wealthy people have left the city. Retailing mostly

    closed. Unemployment very high.

    Local government borrowing from state companies to meet its

    fiscal needs.

    14

  • New Manhattan: The Plan and the

    Reality

    15

  • Meizhou LED Base

    16

  • Taizhou Logistics Port

    17

  • Over-development Everywhere

    No risk associated with over-investment.

    New developments destroy rather than create jobs

    Developments cash in dormant land resources and

    so expand the money supply before the economy is

    capable of absorbing it efficiently. The waste in future

    must be recognized as a reduction in GDP.

    18

  • Some other bubbles

    Tulip Mania, The South Sea Scheme, Railway fever, 1929

    Each craze entailed the rapid expansion of credit

    There tend to be defaults then a long period of calm, while

    market participants wait to see whether the bubble will burst,

    Confidence declines, but people still want to take advantage of

    the bubble.

    There will be mini-recoveries but ever briefer

    Credit becomes shorter term and higher-cost

    When one market participant steps down, the circle breaks.

    19

  • Tulips: 1630s

    Booming textiles trade creates major wealth expansion

    for the Dutch.

    Syndicates were forming to support voyages. Company

    shares were traded.

    As prices rose, the quality of the tulips declined.

    Annual average wage: 200 florins. Emperor Augustus

    tulip in 1637: 9,000 florins.

    20

    Edward Chancellor: The Devil Take the Hindmost

  • Souq al-Manakh, 1982

    Trade in Kuwaiti stock market was conducted using

    post-dated personal checks.

    In eight months, the value of the cheques exceeded

    $90 billion, and interest rates were 300%. The shares

    exchanged were nominally worth $200 million.

    Cheques were due at end of year. But in August, one

    speculator asked that a check be cashed early. The

    owner defaulted and the market crashed.

    21

    Edward Chancellor: The Devil Take the Hindmost

  • South Sea Mania, 1720

    The expansion of British trade combined with the

    murkiness of investment in colonial expansion to

    generate speculation in many traded companies.

    The South Sea Company bought British public debt in

    return for shares plus fiscal commitments to pay

    interest. Then it traded the shares actively to increase

    value.

    Copycat companies emerged. To protect the share

    price, the government passed the Bubble Act to

    curtail themand this triggered a market sell-off.

    22Edward Chancellor: The Devil Take the Hindmost

  • Some Commonalities

    Pre-condition is expansion of the money supply. Money has to

    go somewhere.

    Forward delivery stretches out; the object of speculation is not

    actually being delivered.

    A confidence jolt is followed by a quiet scramble to recover

    value, then a decisive fall.

    There is always some specious argument about why the object

    of speculation is actually very valuableFlorida real estate has

    an ocean view. The internet will create phenomenal value.

    Urbanization will generate 20 years of growth.

    23

  • Two paths to crisis

    Probabilistic

    The system develops multiple areas of instability. Odds are

    that some external shock will trigger a panic.

    Types of triggers:

    Large and politically sensitive default

    Bank run

    Pre-paid apartments are not delivered, owners protest publicly

    Significant fall-off in exports or major devaluation by a trading

    competitor

    Big default by a debtor nation

    24

  • Two paths to crisis

    Deterministic

    The banking system reaches the end of its ability to kick the

    can down the road.

    Types of triggers:

    Term deposits, wealth management products default en masse;

    investors lose their principal.

    Cash runs short; banks do not have money to lend. Economic

    activity grinds to a halt.

    Government tries to ease cash shortage by printing money and

    generating hyper inflation.

    25

  • The Most Vulnerable Regions

    Inner Mongolia

    Zhejiang

    Jiangsu

    Hefei/Bengbu

    Guiyang

    Tianjin

    26

  • Post-Crisis Scenarios

    27

    Scenario 1: Lost Decade

    Gradual deleveraging and absorption of over-

    capacity means that the economy sees very low

    growth, under 3% annually, for a very long time.

    Deflation. Consumers hoard cash.

    Growth drops even lower. Unemployment is high.

    Scenario 2: Tabula Rasa

    Deflate asset value through high inflation,

    significant devaluation of the currency, and

    opening of capital account or re-issuance of a

    new currency.

    De-legitimate the gray market, rewrite the rules.

    Use aggressive government buying to defend

    against attacks on the stock market.

    Freeze deposits, out conditions on their

    withdrawal.

    State assets are auctioned off.

    Scenario 3: Fragmentation

    Governments, under pressure to find cash for

    their own operations, begin freelancing. They

    privatize whole functions and farm taxes. They

    impose fees on services and unofficial tariffs on

    products from other regions. Eventually, some

    issue their own currencies.

    Some regional economies improve, some see

    negative growth. Investment capital follows the

    growth and exacerbates the imbalances.

    Scenario 4: Dramatic Reform

    Its back to the wall, the central government

    initiates sweeping reforms in financial services,

    health, education, and distribution. Unrestricted

    private ownership is permitted. Growth in

    services sectors over time lifts the banks out of

    the crisis and recapitalizes them.

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