China

The EU accounts for roughly $400 billion of China’s exports, making it China’s single largest export market. So if Europe collapses, China’s economy takes a BIG hit. Remember, China is a centrally controlled economy, NOT a dynamic open market economy. Put another way, the entire China “economic miracle” is based on the current system continuing to operate in some form (China can continue to export, rip off intellectual property that is developed elsewhere, throw its weight around, etc).

Precisely a year ago, a summary report by Fitch shone the first, if relatively weak, light on the massive Chinese securitization industry which had for years allowed the country to fund its housing bubble without forcing the banks to actually take much if any of the loan risk associated with this unprecedented expansion. At the time of the Fitch report, the securitization discrepancy was not deemed to be excessive and at about RMB 1 trillion in annual issuance it was promptly swept under the rug. Nonetheless the key statement remained: "Fitch believes the vast majority of these transactions are not publicly disclosed by Chinese banks, and few, if any, traces of the loans remain in financial statements." More recently, and long overdue, Moody's took a refresh look at the same problem and on July 4 released a rather disturbing report which found "that the Chinese audit agency could be understating banks' exposures to local governments by as much as RMB 3.5 trillion." At 10% of GDP, the number sure is starting to get larger. Today we present what we believe is the most comprehensive report we have seen to date on the matter of the Chinese "Shadow Banking" industry courtesy of SocGen. For those who enjoy putting things into perspective, SocGen quantifies the total shadow banking system in China to be as large as RMB10 trillion (or 55%, of the Total Social Financing of RBM18 trillion): nearly USD1.5 trillion. While the number is not massive (considering that the most recent corresponding shadow banking number for the US is well higher at about $16 trillion), it keeps increasing as a portion of GDP. Why is this important? Because as SocGen's Wei Yao says, "The currently unsupervised development of the informal financing market delays the intended impact of monetary policy tightening, but adds to the risk of precipitating a liquidity crunch of the entire financial system later." So it this Chinese shadow banking system a potential monetary time bomb, destabilizing the PBOC's efforts at normalization and adding materially to systemic risk? Read on.

Just because China was already delighted with Obama's reception of the Dalai Lama, here come John McCain and John Kerry warning China to mind it territorial waters, because apparently US national interests are threatened. Per the FT: “We are concerned that a series of naval incidents in recent months has raised tensions in the region,” said John Kerry, the Democratic chairman of the Senate foreign relations committee, and John McCain, the former Republican presidential candidate. “If appropriate steps are not taken to calm the situation, future incidents could escalate, jeopardising the vital national interests of the United States.” The logical follow up is glairngly obvious but here it is: "China is likely to see the comments as a provocation as they echo remarks by Hillary Clinton, US secretary of state, last year that infuriated Beijing. Speaking at the Asean Regional Forum (ARF) in Hanoi last July, Mrs Clinton angered Beijing by saying the US had “a national interest in freedom of navigation . . . in the South China Sea." What is surprising is that the US is dumb enough to bait China with such provocations as the US Treasury market is now, more than at any other point in the past 3 years, reliant on Chinese bond purchases. And for all those who claim that China has no other alternative where to recycle its trade surplus dollars, we bring you exhibit i) the EURUSD, where China sells dollars and buys euros, and ii) Eurozone bonds over the past months, which it has been gobbling up ravenously. So yes: it does have alternatives, and it may very well make a rather forceful statement to that extent.

The Treasury released its May Treasury International Capital data today, which confirms recent trends: while China, both domestically and through the UK, and Japan both added to their gross exposure of US debt in May, Russia's holdings continued to tumble in line with warnings out of Moscow discussed previously and with the continued Kremlin rotation out of Treasurys and into gold. And while Putin has obviously had enough with shenanigans in the US, the same can not be said for his posturing colleagues in China (and Japan) who at least two months ago, brought their holdings of US to 2011 (and record) highs of $1159.8MM and $912.4MM respectively. So much for China dumping bonds. Another source of Treasury demand: petrodollars, which saw their UST holdings in May hit an all time high of $229.8 billion. Overall, gross purchases of Long-Term US securities by official and private foreign buyers declined modestly to $44.6 billion from $44.8 billion. Netting out foreign securities purchased of $21 billion, yields net flows of $23.6 billion on expectations of $40 billion, or in other words May saw a modestly lower inflationary impact due to an influx in foreign capital in the US economy. Also when netting out US purchases of foreign securities as well as changes in bank dollar-denominated liabilities the net number was -$67.5 billion.

• China 2Q GDP rises 9.5% y/y vs est. 9.3%; rate is slowest since 3Q 2009.
• 1H GDP rises 9.6% vs est. 9.5%.
• June industrial production increases 15.1% y/y vs est. 13.1%, rose 13.3% in May; June IP up 1.48% q/q
• 1H IP up 14.3% y/y vs est. 13.9%
• June retail sales rise 17.7% y/y vs est. 17.0%; 1H retail sales rise 16.8% vs est. 16.7%
• 2Q GDP up 2.2% q/q vs 2.1% in 1Q
• 1H fixed asset investment exc. rural rises 25.6% vs est. 25.7%
• NOTE: GDP grew 9.7% y/y in 1Q.

As of this morning China has migrated from a purely symbolic European White Knight to an actual one. While overnight trading action was set to recreate the panic from September 15, 2008, suddenly something changed. That something? China. Per Dow Jones: "Bunds give up nearly all of Tuesday's early gains with the September contract just 12 ticks higher on the day at 129.26 after making a spike at 130.91, a gain of 177 ticks from the open. The latest, unconfirmed, rumor pushing bunds lower is that China is behind the supposed ECB enquiries for peripheral debt prices. As yet no official confirmation from market sources of any central bank buying. In the cash space, the 2-year yields 1.235% and the 10-year 2.65%." As China has been actively buying up EURs over the past two months and is now massively underwater on a cost position that may be in the hundreds, but is certainly in the tens of billions of dollars, the ongoing collapse in the EUR currency will now force the PBOC to resort to increasingly more drastic measures to protect its strategic investment. The irony of this is that the Swiss National Bank, which this morning had to watch in horror as the EURCHF plummeted to 1.15 and for the longest time has been fighting the Fed (which loves a strong EUR) has been joined by the PBOC, which is now also trading on its behalf. The First Central Bank War is now officially on.

One of the main catalysts for today's European market action was the Italian 1 year Bill issuance which was supposed to set the tone for Italian bond demand, especially since thanks to ISDA's stupidity (which had made it clear CDS will not trigger in any event as the organization is completely spineless), there is no reason to any longer hedge a negative basis at issuance. Well, Italy did pull it off, although at terms that a month ago would have inspired shock within the market. "The 6.75 billion euro sale was the first test of appetite for Italian paper since a surge in nerves that it will be next to fall in the euro zone's debt crisis due to domestic political tensions and a combination of high public debt and low growth. The gross yield on the 12-month BOT bills rose to 3.67 percent from 2.147 percent at a previous auction in June. This was the highest level since September 2008, according to Reuters calculations on Italian Treasury data. The bid-to-cover ratio fell to 1.55 times from 1.71 in June, when the treasury sold a slightly lower 6 billion euros in total." However, even this data was very suspect after 10 Year Italian-Bund spreads hit a new record wide of 355 bps earlier as the Italian contagion is now fully on. In response, both the ECB and China are now rumored to be scooping up all peripheral bonds in the secondary after a long hiatus as the ECB is on the verge of panicking, side by side with European bond investors, following remarks by Dutch Finance Minister De Jager who said, as predicted yesterday, that a Greek selective default "Is not excluded anymore."

China's inflation battle would be a vertical battle climb for Beijing, and is nowhere close to "have peaked in June" as many analysts have predicted.

Europe is now openly burning once again (Italy-Bund spreads just hit a new record), the US is 9 days away from being bankrupt, and completing the trifecta is China, which just failed to sell half of the proposed 50 billion in CNY of local government debt at an auction, courtesy of the SHIBOR supernova which oddly only Zero Hedge has been covering. From Bloomberg: "China’s finance ministry failed to sell all of the three-year debt offered at an auction on behalf of local governments as a cash crunch curbed demand. The ministry sold 23.9 billion yuan ($3.7 billion) of bonds at a yield of 3.93 percent on behalf of 11 provinces and municipalities, falling short of its 25 billion yuan target, said a trader at a finance company required to bid at the auction. The Shanghai interbank offered rate, or Shibor, for three-month yuan loans, was fixed at 6.24 percent today, near a record high of 6.46 percent reached on June 28. “While the interbank borrowing cost is so high, investors won’t spend money on local government debt,” said Huang Yanhong, a bond analyst at Bank of Nanjing Co. in Nanjing. “Demand is low also because the debt’s secondary-market trading isn’t active. After you buy it, you can only hold it till maturity." Who would have possibly thought that 7 week money costing 7% and more could have implications and stuff...

The PBoC just announced its 3rd interest rate hike for 2011. In a statement just released, the Chinese central bank hiked its one year benchmark deposit and lending rates by 0.25%. To those following the 1 and 2 Week SHIBOR and repo rates this is hardly a surprise, as the recent liquidity thawing experienced an abrupt reverse in the past two days. In the meantime, expect to see more realization that the Chinese soft landing may be in for some bumpy times.

The timing on the earlier pronouncement that rating agencies may have found religion could not have been better. Not even an hour later, here comes Moody's with a blockbuster which may put China's "White Knight" status, at least as ar as Europe is concerned, in grave danger. In a report just released, the rating agency not only warns that China's debt problem is "bigger than stated" (i.e., China is hiding a ton of ugly stuff off the books), but goes ahead to quantify it: "Of the RMB 10.7 trillion (about $1.6 trillion) of local government debt examined by the Chinese audit agency, RMB 8.5 trillion ($1.3 trillion) was funded by banks. However, Moody's has identified another potential RMB 3.5 trillion ($540 billion) of such loans that the Chinese auditors did not discuss in their report....we find that the Chinese audit agency could be understating banks' exposures to local governments by as much as RMB 3.5 trillion." Naturally, the implication is that this is an absolutely willing "omission" (thank you central planning), which means that of China's $5.8 trillion GDP (or whatever imaginary number the Polit Bureau is happy with throwing around for mass consumption), $540 billion is debt that is "unaccounted for", most likely due to being, well, bad. That would be equivalent to saying that $1.4 trillion of US corporate debt is delinquent. And lest anything is lost in translation, Moody's drives the steak through the Dragon's heart: "Since these loans to local governments are not covered by the NAO
report, this means they are not considered by the audit agency as real
claims on local governments. This indicates that these loans are most
likely poorly documented and may pose the greatest risk of delinquency." So let's get this straight: a country which has 10% of its GDP in the form of bad debt, is somehow expected to be credible enough to buy not only Greek debt, but the EURUSD each and every day? Mmmmk. In the meantime, Dagong downgrades the US to junk status in 5, 4, 3...

There are more than 1 million college-educated "ants" in China making an average $286 a month. While China seems to have an over-supply of college grads, the United States, on the other hand, is not producing enough college-educated workers, at least according to a new study released by Georgetown University.

The CPC (Communist Party of China) was founded on July 1, 1921 in Shanghai with a large working class support base. Throughout the past 60 years or so, China has never deviate much from socialism. With rapid growth, cracks are starting to surface.

It seems that the global economic decline is not limited to the Japapense maanufcaturing base: as expected in a globalized world, manufacturing weakness has now spread to both China and the UK, whose PMI indices are both fractionally above stagnation. On China: "China's official Purchasing Managers Index fell to a 28-month low to 50.9 in June, (below expectations) with the imports index tumbling to 48.7, the lowest since August 2010. It was followed shortly after by the HSBC China manufacturing PMI for June, which slid to 50.1, marking the lowest level since the second quarter of 2009. The drop was sttributed to: "falling liquidity levels, higher interest rates and shrinking tighter
credit availability." Which means that the PBoC will be forced to act to rekindle its industrial base even as prices are still not under control and the upcoming inflation print is expected to come north of 6%. The UK's own PMI also was below expectations, coming at 51.3 on consensus of 52 and below May's 52.3 "The CIPS Manufacturing Purchasing Managers Index (PMI), a composite index measuring manufacturing activity, came in at 51.3 in June, down from a revised 52.0 in May, hitting its lowest level since September 2009...UK manufacturing sector activity growth has slowed dramatically in the CIPS series since early 2011. In February the headline index posted 61.5, matching January's record high for the series. In March the manufacturing PMI posted 56.4, then 54.4 in April, then the revised 52.0 in May, its lowest reading since September 2009. Now it has fallen to 51.3 in June, just 1.3 points above the 50 stagnation level." As a result the central banker dilemma is now at its peak, as the banking cartel is unclear if it should hike rates and stimulation inflation, or further lower and cause outright stagnation. As we said a few weeks ago, this is what centrally planned stagflation looks like. But luckily we have the US, whose Chicago ISM is expected to once again indicate a reverse decoupling is the name of the game for a few months, as despite a global economic contraction, the US is somehow growing, despite the end of QE2 and no fiscal stimulus anywhere on the horizon.

Following the abysmal decision by the Obama administration, presented in IEA letterhead, to release crude stockpiles, the resulting lower prices lasted less than one week, and in the case of gasoline, the price has actually surged way above the decision day fixing. So what is an administration with no credibility to do? Why double down of course, and sell even more crude at firesale prices to the Chinese. Per Reuters: "The International Energy Agency could decide by mid-July whether the release of strategic oil reserves needs to be extended for a month or two, an official said." And there is that transitory word again: "Richard Jones, deputy executive director of the
IEA, said he believed the release would be temporary since demand would
likely drop in the fourth quarter." Well demand may drop, but the last time demand was actually relevant in price discovery was sometime in the 20th century. Welcome to the era of oil prices defined by monetary policy.