EDITOR: | January 12th, 2016 | 10 Comments

2015 – China’s Annus Horribilis

| January 12, 2016 | 10 Comments
image_pdfimage_print

For the Japanese, their anni horribili at the end of the 1980s are chiefly remembered for overpaying for the Rockefeller Center and golf club acreage. When the Brazilians come a cropper, it’s a case of party like its 1959, and return to the basics of fresh air, coconuts and sunshine. But when it comes to hubris the Chinese, as in everything, outdo everyone. The new self-proclaimed Masters of the Universe have managed to end the year choking themselves, and their economy, to death in a cloud of Purple Fumes (cue the Performer once known as Prince) and shown that as for regulation (and development) of financial markets the Chinese, to put it more politely, could not run a booze-up in a brewery.

The last weeks of 2016 saw several prominent financial market figures disappear and then reappear (including the reputed Chinese version of Warren Buffett), the aforementioned pollution disaster and the start of criminal investigations relating to the FANYA schemozzle. There is an innate tendency for institutions in the capitalist side of the Chinese economy to deteriorate into illegality and irregularity with remarkable speed. In this aspect the Chinese system appears most akin to the rip-roaring US markets of the late 19th century when Robber Barons ruled the roost on Wall Street and established suffocating and anti-competitive cartels/trusts.

FANYA

For the mining community the most important thing about China is the demand aspect as this has driven so much of the global mining industry’s thought process over the past 20 years, however for the

The establishment of the FANYA Exchange with its focus on specialty metals seemed like a logical and inevitable evolution of the Chinese dominance of the production of (many) specialty metals and the substantial position it also held as a processor and end-user. FANYA initially started out with specialty metals and then diversified into fixed income products. The problems in the Bismuth, Indium and Antimony trading by the exchange’s investor base are well documented now.

In mid-July Metal Bulletin reported that the Fanya Metal Exchange had suspended accepting applications from companies to sell Indium, Germanium and Bismuth on the exchange between June 23 and August 31. An official from Fanya, who refused to be named, cited “Liquidity-related problems” were the major reason for the decision. That there should be “liquidity problems” in trading notoriously illiquid metals in the pre-FANYA era, comes as no surprise to participants in the global market for specialty metals.

While FANYA has been most (in)famous its metals trading, it has also had a fixed-income element, which not unsurprisingly has reputedly also gone bad. The Financial Times reported in September that “hundreds of well-heeled urban professionals who had purchased high-interest rate products from the Fanya Metal Exchange united with distribution agents who sold them in an unusual protest….in the financial heart of Beijing”.

Nabbed

The FT captured the moment at which the head of FANYA, Shan Juiliang was manhandled by a crowd in Shanghai. They dragged him off to the police to have him arrested. Whether his potential fate at the hands of the crowd or in the Chinese legal system will be a better one will remain to be seen.

The big question, as everyone knew six months ago that FANYA was going down in a welter of financial irregularities, is why did it take so long to look into the matter? Obviously people in high places wanted to cover their behinds (and unwind positions) before the Great Unwashed cottoned on. However, the public are now so far ahead of the authorities in catching a whiff of scandal that the Powers that Be are last to know.

Chinese “Statistics”

Time and again we have seen the Chinese “issue” with deceptive practices on bonded warehouses and the collateralization and double-counting of fictitious or “massaged” inventories. It is very easy to create theoretical liquidity by miscounting (read exaggerating) warehouse numbers then creating paper instruments based on the bogus holdings, trade them fast and furiously and voila, liquidity. The whole scheme (never let the word “Ponzi” cross our lips) comes apart at the seams when someone wants physical delivery and then the game is over. In China of course the small and medium sized investor can be stalled for a while, while the big fish exit their positions and when the curtain is eventually pulled back to reveal that the “cupboard is bare” then the recriminations start flying. A few random death sentences may be meted out (involuntary organ donations, anyone?) and the matter is regarded as swept under the rug until the next time.

The result though is that China has blown up chances of being taken seriously as a locale for trading of commodities due to this repeated flaunting of warehouse statistics which are at the root of the credibility of any market in the metals trading world.

Bubbles

The Chinese cannot be criticized for having “bubbles” in their stock exchange(s) for the US is a repeat offender in this regard, with Alan Greenspan being a notorious bubble-blower with a goodly part of the US economy and the High Net Worth sector regularly refilling their coffers through repeated pump and dumps on a truly grand scale. However in the case of China a casino-ish atmosphere has not only existed, but been encouraged. The closest that the US has come to this was the dot-com era market of 1998-2000, which was mainly tech/media/telecoms (rather than a whole market) and 1929, which was a very long time ago and before hardly any legislation governed markets.

While regulators in the West, in the wake of a market bust, go into a frenzy of reregulating and attempting to close the gate after the horse has bolted, the Chinese on the other hand are quite shameless with the goal being to reinflate the bubble as fast as possible. Investors in the West go into soul-searching wondering why they were suckered or why they suckered themselves, whilst in China introspection seemingly has no place and mass amnesia is seen as the cure for all ills.

Robber Barons

China looks like the US in the Age of the Robber Barons in the late 1800s. The trouble for China is that we are talking about 130 years ago. It is not that hard in this day and age to be up to date in regulatory and supervisory matters and systems. If you can have stock tickers wrapped around office blocks then why can’t you buy in some skillsets on market regulation? The answer is largely because the authorities don’t want to appear to be taking advice from the Gwai Lo. Frankly they could save themselves (and everyone else) a lot of grief is they forsook the financial Wild West (East?) and got their house in order in 2016.

Riding the S-Curve

Or we could less charitably say going down the S-bend! We found an interesting thesis, posited by a Charles Hugh Smith, that tallied with our own view that China is following a well-trodden path down which Japan, Taiwan and South Korea have already travelled. China would like to think it is different and heading down some Middle Kingdom version of the Thousand Year Reich (oops!) when in fact it is just doing what all economies have done since the dawn of time, and that is pursuing an S-shaped trajectory.

s-curve

We have seen this process described as being somewhat akin to a rocket’s trajectory with an ignition phase as the fuel of financialization and untapped productive capacity is ignited. The high growth rate of credit and production overwhelms all other factors, as rising profits and production increases wages which then support further expansion of credit and consumption which then supports more production (or excess-capacity).

After this the thrust that comes from “financialisation” is exhausted, and the previously fast-growing economy moves forward on momentum alone. As the economy weakens, this momentum is to the downside. This is where we find ourselves now in the China cycle as everything that worked in the boost phase reverses, as nothing works any more. Investors in China’s “markets” lose every bet and officialdom’s efforts to reverse the decline end in repeated failure.

Conclusion

While many in Western markets (and particularly in the US) are used to complaints that the system is rigged against the investor class by the Powers that Be, the complaints are usually just hyperbole and blame-searching after the one a decade meltdowns that we have become inured to. In China though, like all casinos, the House always ends up winning and the punters, by and large, end up going home without their shirts. The markets in the West may end up occasionally ripping off investors whereas in China they seem to be set up with the explicit purpose of fleecing the lambs. The results is that the middle and lower middle classes keep having their savings confiscated for the greater good of those higher up the totem pole that mastermind, tolerate, encourage and then cover-up the scams. It is like China is in the grip of a horde of Bernie Madoff clones.

If 2015 was bad then 2016 has got off to an even worse start with two suspensions of trading on the Stock Exchange in the first few days of the New Year. This was followed by the same old intervention which obviously failed in the first instance because it had to be applied again a few days later. The “Street cred” of the Chinese “powers that be” that pull the financial levers is totally shot. Major figures on the financial stage appear and disappear like characters in a Feydeau farce. Re-education used to involve years in the paddy-fields and now consists of a weekend of being brow-beaten in a board room at the Ministry of Finance. Maybe the old ways were better!

Once a soap bubble is burst there is no reinflating it. The Chinese should face the fact and move on. They are now in a new place that the rest of us in the Western economies have been in all too frequently in recent decades and they may care to learn from it… even if it means having to lose a little face.


Christopher Ecclestone

Editor:

Christopher Ecclestone is a Principal and mining strategist at Hallgarten & Company in London. Prior to founding Hallgarten & Company in New York in 2003 ... <Read more about Christopher Ecclestone>


Copyright © 2016 InvestorIntel Corp. All rights reserved. More & Disclaimer »


Comments

  • Asher Berube

    Great Analysis on China, particularly the topic of Bubbles.

    January 12, 2016 - 12:29 PM

  • Jeff Thompson

    All the more reason the rest of the world needs to set up several independent rare earth supply chains, even if they do cost more than buying from China. Security of supply needs to be capitalized. Very eloquent piece, Chris.

    January 12, 2016 - 3:24 PM

  • Hiwayman

    Chris,
    As always-good counsel.
    Your takeaway…..
    There is one constant in life–the natural corruption
    of human nature–it never rests!
    Go well.

    January 13, 2016 - 1:10 AM

  • Lok Chong

    Mr. Ecclestone presented a compelling/frightening prognosis to small interest groups of bystanders, paid-up ticket holders, insiders and outsiders, what are his prescriptions for them to capitalise from this circus/hubris/lotto?

    January 13, 2016 - 3:11 AM

  • Christopher Ecclestone

    Good question.. As far as the Chinese investment public are concerned we really need the evolution of something like the Merrill Lynch of old (before it started putting anyone but the client first). The evolution of a serious brokerage firm for the middle classes to make dull but worthy investments would be a major step forward.

    On metals trading, I think the only way a specialty metals exchange will work would be for it to be set up by maybe a coalition of producers (at the risk though of being “Dracula in charge of the blood bank”) in league with a ministry and (shock! horror!!) quarterly auditing of the warehouses by a respected international quality control firm, such as SGS. While it might involve loss of face to not have faith in a domestic auditor frankly much more face (and money) is lost through having the repeated debacles we have seen.

    And having the exchange open to international membership through well-known brokers/traders would also help. FANYA was run like a back alleyway betting shop.

    January 13, 2016 - 4:21 AM

  • Ann Bridges

    I tackle both the issue of the motivation of having a stock market in China (“Private Offerings”) and the issue of a sole rare earth supply chain being compromised (“Rare Mettle”). In each of these, the cultural norm of face is a key element, and one that Westerners too readily dismiss. It is there on the surface, even if businesspeople and politicians are ultimately pragmatic, and therefore part of the public dialog and decision-making process. I’m not sure how much progress there will be, even if they follow the steps of Japan, etc., China is bigger, has more military ambition, and has learned to throw its weight around in the modern world, including currency influence now. We’ll see if Jack Lifton is right on his predictions…

    January 13, 2016 - 11:22 AM

  • Lok Chong

    FANYA or other state enterprise/authority will be the last to admit wrong-doing and/or incompetence etc. leading to lost of face and jeopardizing PRC’s pre-dominance over the technology metal space including REE and graphite. Deng Xiao Ping foresaw that coming over 30 years ago and said “the Arabs have oil but we have rare earth…” and no Western power(s) tried to stop them then.

    OPEC lead by Saudi Arabia is now losing their grip over oil because of competition and divisions within and without making them unable to distort and manipulate the economics of supply and demand.
    I can envisage a video-clip of Lynas hoisting up a PRC flag in their Malaysian compound. Who can deny the red dragon taking its turn?

    January 14, 2016 - 3:21 AM

  • Lok Chong

    I think Jack Lifton is practical and a pragmatist who can work with the Chinese and vice-versa. With supply bottle-necks looming against an onset of unrelenting demand for LIT carbonate, tritenate, mica etc. I think Jack Lifton is correct to predict “It got to go higher”.

    January 14, 2016 - 4:08 AM

  • Jeff Thompson

    I suspect that viewing China a monolithic entity may not be entirely accurate. If Chinese domestic rare earth producers have driven the market prices so low that even they are running at a loss (a monetary loss, not to mention the mounting environmental losses), perhaps this is more than just trying to suppress ROW development. There may internal competing interests within China that are battling against each other for market share, or the “right” to be the dominant Chinese producer. The country is too opaque to know this, but I look at the analogy of OPEC.

    Many people thought once OPEC had spent about a year driving the price of oil down into the $40/barrel range that would be far enough, but with oil now breaching $30/barrel this week and many now predicting $20/barrel or even less, it becomes apparent that OPEC is not a “them”, it is a collection of independent actors whose motivations are entirely self-interested. Saudi Arabia can’t stand Iran, and vice-versa, hatred recently renewed by the execution of one of their clerics. All signs point to the factions within OPEC continuing to compete against each other both to maintain market share as well as for reasons that have nothing to do with economics, and more importantly reasons that will never go away, as a 1400 years of history attests to.

    Saudi Arabia and Iran are small countries, but OPEC is a large organization. China is a large country, but perhaps better viewed as a large organization, as lines drawn on a map over such a wide geographic area obscure what happens on a more local level within the country. Is it possible there are internal factions within China that have reasons to compete with each other in producing rare earths, not to suppress rest of world development, but for pride/survival of their local ways of life? Perhaps the outside view of the top down “Five Year Plans” is not as uniform and harmonious as the Chinese government would have the world believe, and their is an internal race to the bottom to outproduce their provincial neighbors.

    January 16, 2016 - 7:48 AM

  • Positroll

    What’s so hard to understand? The Chinese central government picked 5-6 players to take over the REE mining business – those businesses that had the most political clout in Beijing behind them. All those businesses with a little less (or rather local) political clout behind them were told to take a hike. One would call it expropriation without compensation except of course for the fact that theoretically all the land belongs to the state. Still, you got some “winners” and a bunch of disgruntled losers. Those political losers now became “illegal producers”, as they and their backers weren’t too happy with what Beijing decided unilaterally and simply went on ignoring the center, trying to sell as much as possible asap to the Japanese etc before the center could effectively close them down, thereby killing the price and wasting a lot of good resources with shabby production methods.

    In the future, more and more of these operations will either be closed down by the center, or run out of resources that can be exploited without impacting the interests of the local middle class (esp water + food). Once that happens, REE prices will go up again. I’d say about 2-3 years from now is a good bet …

    January 20, 2016 - 10:44 AM

Leave a Reply

Your email address will not be published. Required fields are marked *