The big story lately has been capital flowing out of China. But I don’t think this is well understood.
Check out this chart from Bloomberg:
As you can see, in 2015 capital all of a sudden flowed out of China at a rapid pace. What is going on?
A lot has been written about Chinese capital escaping a corruption clampdown and a general attempt by the middle class to get their wealth out of China. The ‘Chinese buying up global property’ story is a reflection of that.
Here’s the Bloomberg story with the numbers and a different explanation:
‘The problem now is that more money wants to get out of the country than wants to get in. Here’s the math: Last year, the IIF estimates, China had a little more than $250 billion coming in from the surplus on its current account, the broadest measure of trade. It got an additional $70 billion or so in net capital from nonresidents, including Chinese companies’ overseas affiliates. But those inflows were swamped by a record $550 billion in net outflows by individuals and companies inside China.
‘Who stashed all that money abroad? The Bank for International Settlements attempted to answer that question in its Quarterly Review in September using the example of a hypothetical Chinese multinational. During the boom years, BIS economist Robert McCauley wrote, such a company made money by borrowing at near-zero rates in the U.S. and Europe, converting the money to yuan, and investing in China at higher yields. Now, he wrote, it was reversing course: borrowing more in yuan and holding more money in foreign currencies.’
This explanation looks close to the mark. Remember the high yielding products offered by China’s shadow banking system? Borrowing US dollars at low rates and investing in these products was an easy way for Chinese corporates to make extra money. And given the US dollar/yuan peg, there was no currency risk to doing so.
But when the Chinese government devalued the yuan back in August 2015, it brought this trade undone. That’s why you see the recent plunge in capital flows in the chart above.
This trade (one of borrowing in US dollars, then selling those dollars to buy yuan denominated financial assets) is now in the process of unwinding.
For that to happen, you need to sell yuan to buy back the US dollars to repay the loan. Hence the pressure on the yuan and the upward pressure on the US dollar.
But most people don’t realise why the unwinding of this trade is negative for financial assets. When a loan is repaid, it represents a disappearance of money. That means less money to slosh around financial markets and inflate asset values.
Strangely, this dynamic doesn’t appear to be impacting on China’s credit growth.
China’s credit growth surges
Chinese credit data out today was strong, and probably reflects efforts late last year by the government to stimulate growth. From the Financial Times:
‘New data show that “aggregate financing,” the broadest measure of Chinese credit growth available, jumped 78 per cent between November and December, to Rmb1.820tn ($276bn) — the most since June, according to the National Bureau of Statistics.
‘The sharp increase follows a cut to benchmark interest rates in late October – the sixth cut in a year – as the economy grows at its slowest annual pace in 25 years. Economists were only anticipating an increase to Rmb1.150tn.
‘Details suggest the shadow banking sector picked up momentum. “New yuan loans”, which track borrowing in the normal banking sector, were only Rmb598bn, about Rmb100bn below forecasts and accounting for less than a third of the month’s total.’
Hmmm. So new loans from the commercial banking system were weaker than expected while loans from ‘shadow banks’ surged.
Given the capital flight story above, that suggests the increase in shadow banking system loans are an attempt to plug the gaps left by fleeing capital.
If that is the case, this whole China credit boom and bust story is still in its early stages. I fear that it’s going to get really ugly as 2016 progresses.
Where does oil fit in?
Oil has been in the thick of it lately. But it’s not just a story about too much supply and not enough demand. It’s also currency related. That is, as the US dollar strengthens, oil weakens. Check out this chart (and related commentary) from Ben Hunt’s excellent Epsilon Theory letter.
‘Here’s a 5-year chart of the broad-weighted US dollar index (this is the index the Fed publishes, which – unlike the DXY index and its >50% Euro weighting – weights all US trading partners on a pro rata basis) versus the price of WTI crude oil. The red line marks Yellen’s announcement of the Fed’s current tightening bias in the summer of 2014.’
Source: Bloomberg, January 2016.Click to enlarge
‘Ummm … this nearly perfect inverse relationship is not an accident. I’m not saying that supply and demand don’t matter. Of course they do. What I’m saying is that divergent monetary policy and its reflection in currency exchange rates matters even more. Where is the greatest monetary policy divergence in the world today? Between the US and China. What currency is the largest contributor to the Fed’s broad-weighted dollar index? The yuan (21.5%). THIS is what you need to pay attention to in order to understand what’s going on with oil. THIS is why the game of Chicken between the Fed and the PBOC is so much more relevant to markets than the game of Chicken between Saudi Arabia and Texas.’
So, volatility in oil and China are related themes. It all comes down to the incongruence of having a pegged currency when one economy is relatively strong while the other is desperately trying to head off a credit bust.
Markets will put up with such a situation for some time…then they will turn. In 2016, it looks like markets have turned…
Finally, let’s have a quick look at BHP’s disastrous foray into US shale oil. Today, it announced an after-tax writedown on the value of its shale oil assets of nearly $5 billion.
After spending $20 billion on the assets in 2012, and an additional $15 billion in capital expenditure since, BHP has now written down around $13 billion in asset value.
At the current price of oil, you’d have to wonder whether the assets are generating a profit. If they are, I’d say it’s a poor one.
Look, commodity markets are notoriously cyclical. I’m not saying running a business like this is easy. But BHP (and many others) were seduced into thinking the rise of China put an end to the commodity cycle.
Even a simpleton like me warned about China years ago. It wasn’t hard to see.
Former boss Marius Kloppers was responsible for the US shale acquisitions, but he is long gone with a handsome payout. That makes it an easier announcement for current boos Andrew Mackenzie to make.
But it just goes to show that bull markets create genius, and bear markets reveal the truth. The truth of the matter is that BHP hasn’t managed this commodity cycle at all well. In fact, it invested billions of shareholder money at the top of the cycle.
You’ll see further evidence of this mismanagement next month when it reveals an inevitable cut to its ‘progressive’ dividend.
I know there’s a temptation to buy the bottom and ‘pick up a bargain’. But BHP will be in the doghouse for a long time to come.
Editor, Crisis & Opportunity
Editor’s note: The above article was originally published in Port Phillip Insider.
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