Welcome to the Capital Note, a newsletter about business, finance and economics. On the menu today: the disappearance of a Chinese billionaire, SOE defaults, and the mounting risks to China’s financial system.
The CCP’s Mixed Messages
Entering the new year, the Chinese government is sending mixed messages to foreign investors. Just as it begins opening its financial system to overseas institutions, the Chinese Communist Party is pursuing a high-profile crackdown on the country’s single most prominent businessman.
In November, the Chinese authorities conspicuously halted the IPO of Ant Group, a payments company, after its billionaire founder Jack Ma (better known for the e-commerce firm Alibaba) publicly criticized the country’s regulators. Just as Ant was slated to go public, Ma likened Chinese lenders, which require sizable collateral and guarantees from their borrowers, to pawn shops. He blamed an overly cautious regulatory environment, arguing that “China’s financial system basically has no risk, it is systemically lacking in risk.”
China’s richest man has since disappeared from the public eye. Speculation as to his whereabouts began when another Alibaba executive filled in for Ma on an annually televised game show last week. Spokesmen for Ma’s companies have declined to disclose his whereabout to the media. Meanwhile, Alibaba has lost close to $200 billion in value.
This is bad for obvious reasons: It demonstrates in stark terms to would-be Chinese entrepreneurs that they’d be better off starting businesses elsewhere. Outright belligerence toward business owners does not bode well for an economy where private firms generate three times the return on capital as state-owned enterprises. Indeed, the aggregate return for all Chinese corporations has halved since Xi Jinping took power in 2012 due in large part to his consolidation of economic authority. It’s hard to be bullish on China’s tech sector after the massive selloff catalyzed by the Ma incident.
It’s also bad for more specific reasons: China’s biggest economic weakness is lagging domestic consumption. The country’s savings rate has plateaued at around 45 percent in recent years despite consistent GDP growth. As a major lender to households, Ant makes it easier for the Chinese to spend money. By inhibiting consumer credit, the CCP is kneecapping its efforts to develop a robust domestic market.
Strangely, the crackdown on private business coincides with a crackdown on state-owned enterprises. A Bloomberg article today:
After letting inefficient firms survive for years, Beijing is now allowing them to fail. Bond defaults rose to a record $30 billion in 2020, including high-profile enterprises that had previously counted on the implicit guarantees of the state. Scrutiny and punishment of credit-rating agencies are increasing, while domestic exchanges delisted at least 16 stocks from their main boards last year — the most in data going back to 1999.
As I mentioned in a December note:
The cracks began to show in September, when China Evergrande Group, the country’s largest property developer, alerted regulators of solvency issues. The company’s bonds plummeted before state-backed investment firms stepped in with a $4.6 billion lifeline. That didn’t contain the damage: A string of defaults by both SOEs and private firms followed.
The Evergrande default was the first sign that the Party would no longer prop up inefficient SOEs. Couple that with tight monetary policy that restricts the flow of credit, and a sizeable portion of the Chinese state’s businesses could face insolvency in 2021. On one hand, that’s a welcome sign that the Party is taking structural reform seriously. On the other, the Chinese “financial system becomes most vulnerable when Beijing’s credibility erodes and implicit guarantees on assets are suddenly questioned,” as the Center for Strategic and International Studies pointed out in a report last year.
It’s a doubly puzzling pivot in light of the zeal with which Xi’s government has gone after Ma. If the Party no longer intends to prop up SOEs, presumably private businesses — businesses such as Ant Group, Alibaba, and Tencent — will play larger roles in the Chinese economy. But while attempting to trim the fat off bloated state firms, Beijing is also bullying private firms.
Around the Web
In the Wall Street Journal, Andy Kessler argues that Federal Reserve asset purchases are restricting the supply of Treasury securities:
In March credit spreads between good and junkier debt widened and Treasury prices spiked as yields plummeted because of the buying frenzy. The interest rate on one-month Treasurys dropped from 1.61% on Feb. 18 to 0.00% on March 28. That was the scramble for good collateral.
But wait, U.S. government debt was $24 trillion in March—why weren’t there enough Treasurys around to buy? Because, you guessed it, the Fed has been gobbling them up, $80 billion a month, for quantitative easing. Mr. Snider explains, “low interest rates were not from the Fed’s buying bonds, but from stripping the market of good collateral.” The Dow’s 22-day plunge into a bear market (from Feb. 20 to March 12) wasn’t from feared lockdowns, but from fear of a financial meltdown caused by lack of good collateral for the credit market to function.
Dan Wang of Gavekal Dragonomics has published his annual letter:
This year made me believe that China is the country with the most can-do spirit in the world. Every segment of society mobilized to contain the pandemic. One manufacturer expressed astonishment to me at how slowly western counterparts moved. US companies had to ask whether making masks aligned with the company’s core competence. Chinese companies simply decided that making money is their core competence, and therefore they should be making masks. The State Council reported that between March and May, China exported 70 billion masks and nearly 100,000 ventilators . . .
It’s obvious that the authorities in Wuhan screwed up big, but it’s also the case that the central government organized an effective response to virus containment. It’s not just the manufacturers: the consumer internet companies leapt into action in a way that their US peers did not.
After a year in which China managed both to ignite a global catastrophe and to emerge arguably stronger than before, I’ve been thinking about the paradox of the Chinese economy: always on the brink of collapse, yet perennially resilient. The CSIS’s China Economic Risk Matrix explains why:
While the nature of China’s political system and its lack of legal constraints may offer some temporary advantages in managing financial crises, it also creates obstacles to effective management… China has seen financial risks accumulate precisely because China’s leaders are trying to avoid the political risks that would result from bankruptcies, unemployment, and slower growth. As a result, financial institutions tend to accrue additional risky assets and bad loans in the performance of national service, storing up some of the risks that are now materializing with China’s banking system.
And it’s difficult to see how this cycle ends, because:
There are no precedents for managing the consequences of a credit expansion of this size. Once the levels of debt and complexity in China’s financial system reach a certain level, problems become more difficult to manage effectively. Losses must be taken, and it is often political decisions rather than decisions based on economic efficiency that will determine where the costs will be borne. No one can be confident that China has reached an unsustainable level of debt (any level of debt can be serviced if interest rates are low enough), but it is notable that China’s technocrats have attempted to push back on rapid rates of credit growth throughout the post-crisis period.
To sign up for the Capital Note, follow this link.