Gavekal on China

The dynamism of China's industrialization process is such that it is easy to both exaggerate the upsides ("a billion customers") as well as the downsides ("ghost cities abound!"). As we see it, it seems the downsides are currently being exaggerated. This is not overly surprising, because China's policymakers have indeed been fighting the dragon of excessive liquidity creation since 2009, and this has been neither easy nor pretty. But while there are undoubtedly very real financial risks, with some companies and individuals facing very real stress, investors should put the situation in context. Indeed, we refer readers to Joyce's ad hoc published yesterday, The Shadow Knows-Exploring China's Hidden Financial System, which highlights that:

* The unofficial funding channels which have evaded official credit restrictions in the past year, and thus made it harder for Beijing to control inflation, have always existed. Moreover, these unofficial channels are actually a long-term positive: in the state controlled financing sector, credit is not only irrationally (cheaply) priced, but it is often allotted to favored parties (such as state-owned companies). In "shadow financing" activities, we are now witnessing market pricing of both deposits and loans-which is the exact structural direction in which China's financial system needs to move. In the long run, this is a good thing.

* No doubt, however, shadow financing activities have gotten out of hand recently, and have complicated Beijing's effort to fight inflation. We estimate that shadow financing activities made up about 16% of total outstanding credit in the past decade; however credit extended through channels other than the formal bank loans and the bond market reached about RMB17 trillion by mid-2011, or about 25% of the total. Moreover, shadow financing accounted for more than 40% of new credit creation in 2010 and 1H11.

....Our view is that China is likely to continue to tighten shadow financing, but will, in small, quiet ways, such as through open market operations, start to loosen official liquidity conditions.