China

Over the past two weeks, we have been suggesting, tongue in cheekily, that despite the relentless desires of everyone to sell the EUR, it has continued to drift higher, due to some inexplicable force with bottomless pockets, which, after some deductive logic, we assumed was China. It turns out we were correct. Naturally, figuring out what China does with its $3 trillion in foreign reserves is sometimes more complex than brain surgery (except what it does every time it sees a barrel of oil for sale: then it is pretty much guaranteed what it will do). But when it comes to preserving its 3 rounds of horrendous European down payments, it was pretty logical that China would do everything in its power to prevent a waterfall effect that would result in Europe imploding in a ball of illiquid singularity. The WSJ has confirmed that China's SAFE is actively doing all it can to transfer billions of its dollar-denominated holdings into euros. And while this does not mean the EUR is the new reserve currency, it certainly means that China has now become the deciding factor as to just who is (much to the chagrin of Markel, and delight of Geithner... for the time being).

China is struggling with inflation, speculation, an increasingly polarized society and even some social unrest. Shilling continues his 5 part China article today on how the country is strolling along the path leading to Hard Landing.

Some time ago it was revealed that in its rush to catch up with western military technology, China has now developed an aircraft carrier and a stealth fighter (reverse engineering efficiency notwithdtanding). Now, it appears that China has developed its first ever unmanned drone. Wired has the latest: "It was another big reveal in a long history of them. Six months after the Chinese air force let the first photos of its new stealth fighter
leak online, Beijing’s military has “accidentally” showed off another
secretive weapon system: a small drone, apparently used to scout ahead
of China’s fast-growing fleet of warships. Details of the Unmanned Aerial Vehicle — gleaned entirely from a snapshot
(.pdf) taken by a Japanese navy patrol plane last week — are sketchy,
at best. But the new UAV certainly represents a step forward in China’s development of American-style spy drones." Of course, the "leak" is anything but, and is merely another attempt to demonstrate its ongoing scramble to keep up with the US across all verticals. After all: why peg to the dollar, if you can't peg to the military. And while these attempts at oneupmanship are childish, expect to see a very vocal response from the headline hungry general population which may soon find itself in a "panic" over the fact that the biggest communist power in the world is suddenly getting "just as strong."

As expected, China is the new IMF. No surprise there.

• CHINESE PREMIER WEN TELLS BBC WILL LEND TO EUROPEAN COUNTRIES HAVING TROUBLE BORROWING

All this means is that China will do everything in its power to prevent the ECB from launching an outright unsterilized monetization episode, which will double the amount of importable inflation (plunging EUR) to hit the Chinese domestic economy, and destabilize the already shaky stability, so critical for the Chinese communist party. And since the USD and the CNY are pegged, this has the added benefit of devaluaing the CNY instead even more if not against the USD, then against the CNY, which is now importing European sovereign risk and will continue to do so, until China finds itself in the same lock out as half of Europe currently.

In continuing its recent pursuit of "white knight on full retard tilt" policies vis-a-vis the endless European bailout, and throwing good money after bad after horrible after totally lost, today Chinese premier Wen Jiabao said that not only would China do everything in its power to preserve the EUR (after all that CNY needs to be cheap against some currency) and "work for expeditious recovery and stable growth" but also unveiled that it is now preparing to go ahead an buy Hungarian bonds. As if owning Greek, Portuguese, Spanish and Irish debt was not enough. It seems China has learned from the best, and either knows something others don't (except for the SHIBOR market of course) or is actively preparing to become Too Biggest To Fail by making sure that should something bad happen to it literally the entire world will follow it into the depths of hell. Which, as Jamie Dimon, Vik Pandit, Lloyd et al have known for the past 3 years, is not a bad strategy. Look for China to keep buying up ever more European debt as it intertwines its fate with that of the rest of the central planning cartel: a development we can only compare to the ever deteriorating Spanish Cajas desire to buy up as many semi-healthy banks as they possibly can to prevent a policy determination to shut them, and their billions of bad debts, down.

Step aside IMF, China is now in the driver's seat. Officially.

About a week ago, Goldman Sachs closed its tactical short USDCNY Non-Deliverable Forward trade, which was opened on June 10, 2010 and which expired a year later for a 4.2% gain. Goldman added: "Our view has not changed. The necessary adjustments to global imbalances demand a weaker US Dollar, and especially so vs the CNY. The cyclical and political backdrop remains supportive along those lines. Moreover, we expect $/CNY depreciation to continue/extend in the months to come. We remain positioned for the theme via our $/CNY NDF recommended Top Trade with longer initial maturity, expiring on 4 December 2012." Nonetheless, something appears to have shifted in the derivative CNY market, where as Bloomberg points out, it now costs more to bet on RMB weakness than strength. It adds: "China appears headed for a hard landing as the country’s housing market shows more signs of weakness. Currency traders have reduced their expectations for more appreciation of the yuan versus the dollar in the derivatives market, meaning they expect Chinese policy makers to fundamentally shift their approach to the currency due to economic softening. Other markets may soon follow currency’s lead." As the attached chart shows the USDCNY 3 Month 25 Delta Risk Reversal for the first time since September 2009, there appears to be some outright bearishness on the renminbi appreciation scenario. Does this mean that yesterday's decline in the official fixing rate to 6.4736 on Thursday, lower than the record high of 6.4683 on Wednesday is more than a one time adjustment and is the start of a new trend? We will find out soon enough.

Merely minutes after reporting the third daily surge in the SHIBOR we see a Dow Jones update which confirms that this liquidity escalation is far more serious than a merely transitory jump in short-term lending rates. Per DJ: "China's central bank said Wednesday it will suspend its regular open market operation Thursday, in an apparent response to the tight liquidity conditions in the banking system." As a result of the just reported 7 Day SHIBOR hitting 8.81%, the highest since October 2007, the PBoC will not conduct regularly scheduled open market operations tomorrow when it offers three-month paper, to mop up excess liquidity in the country. "The PBOC sold CNY1 billion ($154.6 million) worth of one-year bills at 3.4019% in its operation Tuesday, after leaving the rate unchanged at 3.3058% for the past 11 weeks. On Thursday last week, the PBOC lifted the rate on its three-month bills by eight basis points to 2.9985%, the first increase on the three-month central bank bill yield since early April. "It is difficult for the central bank to find enough demand for its short-term bill offering amid the severe liquidity squeeze in the money market. If it persisted with the three-month bill offering tomorrow, the yield would jump again, adding pressure to the central bank's operating costs," said a Shanghai-based trader with a local bank."

Yesterday, when we pointed out the surge in the overnight SHIBOR, many were quick to dismiss this dramatic contraction in liquidity, because it happened to be a replica of a comparable such move before the Lunar New Year which did not end result in an end of the world type event. And while many ignored this very disturbing interbank lending lock up sign, there was someone who did not: the PBoC. According to Market News, "The People's Bank of China has conducted reserve bond repurchase agreements with at least one bank in a bid to ease liquidity conditions, local media reports said Tuesday. The National Business Daily cited an interbank market trader as saying the central bank injected at least CNY50 billion into the China Construction Bank on Monday via a 14-day reverse repo at 7.5%." Which incidentally is how it should be done: want to get emergency funding from your central bank? Sure. But it will cost you a whopping 7.5%. Now the question of whether CNY50 billion is enough (and in related news, the USDCNY parity just dropped to a fresh all time record low of 6.4690) is a different matter altogether: we expect to get today's updated SHIBOR fixing any second, and have a feeling more reverse repos will have to be injected before this is over.

The country which has so far been doubling down on its losses in European bond exposure, much to the amusement of cynical onlookers, has finally disclosed that Europe is the locus of Chinese vital self interests, and that should Europe go down, one very major domino would be the implosion of China itself. Per Reuters: "China's "vital" interests are at stake if Europe cannot resolve its debt crisis, the Chinese Foreign Ministry said on Friday as it voiced concern about the economic problems of its biggest trading partner. At a media briefing ahead of Chinese Premier Wen Jiabao's visit to Europe next week, Vice Foreign Minister Fu Ying made plain that China had tried to help Europe overcome its troubles by buying more European debt and encouraging bilateral trade..."Whether the European economy can recover and whether some European economies can overcome their hardships and escape crisis, is vitally important for us," Fu said. "China has consistently been quite concerned with the state of the European economy," she said." And just like every time before when China has tripled and quadrupled, and now quintupled, on Greek, Portuguese and other debt, so this time will be no different as merely loading up an insolvent entity with even more leverage does nothing but shorten the half life of each additional "bailout." When Greece blows up, forget the other European countries: keep a close eye on China.

Despite their many differences, the economies of China and the U.S. share a number of key traits: both are corrupt, rigged, crony-Capitalist, rely on phony statistics and propaganda and operate with two sets of rules: one for the Elites, and another for the masses. Given these similarities, it's no wonder that the wheels are falling off both economies. There are some key differences, of course, which will make the crashing of China's boom all the harder. China's leadership likes to do things in a big way, and so its campaign of "extend and pretend" over the past three years has been unprecedented. This isn't just the consequence of a Command Economy overseen by a Central State; the "extend and pretend" boom was fueled by stupendous borrowing by local governments and private enterprise as well. This flood of money has severely distorted China's economy, yet the imbalances are now normalized. When a system become this precarious and imbalanced, it can best be modeled by stick/slip destabilization: blaming the last grain of sand that destabilizes the entire pile for the collapse is to ignore the real cause: the entire system is unstable. Here are a few factors which are widely misunderstood or discounted by the mainstream financial media.

When we reported last night's Chinese economic data dump we said: "Expect to see renewed calls on the PBoC to hike rates imminently." As it occasionally happens, we were rather spot on: per Bloomberg: "China ordered lenders to set aside more cash as reserves after inflation accelerated to the fastest pace in almost three years in May and industrial production rose more than estimates. A half percentage point increase announced by the central bank today and effective June 20 will take the ratio to a record 21.5 percent for the nation’s biggest lenders. The move was hours after data showing the annual inflation rate climbed to 5.5 percent." As we noted last night after reporting the latest Chinese data, while the economy is once again heating up, risks of outright stagflation have been reduced now that various other metrics aside from inflation also beat expectations, putting the onus squarely on the PBoC. And the central bank did not disappoint. That said, since the RRR-hike route has taken China nowhere fast, and with inflation at a 3 year high, the PBoC's next decision of an outright rate hike will be far more complex: "Signs the world’s second-biggest economy is maintaining momentum after increases in borrowing costs and curbs on real estate may have encouraged policy makers to add to tightening measures. At the same time, weakness in the global economy and data yesterday showing slower bank lending and money-supply growth may make a decision on further raising interest rates a tougher call." In this case, we expect to see doctored CPI data to begin dropping in June and onward, unless there is another climatic disaster which really sends the angry mobs loose.

In an indication of the prevailing popular mood among the key marginal economic force in China - its migrant worker population - hundreds of protesters rioted in the southern China city of Gunaghzou after a young pregnant street hawker was harassed by security guards, media reports said Monday. From Reuters: "Hong Kong television showed seething crowds of migrant workers from the southwestern province of Sichuan running through the streets of Zengcheng, smashing windows, setting fire to government buildings and overturning police vehicles. Riot police were shown firing tear gas Sunday night, deploying armoured vehicles to disperse the crowds and handcuffing protesters. Witnesses said there were more than 1,000 protesters and at least one government office had been besieged. "People were running around like crazy," a shopowner in the area told the South China Morning Post newspaper. "I had to shut the shop by 7 p.m. and dared not come out." While China reported slowing monetary conditions, with a miss in both the M2 and loan issuance in May, it is unclear what the Chinese equivalents of Bernanke's 15 minutes to Inflation: OFF is: as a reminder the upcoming CPI print is expected to come at a record 5.5%, which is the only piece of data that truly matters in China. If inflation continues its runaway rise, whether due to climatic conditions, or importing Bernanke's monetary policies, expect to see many more stories of violent popular unrest.

These are serious challenges Beijing’s now facing and seems to lack adequate policy tools to tackle...Hedge funds and Fed’s QE2 are not all to blame for all these. The Chinese economy already stands close to the edge. What speculators do is to push it over and profiteer handsomely from the chaos. While the US enjoys the luxury provided by the dollar’s world currency status and diplomatic alliance with many major trade partners to export its liquidity and inflation, China enjoys none of that. They should look at the dollars in their hands with fear and doubt. So called Beijing consensus makes little sense, because the world is fast changing, pegging a country’s growth to a certain set of policy tools or a certain reserve currency(the US dollar) is equally dangerous. The battle between Keynes and Friedman has long proven the only consensus is to adapt and change. Right now China needs to adapt and change fast. Or this will be the best time in history to short China.

“…through thousands of years of Chinese history, I know no example where outside pressures about the domestic structure of China produced domestic changes in, in [cq] China. ...”