China Dragon Has The Flu

The China payments and deposits system experienced a sudden liquidity freeze up earlier
in the month. First the PBOC slapped the wrists of the bankers. The squeeze intensified.
But now the PBOC, in its role of central bank lender of last resort, has agreed to provide
liquidity and stability to the short term interbank market. From personal experience as an
old banker, I can tell you that disruptions in the interbank market (daylight overdrafts)
means one or more major lenders is having liquidity problems. The PBOC vigorously
ramped up liquidity over the past two years to bring China out of a sharp economic
slowdown. There was a good, but short lived bump in growth in the latter part of 2012,
but with a slow global economy, exports fizzled. Moreover, even the Gov. has owned
up to inflating export data to Hong Kong. Thus, the surge of lending in a ramp up
to growth that flopped found borrowers with lower than projected volumes, weaker
pricing and a significant slump in debt service capability on a cash flow basis. It also
looks like real estate lending has continued to be aggressive, and since some players still
seem to like stockpiling properties rather than selling or renting them, parts of this
huge portfolio are not generating cash to service the debt.

If China's real growth potential has dropped to a range 7.0 - 7.5%, the PBOC simply
cannot provide liquidity at a rapid 20% annual growth rate. China Money Supply M2
Otherwise, real estate assets may bubble up further and the economy's debt service
capability will continue to shrink. So the reform focus should not be on China's banks
or its large and growing shadow banking system but on CP's top finance people and the
PBOC itself. As it has in the past, China can buy up underperforming loans and file
them away in a semi - official portfolio, but it cannot get past this issue without
making the PBOC and its handlers more responsible.

The China stock market started off the year beautifully, moving up with indications
of better growth. But the growth was deliberately overstated, and the early targets
were blown. Then came the liquidity freeze up, all nicely mirrored in the
Shanghai Composite.

The stock market is deeply oversold and can bounce further. The Shanghai is fairly
valued up around the 2400 level based on growth of 7% or a little better, but Xi and
Li have a long way to go to repair China's tarnished credibility.