Tuesday, 24 January 2017

China Going Out anno 2017

The Chinese Government’s “Go Out Policy” or “Going Out Strategy” (走出去战略) dates from 1999, and has continued to evolve from that date on. The policy involves active government support to Chinese enterprises to promote and support overseas acquisitions.

That this has been a successful policy has been felt by the whole world: Chinese overseas acquisitions have grown rapidly, with 2016 breaking another record: Chinese outbound investment for the year until December totalled USD 146 bln. This amount does not include the significant Chinese government loans and grants to foreign governments to facilitate trade and business. Including that, the number is considerably higher still, at USD 355 bln for the first 9 months of 2016.

The Chinese regulators have recently issued new rules with regard to outbound investment, increasing the scrutiny of certain types of transactions, but these are only meant to prevent money flowing out of the country under the guise of overseas sham acquisitions staged in order to transfer money overseas. Bona fide acquisitions which make strategic sense, and fit the business of the Chinese acquirer, will still get approved going forward. The acquisition of so-called “trophy assets” and completely unrelated businesses will be more challenging.

While the very rapid growth of Chinese outbound investment both in nominal terms and as a percentage is extremely impressive, it is still a small percentage of China’s GDP at around 7% when compared to, for example, the US (20%) or Germany (47%) there clearly still is ample room for further overseas investments. This was also recently expressed at a recent conference in Beijing by a former Associate Minister of MOFCOM, Mr. Long Yongtu, who predicted that by the end of the current Five Year Plan in 2020, Chinese outbound investment will exceed USD 300 mln per annum. 

In addition, the “Belt & Road Initiative” (or “OBOR”) will also be a strong impetus for Chinese companies to invest abroad in the OBOR countries. The first signs of this are already becoming evident.

There are however signs that China needs to handle this growing wave of foreign investments with care and a certain finesse: USD 40 bln of transactions were either not approved by foreign regulators, or pulled because it was evident that there were going to be regulatory or political issues. Certain countries have stated that they will implement new oversight bodies to scrutinise foreign investment transactions; most recently Australia. Clearly under the new government, the United States will become more challenging for potential Chinese investors.

As the United States Government turns to a more protectionist, isolationist mode many countries will turn elsewhere for their predictable, dependable strategic partnerships. This will cause major geopolitical shifts, and China looks to become a beneficiary of this. The Belt & Road Initiative, (which as we have explained in the past is much more than a strategy to deal with steel and cement overcapacity), should accelerate as China plays a more dominant role moving forward. This in turn will be the catalyst for even more Chinese outbound investment in the coming years. How this outbound mode will interact with the new US inbound mode will be one of the most important and interesting things to watch in the coming months.

Daniel P. de Blocq van Scheltinga
Polarwide Ltd.

Monday, 17 November 2014

Hong Kong Shanghai Connect: A Huge Leap Forward

The Hong Kong-Shanghai Connect has finally started. 

This is a very, very significant step in the reform process that China has started, and as outlined in 2013 during the Third Plenum (please see our China Compass of both March and May 2014), this is an important puzzle piece in the whole financial reform and liberalization process: a PRC stock exchange has opened up to the world.

Non PRC investors (not only Hong Kong residents but all overseas investors) are now able to directly buy shares listed on the Shanghai stock exchange, (“northbound”), and qualified PRC investors (individual investors with a minimum of RMB 500k in their accounts, in other words the better off) are able to invest in HK listed stocks (“southbound”), (including of course the international firms that have used HK as a listing exchange, who will now benefit from a huge potential new investor base).

There are exceptions in both directions, such as shares not traded in RMB in Shanghai (so called “B” shares) or not traded in HKD in Hong Kong, or Hong Kong shares with a dual listing in another Chinese city than Shanghai. 

Also the Hong Kong Shanghai Connect does not work for IPO’s; international investors can continue to participate in HK IPO’s, but not in Shanghai as yet. Similarly the Chinese investors in Hong Kong IPO’s cannot use the Connect for this purpose. This is bound to change over time.

Nevertheless the two exchanges become so closely intertwined, that this is clearly the first step of a long process through which ultimately One China Exchange will be created. Already there is talk of a future addition of Shenzhen to this couple, creating a really powerful threesome.

Already the new “virtual” HK-Shanghai combination becomes the 2nd largest stock exchange globally by capitalisation, and 3rd largest by turnover.

Focusing first on the northbound traffic into Shanghai:

Suddenly 985 Chinese companies (855 that did not have a dual listing with HK), become accessible to the global investment community. This will increase the global investment focus on the top companies in this group, which will slowly but surely have a positive impact on transparency. The global investor focus on China will increase, and evolve from just macroeconomics to specific company analysis. (Knowledge of Putonghua and a real understanding of China will be a plus!)

There is also a deeper agenda; many SOE’s have listed subsidiaries in Shanghai. International investors will over time force the SOE’s to act increasingly like the private sector, which fits perfectly with the Governments agenda to stimulate SOE reform.  

Remember that the new mantra is that “market forces will play a decisive role in the allocation of all resources”, which includes capital, and includes SOE’s. Similarly the Government is looking for private investment in the public SOE’s, in order to assist them to reform. The Connect is a backdoor into some SOE’s.

With regard to the southbound traffic:

Chinese investors have had limited opportunities to (legally) invest their funds; hence the real estate prices, the success of Yu E Bao (Alibaba’s savings account), and the wealth management products linked to shadow banking.

We believe the demand for diversification is very strong, (driven also by a very high savings quotient) and therefore the chance to invest in Hong Kong stocks that are not also listed in China, or even sectors that are not available through the Chinese exchanges, will be taken up with huge eagerness.

Other issues that will logically materialise:

The purpose of Chinese companies having dual listings SH-HK mostly falls away. This is bound to have a longer term negative impact for Hong Kong, as Hong Kong was also the PRC company’s window to the west. The Shanghai listed PRC companies will over time likely opt to focus on Shanghai, and delist their HK shares, as currency exchange regulations also liberalise.

On the other hand however, Hong Kong does become more important as a listing exchange for international companies seeking exposure to Chinese investors.

All in all exciting times. The Connect is but another step forward on the reform path, albeit a huge leap for Chinese financial reform.

Daniel P. de Blocq van Schetlinga
Polarwide Ltd.

Wednesday, 11 June 2014

Your Compass on China (June 2014)

June 2014

Daniël de Blocq van Scheltinga +852 2530 0611

Paul Hodges +44 (0)20 7700 6100 

Here Today, Gone Tomorrow?A Simple Guide to China’s World of Trade Finance

Executive Summary

  • This Simple Guide to China’s World of Trade Finance aims to explain the mechanisms behind the barely-understood financing deals that have come to dominate China’s multi-$bn markets for copperiron, rubber and other major commodities
  • This ‘collateral trade’ seems now to be in danger of imploding, creating major risk for the world’s commodity and financial markets, as well as for China’s property market
  • The trade’s origin lies in China’s stimulus programmes since 2009, which created a major boom in housing markets, often financed through the shadow banking system
  •  In turn, trade finance schemes became a popular funding mechanism for such investments: with commodities such as copper becoming collateral for this funding
  • The 3rd Plenum’s decision to allow market forces to play a “decisive” role in the economy means the property boom is now facing a government-initiated squeeze, whilst the People’s Bank of China (PBOC) is investigating the trade finance schemes
  • Product now tied up in this ‘collateral trade’ is likely to be released onto the market in a disorderly manner: China’s housing market bubble risks losing air very quickly 

1.     Introduction

Chart 1: Copper in bonded warehouses in China
Tins of sardines were very hard to obtain in the UK during World War 2.  As a result, the tins were often simply traded between companies, without ever being eaten.

One day, a company decided to open some tins to provide a celebratory lunch for its workforce.  They found that all the sardines had decayed, and were uneatable.  The company complained to its supplier, only to be told - "That's not our fault.  Those sardines were for buying and selling, not for eating."

This is the best analogy we can make for the ‘collateral trade’ now dominating many commodity markets due to the growth of China’s shadow banking sector to $3.5tn+.  This trade has even begun to be seen in polymer markets, with polyethylene now involved.

The ‘collateral trade’ has been a major component of the financing required to support China’s $10tn lending boom over the past 5 years.  The volumes involved are huge – China has been buying two-thirds of the world’s supply of iron ore, and has been responsible for 40% of global copper market demand.  Reuters has suggested that 100 million tonnes of iron ore are currently "off-market" by being tied up in the 'collateral trade'.  This volume is enough to build 1200 buildings the size of New York's Empire State building.

These vast stockpiles have also helped to keep world market prices at high levels in recent years.  But now there are clear signs that the various schemes involved in the bizarre world of China's trade finance, which helped finance these stockpiles, are imploding.  The reason is that China’s leadership want market forces to play a much greater role in the economy, as we described in Will Market Forces Start to Play a Major Role in China?
Two such schemes are as follows:

Scheme 1: Using inventory to invest off-shore funds in WMPs

Chart 2: How Letters of Credit have been used to fund property trading via WMPs
This scheme uses inventory to obtain off-shore cash to invest in Wealth Management Products (WMPs) via the shadow banking system.  These WMPs can attract interest rates of up to 60%, from real estate developers to finance building work on their apartment blocks.

An example of how it can operate using Letter of Credit (L/C) trade finance is as follows:
  •  LC1 Is opened.  Company A opens an L/C with a major bank to import copper
  •  LC1 is used to pay the copper producer
  • Company A typically then has 6 months to repay LC1, having paid a 20% deposit
  •  But demand is weak, so it doesn't need the inventory for its normal business 
  • So it decides to sell the copper to an associated overseas company (‘Company B’)
  • Company B is often a Hong Kong-based company, able to access offshore funding
  • Company B pays Company A with this offshore money, allowing Company A to invest in high-return Wealth Management Products (WMP) via the shadow banking system
  •  LC2 is opened.  Company A then obtains another L/C (“LC2”), and buys back the same copper from Company B: as before, LC2 need not be repaid within 6 months
  • At this point the copper is now back in China, and Company B has been repaid
  • Company B then buys back the copper using offshore funding, enabling Company A to repay LC1

Company A now only has only LC2 left to repay, and its investment in WMPs means it is earning a much higher interest rate than cost of the L/C.  In addition, the relentless appreciation of the renminbi since 2009 created an additional exchange rate gain. 

A key attraction of the system is that whole cycle can be repeated endlessly.  It can also involve multiple trades and overseas associated companies.  Investment bank Goldman Sachs suggest that up to $160bn may have been involved in such capital inflows since 2010.

The commodity is, of course, never actually used.  But because it is being held off-market as collateral, the outside world assumes this perceived demand is proof of China’s insatiable demand for commodities.  So investors line up to fund new developments to increase global supply, not realising the end-use of their money is to fuel China’s property bubble.

Scheme 2: Buying imported product to sell on the futures market

This scheme is a simple variant on the above. It involves buying an imported product on normal 180 day (or longer) payment terms, and then immediately selling the product on a futures market.  This is what appears to have happened in Q1 with polyethylene.
The buyer then uses the credit provided by the seller to fund their investment in WMPs.       

2.     Everybody loved these Schemes – until the 3rd Plenum       

The above schemes have been in operation since the stimulus programme began in 2009, and the players have made very healthy profits from them.  The previous Chinese leadership was also happy to allow these schemes to flourish.  They saw shadow banking as helping to support some of their key objectives by:

  • Creating a property 'wealth effect' to boost domestic consumption
  • Boosting employment by encouraging construction projects
  • Replacing lost export business to the West with domestic consumption
  • Maintaining relatively high levels of domestic economic growth
The producers of the various commodities involved, and their investors were also happy.  Commodities tied up in 'collateral financing' were effectively "off-market" as they couldn't be sold into the physical market.  So the 'collateral trade' helped to create the illusion of a tight market, and provided major support for world prices.
China’s 3rd Plenum changed all this however, as we described in our March Note.

3. Now the new leadership is forcing the sardine cans to be opened

Many players in these schemes had assumed they could continue for ever.  But China's new leadership understands that China's credit bubble has created enormous risks for economic stability.  As state-owned China Daily commented last month under the heading 'Let the bubble be squeezed':

"Admittedly, a thriving real estate sector has served as both a growth engine for many local economies and a key driver behind the country's urbanization.  However, it makes no sense to try to sustain a property boom at any cost when it has become dangerously frothy.   Fortunately, policymakers from the central bank have not blinked in face of the short-term pressure of shrinking property sales."

Similarly, China’s Academy of Urban Design has warned:
"China, on the one hand, has witnessed the absurd phenomenon of 'ghost cities' and excess investment in property development. On the other hand, it has large, densely packed cities that have scant traffic management and medical resources.”

Thus the People's Bank of China (PBOC), the central bank, has begun to change the regulatory system.  One policy move has been to create exchange rate volatility by pushing down the value of the renminbi versus the US$.  This creates losses for those speculating in the trade finance area, and makes people more cautious about future exchange rate gains.

Now, however, the issue has begun to assume global significance.  This month, a $1.6bn scandal has erupted at China’s 3rd largest port, Qingdao, allegedly involving multiple loans made using the same collateral.  Reportedly, it involves 20KT of copper, almost 100KT of aluminium ingots and about 200KT of alumina.  We believe further scandals are likely to erupt in coming weeks, due to the pervasive use of trade finance for the ‘collateral trade’.  

Everyone was happy ‘to turn a blind eye’ to the collateral trade when it was earning vast profits for all concerned.  But now, the party appears to be over.  And the hangover that it leaves is likely to be extensive:
  • Many banks are now increasing their deposit level for Letters of Credit from 20% to 50%, and there are rumours that Letters of Credit may even be banned altogether
  • Thus there is clear potential for a cascade effect to begin, bringing down the whole house of cards.  Many of the companies involved in the ‘collateral trade’ probably cannot afford a 50% deposit, when the time comes to rollover their borrowing:
  • They will then have to close their financing deals 
  • The copper or other commodity will then return to its original owner 
  • And as demand has slowed still further, they may well have to sell it
  • The impact could be large, given China’s dominant position in world markets
At the same time, of course, the government’s decision to squeeze the property bubble removes the original rationale for the trade finance schemes to exist.  In fact, it is more likely that any downturn in the property sector will be self-reinforcing, just as the government seems to desire.

4. Conclusions

It is impossible to overstate the potential importance of these developments.  

Investors have become lulled into a false sense of security in recent years by the combined impact of (a) central bank policy and (b) China’s apparently insatiable demand.  They have not wanted to ask too many questions, for fear of finding that ‘”all that glitters in not gold”.  Thus they have happily financed major expansion in the supply of major commodities, assuming that central banks will keep interest rates low, and that China will continue to buy.

This assumption is likely now to be severely tested.  We suspect that the recent investigations in Qingdao will prove to be just the tip of the iceberg, and fear that the world is about to witness a disorderly unwinding of the ‘collateral trade’.  The gravity of the situation is confirmed by the fact that state-owned Citic Corporation has now gone to court in Qingdao to try and secure the assets it believes that it owns.

The risk that we will now see a 'dash for the exists', as described by Hyman Minsky:
  • Investors have believed that central banks are in complete control
  • They have also assumed that China is set for inevitable and long-lasting growth
  • Thus market volatility has dropped to record lows
  • Margin debt on the New York Stock Exchange has risen to record levels

Minsky argued that such long periods of stability leads to major instability, as investors become complacent about risk.  An event then occurs, such as today’s unwinding of the collateral trade, which makes them realise they have overpaid for assets during the bubble.  They then rush for the exits, only to find that potential buyers have disappeared.

We do not underestimate the potential impact and pain that will likely now ensure. But it is clearly a necessary development.  The volumes now tied up in these bizarre trade finance schemes have simply become too large to be financed on an ongoing basis.  Our concern is that a 'vicious circle' may now develop, impacting both good and bad assets.

Commodity makers investors in their ‘dash for cash’ may well find that liquidity has disappeared from their favoured “risk-on” markets.  They will thus be forced to sell high-quality assets in order to meet their commitments.   


About PolarwidePolarwide is a Hong Kong-based financial and strategic advisory firm advising international companies with their Asian strategy.

Daniël de Blocq van Scheltinga was the first foreigner to be granted permission to run the finance company of a top-tier Chinese State Owned Enterprise, when  establishing and managing ChemChina Finance Company.  Previously, Daniël held a variety of senior positions in corporate and investment banking, including as Asia Pacific Head of Chemicals and Asia Head Asset Based Finance for ABN AMRO.  
He has lived in Hong Kong for 14 years, and continues to spend much of his time in China, advising both international and Chinese firms, as well as leaders in the public and private sectors.  Daniël is a graduate of Leiden University in the Netherlands, holding a Master of Law degree with a speciality of International law.

About IeC: IeC is a London-based strategy consultancy advising Fortune 500 and FTSE 100 companies, investment banks and fund managers.  

      Paul Hodges is a trusted adviser to major companies and the investment community, and has a proven track record of accurately identifying key trends in global marketplaces. He has been widely recognised for correctly forewarning of the 2008 global financial crisis. His analysis of the key role of demographics in driving the global economy is now attracting increasing interest from senior policymakers and executives. 


Paul is Chairman of International eChem (IeC) and non-executive Chairman of NiTech Solutions Ltd. Prior to launching IeC in 1995, Paul spent 17 years with Imperial Chemical Industries (ICI), both in England and the USA, where he held senior executive positions in petrochemicals and chloralkali, and was Executive Director of a $1 billion ICI business. Paul is a Freeman of the City of London and a Member of the Energy Institute.  He is a graduate of the University of York, and later studied with the IMD business school in Switzerland.

This Research Note has been prepared by Polarwide/IeC for general circulation.  The information contained in this Research Note may be retained.  It has not been prepared for the benefit of any particular company or client and may not be relied upon by any company or client or other third party.  Polarwide/IeC do not give investment advice and are not regulated under the UK Financial Services Act. If, notwithstanding the foregoing, this Research Note is relied upon by any person, IeC/Polarwide do not accept, and disclaim, all liability for loss and damage suffered as a result.

©  IeC/Polarwide 2014

Wednesday, 21 May 2014

Typhoon "Reform"

And the financial reforms, discussed extensively in our last Your Compass On China (May 2014), continue unabated and at a fast pace. The following reuters newsreport only underlines what we have been saying all along:

(Reuters) - China's cabinet signaled on Tuesday it is closer to letting local governments directly sell bonds for the first time and said it would phase out opaque financing vehicles that are thought to have built up trillions of dollars of high-risk debt.
In a sweeping statement, the country's top economic planner, the National Development and Reform Commission (NDRC), said Beijing would deliver stable economic growth whilst pursuing reforms.
The promise to stay focused on reforms would appease critics who worry China's enthusiasm for bringing about painful changes may be on the wane as its economy stumbles.
The uncertain outlook for the world's second-largest economy was underscored on Tuesday by remarks from a senior Chinese trade official, who said the country has a tough road ahead if it wants to meet its 7.5 percent trade growth target this year.
Yet the NDRC said in a statement on its website that enacting change is a "first priority" for the government and hopes to make breakthroughs this year in key areas.
On fiscal reform, which caused a market stir on Tuesday after Chinese media reported that China would allow 10 local governments to directly sell municipal bonds, the NDRC signaled that the government won't disappoint investor expectations.
It said China will create a financing system for local governments that will let the sale ofmunicipal bonds be a major source of funding for governments.
Financing vehicles, which are set up by local governments to borrow on their behalf so as to get around laws that prohibit governments from borrowing directly from any parties, would also be phased out.
It said that Beijing would set limits -- or quotas -- on the amount of debt that can be raised by local governments.
"The policy has been made talked about several times, so the market is now waiting for details, in particular how the quotas will be set," said a senior trader at a major Chinese state-owned bank in Shanghai.
"I don't think the central government will immediately let local governments issue lots ofbonds and endanger the overall financial system."
According to Chinese media, China is set to allow the 10 governments that include Zhejiang, Jiangsu, Shandong, Guangdong, Beijing, Shanghai and Shenzhen to directly sell municipal bonds.
Tuesday's statement did not refer to the above plans, though many analysts have said that the only viable, long-term solution for China with regards to its local government debt problem is to develop a thriving municipal bond market.
By allowing direct bond sales, Beijing can require higher degrees of disclosure in prospectuses and can also allow for the distribution of risk to a wider pool of potential investors.
Chinese local governments at present have limited legal options for fund raising, but have proven nimble at exploiting loopholes.
In addition to selling land to raise funds, they have created local government financing vehicles which have gone to the bond and loan markets to raise funds.
Local Chinese governments, which are notorious for being opaque, are estimated by some analysts to owe up to $4 trillion - 42 percent of China's GDP - much of it raised through financing vehicles.
A state audit of local governments' debt in December showed they owed a total of $3 trillion as of June 2013.
But despite concerns about the fiscal health of local governments, bonds sold by their financing vehicles are still sought after by investors. This is partly because many believe they are implicitly guaranteed by the state, even after Beijing allowed the country's first publicly-traded bond to default this year.
Other reforms canvassed in the NDRC guidelines included repeating commitments to a more market-oriented exchange rate, cutting red tape and deepening energy reforms.
"We should seize this time window when the overall price level is stable to actively push price reforms in resource products and sectors including transportation, telecommunications, pharmaceutical and healthcare industries," the NDRC said.
(Reporting by Aileen Wang and Koh Gui Qing in BEIJING and Pete Sweeney and Lu Jianxin in SHANGHAI; Editing by Kim Coghill)