5 Year Plan
China craves respect. In order to join the esteemed high income Western democracies it has to open its financial borders, float its currency and allow business the freedom to succeed and fail. China’s thirteenth 5 Year Plan is due to be revealed formally this month to achieve these and many other specific objectives such as clean energy, urbanization, marked to market assets and a service centric workforce. The evolution of the 5 Year Plans are a product of the tightly controlled Communist State directives begun in 1953 by Mao in sympathy with communist Russia. Symbolically this Planned Economy perpetuation is an oxymoron in today’s effort at laissezfaire capitalism. China will manipulate its data, force labor to move, predetermine its currency values and actively support businesses it deems strategic all the while it attempts to paint an image of a modern unfettered economy.
Fettered Free Floating Currency
Last December the Chinese Yuan gained the International Monetary Fund (IMF) stamp of approval to become a global reserve currency under the stipulation that it would be liquid and freely exchanged in the world marketplace. Every time China opens the door their currency leaves the country sending the Yuan lower. So despite its promises, the Yuan is being tightly manipulated. Why else would the Peoples Bank of China (PBOC) limit the size of currency transactions and raise interbank interest rates to 200% overnight? They want to prevent smart money from finding the true market value of the Yuan, eliminating liquidity and crush speculation. China wants the gain but not the pain that comes with a floating currency system. Corporations and sovereign powers will need to trust the value of the Yuan before investing capital. Having Special Drawing Rights (SDR’s) with the IMF is still a baby step for China that seems to only want a free floating currency when everyone wants to invest in China, but not when they want to send their money to foreign shores. As long as China continues to slow, this will be a costly effort by the PBOC to defend its currency and manage capital flows. For now the Yuan depreciation will be halted, unless Oil crashes to a new low under $26.
Vote of No Confidence
The mirage of perpetual Chinese growth dissolved in 2015 as local businesses have become worried about the lack of future growth.
A lack of growth and actual contraction can be seen here in a new variation of the “official” Purchasing Managers Index (PMI) provided by the Minxin Manufacturing Index (MMI) survey. While both the PMI and MMI are signaling a manufacturing contraction in progress, the MMI sentiment has negatively diverged with the official PMI throughout 2015 and is currently plunging steeply. If this MMI has merit, then we can expect significant support of these subjugated “free” markets with new loans and stimulus.
While not as dramatic as the MMI, the official PMI reveals that the downsizing of Chinese manufacturing is not over and is instead accelerating its rate of contraction. For over 4 years sentiment, order flow and output have been in a net contraction mode and this is prior to the official kick off of the certain closing of production facilities among State Owned Enterprises (SOE’s). Up to 6 Million workers, many showing up to work at zombie enterprises, will be eliminated in the hope that the growing service sector will eventually absorb them and Millions of new laborers from the countryside stuck in the ag sector. This will require a LOT of debt write offs and new loans and further expenditure of state reserves. It will also require “time” when moving an aircraft carrier of this magnitude.
Banks Need a Bigger Boat
China knows it has to intervene continuously and aggressively as capital continues to pour out of its borders seeking higher returns. For years they lured investors into their country with unfair trade barriers and subsidies and became the only capital investment game in town usurping much of the worlds industrial capacity. Now their asset has become a liability as they are wise enough to see the need to shift to a more 1st world service oriented society. They will need to regain confidence in their local investors instead of relying upon controlling when and how much capital can flow out. China wants free capital movement, just so long as its coming in.
As capital flows out and exports contract the desire to convert the Chinese Yuan into Dollars and Euros increases. China has steered several phases of “controlled” devaluations while expending almost $700 Billion of its large reserves slowing the rate of depreciation. Longer term currency values will likely continue to fall, but the PBOC is shifting tactics to prevent further devaluation in favor of more aggressive injections of capital to stimulate loans and investment. In the Western World this was tried with imperfect success. Japan has shown 4 years of massive stimulus and yet moribund consumption and declining exports. China has an even bigger bad debt pool to drain. We are not saying this effort will fail to stimulate, in fact more the opposite. We are speaking more to the scope of bank reserve ratio and interest rate reductions and new money that will be scaled up over the next year to at least temporarily turn this sinking ship toward the safety of shallow waters.
Open the Flood Gates!
It remains to be seen if the January flood of new loans will continue, but we suspect it will be the new normal as the 5 Year Plan directs new loans to (1) write off the exploding bad debt bubble and (2) to provide targeted stimulus into service sector and export oriented businesses. In recent years SOE’s (State companies) accounted for 40% of China’s industrial output and 50% of its loan volume. These are the most inefficient enterprises holding the most bad debt employing 35 to 40 Million workers. Essentially Chinese banks (PBOC) will write down and sequester bad debt from the soon to be shutdown operations of SOE’s and shrinking surplus capacity in coal, steel and other industrial sectors. To pull this off without panic they will need easy money to be thrown at the non-manufacturing service sector to stimulate consumption. This will be a true test of China’s Communist-Capitalist style of Government.
China Needs Inflation
Really the world could use some inflation or at least the animal spirits it wold impart on economies. Higher Oil prices will provide cover for the warts that are multiplying in China, Russia, Japan and emerging markets as revenues would rise and sentiment improve. We have been expecting a bottom in Oil during February and extreme negative sentiment by managers and hedge funds allows for the normal seasonal rally by spring to lift energy prices. Higher prices will reverse the concern over Junk Bonds and provide a boost to leveraging private investment capital as confidence rises. With China stimulus focus emanating from cuts in interest rates and reserve ratios and corresponding new loans, it will try very hard to keep the Yuan/Renimbi from falling to new lows. We can watch this proxy below as higher Oil prices will make their goal easier to achieve, while new lows in Oil would increase the odds of market panic.