Chinese police haul in investment managers to probe “market volatility”

Over the course of this week, every move in global markets has been ascribed to “fear about China”. But it’s pretty clear that most of the media does not really understand what is happening in Chinese “markets” and the Chinese economy.

Markets are closed in China today and tomorrow, while Hong Kong will be open on Friday. On Wednesday, Chinese markets were down more than 4%, but came back to close about flat. Many observers assumed this was because state entities had been told to buy ahead of the big military parade to mark the 70th anniversary of V-J day (15-20 million Chinese people were killed in WW-II).

The biggest financial issues in China are related to local government debt (think municipal debt) and its rapid growth. Local governments have been on a debt issuing spree for years, which is necessary since they have limited taxing authority. Their revenues come from borrowing and selling land to real-estate developers. Those sales are complete with kickbacks and evictions of long-time residents. The problem is, real-estate development has dropped off a cliff so they aren’t buying land anymore. And this week, the Chinese authorities announced they would limit how much local governments can borrow this year (they’ve been talking about limits for three years and set some last year). That means local government revenues and spending are about to fall off a cliff as well.

The best commentary on Chinese credit markets comes from Michael Pettis. His latest post is: If we don’t understand both sides of China’s balance sheet, we understand neither.

But the stock market is what interests most people. So, here’s a scary fact about Chinese stocks. A number of Chinese companies trade on both the Shanghai stock exchange (on-shore A shares) and in Hong Kong (off-shore H shares). Their prices in Shanghai are, on average, 115% higher than the prices in Hong Kong. The shares represent the exact same economic interest in the exact same enterprise. Part of the reason is that so many Chinese stocks have suspended trading. Part of it is that China banned stock sales by major shareholders and executives for six months (through 2015). At one point in July, stock brokerage firms in China were instructed by the authorities not to accept any sell orders.

Whatever the Shanghai stock exchange is, it is definitely not a “market” in the sense that buyers and sellers meet and freely trade there. Hong Kong is much closer to a free market, which means if you believe HK prices are correct, Shanghai should another 50%. There are some “free-market” types who (mistakenly) think the H-share discount represents a “bargain” rather than reality. Or it may mean Rmb has a lot further to fall.

Yesterday, there were reports that Chinese regulators have called in numerous heads of investment management companies in an attempt to probe “market volatility”. Rumors are flying around about forcible detentions, in particular there are numerous stories about the Chinese head of the world’s largest fund of hedge funds, Man Group.

Li’s mobile phone was turned off when called on Monday. Chaoyong Wang, Li’s husband, said in a telephone interview that she is in a meeting with “relevant industry authorities” and he doesn’t know who they are. He said he spoke to her by telephone yesterday and today, expects her back home soon but does not know when.

Someone, somewhere is probably thinking, “I wish they were arresting hedge fund types here”. Remember, this is China. One senior manager told a colleague “If I don’t come back, look after my wife” as he left the office in response to a summons from the authorities.

It’s been an open secret that Chinese economic data, on unemployment, GDP and industrial activity is, shall we say heavily massaged. Lots of market participants have joked about this amongst themselves, but the implications are now being debated more seriously. I’ll let Chris Balding cover some of the more egregious issues:

No less than the second in command of China, the Premier Li Keqiang, has stated that Chinese GDP data is unreliable and “man-made”.  To put this in perspective, thecurrent Premier of China, second in command for the entire country, leading economic policy formulation, a Phd in economics, having spent essentially all his career inside public administration in various posts throughout China advises you not to trust GDP figures…

For more than a decade, Chinese unemployment spent most of its time bouncing between 4-4.2%.  Chinese economists became skeptical of the number and conducted a study estimating urban unemployment during their sample period reached 10.9%.

China has undoubtedly grown significantly over the long run and this is unquestionably good for China and the world. However, that is not the question.  The question is how reliable are Chinese GDP figures.  I believe as a baseline case from my own research alone, real Chinese GDP would need to revised downward by a minimum of 10% or approximately $1 trillion USD.  Add in other known problems and I believe the number could go as high as a downward revision of 30% of real GDP.  Think of it using a simple scenario, let’s assume every year since 2000 China has overstated GDP by 1%.  In other words, 10% is in reality 9%.  That would imply that today, China needs to revise current real GDP downwards by approximately 16%.  This would still mean that China has grown significantly but also, as a mountain of clear evidence indicates, Chinese GDP growth has been overstated. Finally, it is important to note that lots of little numbers are clearly off but all these little numbers add up to big changes especially when added up over time.

Compound interest can work against you folks.

A number of people are saying: All eyes on Chinese markets on Monday.