There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate.

In my last several posts, I’ve focused on the former — the slowdown in China’s GDP growth.  I want to switch gears here for a moment and call attention to a rather alarming story involving the latter — the risk of financial instability — which somehow slipped under most people’s radar screens.

In early April, Caixin magazine ran an article titled “Fool’s Gold Behind Beijing Loan Guarantees”, which documented the silent implosion of Zhongdan Investment Credit Guarantee Co. Ltd., based in China’s capital.  “What’s a credit guarantee company?” you might ask — and ask you should, because these companies and the risks they potentially pose are one of the least understood aspects of China’s “shadow banking” system.  If the risky trust products and wealth funds that Caixin documented last July are China’s equivalent to CDOs, then credit guarantee companies are China’s version of AIG.

As I understand it, credit guarantee companies were originally created to help Small and Medium Enterprises (SMEs) get access to bank loans.  State-run banks are often reluctant to lend to private companies that do not have the hard assets (such as land) or implicit government backing that State-Owned Enterprises (SOEs) enjoy.  Local governments encouraged the formation of a new kind of financial entity, which would charge prospective borrowers a fee and, in exchange, serve as a guarantor to the bank, pledging to pay for any losses in the event of a default.  Having transferred the risk onto someone else’s shoulders, the bank could rest easy and issue the loan (which it otherwise would have been reluctant to make).  In effect, the “credit guarantee” company had sold insurance — otherwise known as a credit default swap (CDS) — to the bank for a risky loan, with the borrower forking over the premium.

Now putting aside what happened at Zhongdan for a moment, let’s just consider what this means.  Like any insurance scheme, this arrangement only “works” if the risks are not correlated.  If you insure 100 people in 100 different towns against a tornado striking, you collect premiums and then, when a tornado strikes one of those towns, you make the payout to one claimant and the premiums from the rest cover it.  If you insure 100 people in the same town against a tornado, you collect premiums for a while at no cost — it looks like a fantastic business.  But if a tornado finally does strike that one town, you have to pay everybody at once and you’re wiped out.  That’s exactly what happened to AIG when it sold credit default swaps on mortgage-backed CDOs.  As long as the housing market didn’t collapse, all they did was collect premiums.  When it did collapse, they went under.  Or rather, they had to be bailed out so that all the banks and other customers who had bought insurance from them — who thought they were insured — wouldn’t go bust when AIG couldn’t pay up.

The concern in China is that — like that tornado — a drop in the local property market, or a decline in exports, could hit all borrowers at once, overwhelming the local credit guarantee company and leaving the banks high and dry.  The risk is exacerbated by the fact that many credit guarantee companies were capitalized with loans from the same banks whose other loans they are guaranteeing.  In effect, banks are insuring themselves, or each other, and would still end up holding the bag on loan losses that are supposedly insured.  (It would be interesting to know how such “guaranteed” loans are treated when regulators perform their much-vaunted stress tests on Chinese banks.  I suspect these loans are considered loss-proof, because they are “insured.”)

Zhongdan, the company in the Caixin article, took these risks one step further.  It persuaded borrowers to take out bank loans based on guarantees from Zhongdan, and then hand some or all of that money back to Zhongdan to invest in Zhongdan’s own “wealth management” products:

Under the arrangement, a participating company would take out a bank loan and give some of the money to Zhongdan for investing in high interest-paying wealth management products for a month or more.

The firm then apparently put those funds to work by buying stakes in small companies such as pawnshops and investment consulting firms, according to the sources. Some of the funds went toward a U.S. consultancy that later failed.

Since this use of funds completely violated banking rules, Zhongdan forged documents indicating the money was being borrowed to pay fictitious suppliers:

To nail one loan, [an executive for a building materials manufacturer] said, Zhongdan formed a shell building materials supplier and wrote a fake contract between the supplier and his company. The document was presented to the bank, which approved the loan. Zhongdan later de-registered the phony supplier.

The whole thing started to unravel in January when banks “reacted to rumors of a liquidity crunch” at Zhongdan:

Several banks that cooperated with Zhongdan smelled trouble and started calling loans they had issued to companies backed by the firm … The next domino fell when the creditor companies, seeking to appease the banks, turned to Zhongdan for help repaying the called loans.  But Zhongdan executives balked, and the domino effect accelerated as companies teetered under bank pressure and the city’s business community shuddered with credit freeze fears.

At that point, regulators stepped in and told everybody to freeze — and to keep all the assets as “good” on everyone’s balance sheets while they figured out what to do next.  Zhongdan had over 300 clients, and guaranteed RMB 3.3 billion (US$ 521 million) in loans from at least 18 banks.  The only liquid assets that the guarantee company appears to have available to pay banks is RMB 210 million (US$ 33 million) in margin accounts deposited with the banks themselves.  Good luck finding the rest:

“Of first importance is to determine the depth of the hole,” Beijing Finance Bureau Deputy Director Li Zhigang said … “If there are no new investors and no new liquidity replenishments, Zhongdan won’t be able to repay.”

Lest you think Zhongdan was just a colorful outlier, think again:

A branch manager at one bank involved in the Zhongdan case said most bankers are fully aware that most companies provide falsified contracts to qualify for loans. Others said they routinely skip certain procedures designed to catch tricksters.

“Banks argue that companies should be held accountable for fraudulent borrowing,” said a company manager who said he obtained several bank loans by working with Zhongdan. “They are determined that they will not admit to knowing these are fake contracts.

“I worked with other guarantee companies before,” he said. “I realized that, in fact, a lot of banks know about this.”

Read that last quote again.  The implication is that Zhongdan’s modus operandi (forging documents to channel loan proceeds into risky investment schemes) is common practice among China’s credit guarantee companies, and that Chinese banks have been willing co-conspirators.  I wish I could tell you the size of the problem, on a systemic level, but that’s part of the problem — it’s too opaque.  Nobody I’ve talked to knows.

One of the reasons banks may have been willing to go along with the charade was the need to fulfill their quotas when it came to boosting SME lending.  If so, it reinforces what I said years ago, that state-mandated set-asides are not the way to improve entrepreneurs’ access to bank lending, that banks need to revise their whole approach to lending:

China’s goal should not be to throw money at SMEs as though they were just another special interest to be subsidized.  It should be to develop a banking system capable of allocating capital to whoever can use it best–including good SMEs.

More importantly, the Zhongdan episode — which I’m amazed hasn’t attracted more attention and concern — illustrates the kind of hidden risks that have developed in China’s financial system, to which bank and regulators have been willing to turn a blind eye in order to meet the insatiable credit demands of investment-led GDP growth.

In a recent report debunking “myths” about China’s economy (which could have been titled “China:  Don’t Worry, Be Happy”), CLSA’s Andy Rothman maintains (in Myth #13, p. 46) that there are “no shadow banks” in China.  “Anything in the shadows sounds scary,” he says, but never fear because all of China’s financial institutions, banks and non-banks, are under the firm control of the Party.  “They are,” he quips, “Party animals.”

Indeed.  Zhongdan and other credit guarantee companies certainly seem to have been partying it up.  Only now is what they have done beginning to emerge from the shadows.  It looks pretty scary to me.

Getting an accurate view of the property sector is complicated by the fact that neither the official price index, nor the Soufun price index, nor the average price/square meter that can be calculated from the investment numbers seem to track very well with each other or with point-of-sale impressions of steep developer discounts over the past eight months.  Developers and local governments also enjoy a great deal of discretion in deciding what to count as a “start” or a “completion.”  Monthly data releases are never revised, which often gives rise to huge corrections that are simply lumped into the end-year December data release, giving a distorted impression of how trends are unfolding (so, for instance, the 19% drop in property starts in December 2011 probably wasn’t as sudden as it appears, and more likely reflected an unreported decline spread over several preceding months).

All that being said, I’m seeing some rather striking patterns in the data that tell us two main things:

1. The market is not poised to recover, but will continue to see greater downward pressure on prices; and
2. Real estate investment is likely to flatten out or start falling, erasing several percentage points of GDP growth.

Last month, many observers took comfort from reports that overall real estate investment in Q1 rose 23.5% (in nominal terms) compared to the same period the previous year.  To be sure, this was a comedown from 2011, when property investment rose 27.9%, or 2010, when it rose 33.2%.  But it still seemed to reflect resilient growth: hardly a collapse in market, more like the kind of modest slowdown consistent with “soft landing.”

Very few people paused to ask where this investment growth was actually coming from.  After all, the market was clearly struggling.  Year-on-year sales in Q1, for all real estate, was down -14.6%.  The decline was even steeper, -17.5%, in residential property, which accounts for about 80% of the market.  Office sales were down -10.2%, while growth in “commercial” (i.e., retail) property sales, which saw a boom in 2011, decelerated to +10.5%.  Although many people were touting a month-on-month sales recovery in March, compared to the Chinese New Year period, March sales were still down -7.8% from the year before, for the sector as a whole, and -9.7% for residential properties (by comparison, sales in January-February were a disaster, falling -20.9% overall, compared to the first two months of 2011, -24.7% for residential).

Given this consistent fall-off in sales, it’s not surprising that new property starts began to stall.  I already mentioned that the 19% drop in new starts in December may have been a bit of a statistical aberration.  Starts (measured in floor space) in Jan-Feb were up 5.1%, although the gains came entirely from office and retail — housing starts were flat.  But overall starts fell by -4.2% in March, with housing starts down -9.8%, ensuring that overall starts for Q1 were flat (+0.3%) with residential starts down -5.2%.  Land sales for Q1 were also flat, with sales proceeds rising 2.5% but land area sold down -3.9%.  In March, they were negative (-3.6% sales revenue, -8.5% area sold).

So if sales were down, and starts were either flat or down, where was the 23.5% investment growth coming from?  Developers, burdened by 70% leverage ratios and loans threatening to come due, were rushing to complete whatever projects were already in their pipeline, in order to put those units onto the market and raise cash.  Completions (measured in floor space) were up 39.3% in Q1, compared to last year (residential completions were similarly up 40.0%).  But, of course, those completed units weren’t selling like last year, so unsold inventories expanded.  At the close of Q1, the total amount of floor space “for sale” was up 35.5%, compared to the same date last year, while the floor space of residential units “for sale” grew 47.4%.

(That’s just the floor space that developers admitted was for sale.  There are plenty of tricks they can use to hold units off the market, in order to massage the official data and avoid spooking buyers.  At the end of 2011, total floor space “under construction” was roughly 4.6 times the floor space sold that year.  Assuming it typically takes three years to build a unit, from start to finish, that suggests about a year and a half worth of excess inventory hidden somewhere in the pipeline.  The ratio for residential property was 4.0, which suggests that, while there may be about a year’s worth of unsold inventory in the housing market, the overhang in commercial real estate is even steeper.  Although in absolute terms, it’s the housing overhang that matters).

China’s developers are playing out a kind of prisoner’s dilemma:  rush to complete, in hopes of cashing out.  But while supply keeps going up, demand is going down.  In late March, a central bank (PBOC) survey reported that only 14.1% of Chinese consumers were looking to buy a house in Q2, the lowest level since 1999.  Only 17.7% expected home prices to rise in Q2, and 62.9% said they still consider prices to be too high.  So all those rushed completions only add to the glut already on the market, driving prices down further and giving buyers — investors and aspiring residents alike — all the more reason to hold off for a better deal. Perhaps this is why Qin Hong, deputy head of research for the Ministry of Housing and Urban-Rural Development (MOHURD), told the Oriental Morning Post in late March that she doesn’t expect housing prices to rebound significantly for the rest of the year.  A strong rebound is impossible, she said, due to the continued property tightening policy and high housing inventory (my italics).

The second implication of the dynamic I’ve just described is that the “resilient” growth in real estate investment that seemed to promise a “soft landing” is not very resilient at all.  It’s more like the last gasp of a market that’s running out of steam.  Once the surge in completions plays out, the declining number of new starts will become the pipeline, and growth in property investment will flatten or go negative.  Property investment accounts for roughly a quarter of gross Fixed Asset Investment (FAI), and net FAI accounts for over half of China’s GDP growth.  As I noted in January, in a back-of-the-envelope thought exercise, if property investment plateaus (growth falls to zero), it could shave as much as 2.6 percentage points off of real GDP growth.  If it fell 10% (in real, not nominal terms) it could bring GDP growth down to 5.3%.

At the time I first saw this dynamic in the data, when the Q1 numbers came out, I figured it would take several months to begin playing out.  But the April numbers suggest it is already happening.  In April, overall completions rose only 2.8% year-on-year (down from 39.3% in Q1), and housing completions flatlined at 0.8% (down from 40.0% in Q1).  As completions petered out, growth in real estate investment decelerated markedly, to just 9.2%, with residential investment growing just 4.0%.  Investment actually fell month-on-month, in absolute terms, by -10.7% overall and -9.5% in housing.  It only grew year-on-year at all because of a low base set last April.  If you plugged this year’s April versus last year’s May, you’d get a year-on-year drop of -9.1% for property investment overall, and -11.0% for housing.  (In this context, it’s worth noting that, according to the Beijing Municipal Bureau of Statistics, overall property investment growth in the capital already went negative in January-February, for the first time in three years, dropping -4.6%).

If there’s one bright side to the plateau in completions, it was that unsold inventories advanced less rapidly over the year before.  Floor space “for sale” did rise in April, in absolute terms, but not by much.  It’s important to remember, though, all the unsold inventory that remains held back and hidden in the pipeline, as noted before.

Meanwhile, the contraction in sales, new starts, and land sales deepened even further in April.  Although the decline in sales appeared to moderate slightly for the sector as a whole (-4.5%) and for housing (-2.9%), this was again largely due to a lower base effect from last April, when sales contracted month-on-month by nearly RMB 100 billion.  This year’s April sales also registered a significant month-on-month decline, by -17.2% for all property and -15.5% for housing.  The more striking news, perhaps, is that commercial property sales, which have been much more resilient until now, also plunged, with office sales falling -23.4% year-on-year and -34.4% compared to March, and retail property sales falling -9.5% year-on-year and -22.7% month-on-month.  April was the first month in which all three categories were in year-on-year decline.

New starts in April fell -14.6% year-on-year and -27.0% month-on-month, for property as a whole.  Housing starts fell -14.4% year-on-year and -23.4% month-on-month.  Office  and retail starts, which had remained quite strong through Q1, also plunged.  Office starts fell -21.0% year-on-year in April, and -45.1% compared to March.  Retail property starts fell -18.7% year-on-year, and -36.8% compared to March.  (The year-on-year April comparisons for office and retail rely on a reverse calculation to isolate April 2011 figures, which NBS did not provide in its earlier releases).  In short, the trendline in starts has dipped into negative double digits across all categories.

Land sales, meanwhile, fell off a cliff.  Land sale revenues in April (RMB 27 billion) were down -54.7% compared to April last year (RMB 60 billion), and -47.0% compared to March (RMB 51 billion).  Total area sold was down -52.5% compared to last April, and -43.4% compared to March (the year-on-year comparison here relies on a similar reverse calculation as before).

It should be no surprise, then, that foreign investors are pulling back from China’s property sector.  Foreign funding for property development was down -91.4% in March and -80.8% in April, compared to the same months last year.

I think most readers will agree, this is pretty powerful stuff.  At least one major sector of the Chinese economy (10-13% of GDP), which had been a leading growth driver, is undoubtedly in contraction.  More importantly, the dynamics behind these numbers suggest that the market has not bottomed out, but is still in the process of unraveling.  That is why I told CNN, in late April:

“No one has hit the panic button yet,” Chovanec said. “Everyone is holding out hope that at some point it turns around somehow. But I also think that’s a triumph of hope over reason.”

On Tuesday, Al Jazeera announced that China has refused to renewed the visa of Melissa Chan, their main correspondent in Beijing — making her the first foreign journalist expelled from China in nearly 15 years.  Since the Chinese government also refused to grant a visa for anyone to replace her, Al Jazeera will be closing its English-language bureau in Beijing.  (It will continue to operate the bureau for its main Arabic-language channel).

Melissa is a friend of mine, who has interviewed me for several of her reports, most notably her pathbreaking report on the “ghost city” of Ordos, and her follow-up two years later.  Although I know she’s disappointed to leave, I told her that being expelled was sort of like China’s version of the Pulitzer Prize — tangible recognition that the work she was doing was important and powerful enough to strike a very high-level nerve.

You can see from the list of video links below that Melissa didn’t shy away from some of the toughest stories out there.  But she was also fair.  She wasn’t trying to make China look bad — although sometimes the truth wasn’t pretty.  She was just trying to make sure that the world got to hear all sides of what was often a complex and challenging story.

• Schoolchildren deaths in Sichuan earthquake (May 2008)
• Uighur unrest in Xinjiang (July 2009)
• Problems with Three Gorges Dam (November 2009)
• Tragic aftermath of Qinghai earthquake (April 2010)
• State monopoly resists smoking ban (May 2010)
• U.S. pressure on China’s currency (May 2010)
• Employee suicides at Foxconn (May 2010)
• Knife attacks on schoolchildren (May 2010)
• Impact of China’s gender imbalance (June 2010)
• Secret experiment in one-child policy (June 2010)
• Challenges facing China’s elderly (June 2010)
• Farmer fends off eviction (July 2010)
• Xinjiang security one year later (July 2010)
• Recycling China’s trash (July 2010)
• House arrest of Nobel Prize-winner’s wife (October 2010)
• Late-term force abortion (October 2010)
• Rare earth trade embargo (November 2010)
• Cellar-dwellers fight for homes (December 2010)
• Beijing traffic controls (December 2010)
• Training China’s pilots (January 2011)
• “My Father is Li Gang” case (January 2011)
• China’s water crisis (February 2011)
• Rising affluence drives obesity (February 2011)
• Search for kidnapped children (February 2011)
• Crackdown on house churches (May 2011)
• Hacking attacks traced to China (June 2011)
• Worries over food safety (June 2011)
• Chinese artist documents corruption (July 2011)
• China’s unused Olympic stadiums (July 2011)
• Jade mining in western China (September 2011)
• Limited choice in village elections (November 2011)
• Inside Communist Party schools (January 2012)
• The Party’s reach in the remote countryside (January 2012)

If you only have time to watch one video, check out Melissa’s recent report (in March 2012) on China’s secret “black jails.”  It will give you an idea of the kind of courageous reporting she has been doing, and I suspect it was one of the things that got her kicked out of the country.  I also suspect that her story, in January, interviewing farmers who knew Xi Jinping as a sent-down youth during the Cultural Revolution, was one more thing that helped wear out her welcome.  While there was nothing really negative about it — in fact, it was quite complimentary — it trespassed over strict (and rather paranoid) rules barring anyone from discussing any aspect of the biography or personality of China’s next leader.

I realize that Al Jazeera is not particularly popular in the U.S. because of the often adversarial perspective it has taken towards Israel and towards America’s role in the Middle East.  But I hope that doesn’t obscure the value of the reporting Melissa has done from China, or diminish concern over the Chinese government’s decision to send her packing.  What that decision says about China, in 2012,  is far more damning than the most critical report any correspondent could file.

Good luck, Melissa.  You will be missed.

By the way, those who are interested can follow Melissa Chan on Twitter (@melissakchan).

(Before my vacation, I promised the next installment of my critical analysis of China’s economic figures, and I won’t disappoint.  I will post it ASAP).

The key to understanding my remarks is that they are a reflection, not of certainty, but uncertainty.  Watching Susan’s reaction, one might easily get the impression I’m handing down a verdict, that I know the official numbers are wrong because I know what the real numbers should be.  In fact, I’m struggling with a dilemma:  how do I speak to what the official headline figures are telling us when they appear to be at odds not only with my own personal observations, but with other official data that are probably more significant and revealing?

In my Bloomberg remarks, I made three core assertions:

1. That the reported decrease in China’s consumer inflation rate (CPI) does not seem to accord with my own daily experience of rising prices in China;
2. That there is reason to suspect the Chinese economy may be growing substantially below China’s reported real GDP growth rate of 8.1% for Q1, and may actually be in contraction (negative growth); and
3. That Chinese companies I have been talking to are seeing flat performance (near zero growth) in Q1, compared to last year.

Each of these are worth looking at in turn — particularly now that the main economic figures for March and Q1 have been released and can be examined in detail.

My first assertion is that the decrease in China’s consumer inflation rate (CPI) — 3.6% in March, down from a peak of 6.5% last July — does not seem to accord with my own daily experience of rising prices in China.  On Bloomberg I offered, as a counterpoint, the fact that the price of the fresh milk I have delivered to my home had, just that weekend, risen by 33%, from 6 yuan/bottle to 8 yuan/bottle.

Now I want to be clear that I am not claiming consumer inflation in China is actually running at 33%.  I’m simply offering an example of the kind of head-turning price hike that remains an all-too-frequent experience despite the government’s declared “success” in getting inflation under control.

To be fair, this particular price hike is more likely due to rising delivery charges than the price of milk itself.  The Chinese media has been buzzing these past few weeks about rapidly rising logistics costs, across the board, which are expected to translate into even greater price hikes in the weeks and months ahead.

But food itself has long been a source of concern, and this is hardly the first time I’ve noted a disconnect between my own observations and the official numbers.  Back in August 2010, before inflation really took off, I wrote a post on the “KFC Index,” noting that the price of my own regular meal at KFC had risen by 32.6% since the year before, from RMB 21.50 to 28.50, far higher than the official rate of food inflation.  After my Bloomberg appearance last week, I figured I ought to check out and see where it stood now.  The same meal — large popcorn chicken, small fries, large Coke — now costs RMB 33.00, a 53.5% increase since I made my first observation, two years and 8 months ago.  On a compounded annualized basis, that works out to an inflation rate of 17.4%.

Two years ago, a business buffet I often go to charge RMB 99/person; it now costs RMB 158, a 61.2% increase, or 27% on a compounded annualized basis.  Our local foot massage place (a popular pastime in China) recently raised its prices 20%, from RMB 168/hour to 198.  Gasoline prices at the pump in China are more than 50% higher than three years ago, rising 10% just this last month — the second hike in less than two months — as you can see in this Reuters video.  (China’s elimination of fuel subsidies, which kept gasoline prices artificially low, is probably a good thing on balance, since they encouraged over-consumption, but it still hits people in the pocketbook.)

Some have suggested that the price increases I’m seeing reflect a higher rate of inflation in Beijing than elsewhere in China.  That’s certainly possible, but it doesn’t help reconcile them with official figures.  According to the official CPI numbers for February, inflation in Beijing stood at 3.5%, barely above the national figure of 3.2% for that month.

None of this necessarily means the National Bureau of Statistics (NBS) is lying, or making up numbers out of thin air.  CPI is calculated based on a basket of goods, the exact composition of which is not disclosed by Chinese authorities, although some analysts have done a decent job of trying to re-engineer it.  I’m sure you could come up with a basket that shows consumer inflation at 3.6%.  Whether that reflects what consumers are actually feeling, though, is another matter.  The picture is complicated by the fact that the government knows what is in the basket and can target those items for price controls and other forms of intervention.  That keeps the prices for the select items — and the index — down, for a while at least.  But it doesn’t solve price pressures, it only distorts their impact on the economy.

Last summer, for instance, the Chinese government dumped a big chunk of its 220,000-ton strategic pork reserves onto the market.  That helped ease prices, but it also lowered the profit incentive for farmers to raise and supply hogs, which could lead to shortages and/or higher prices in the long-run.  The government fined Unilever for talking about raising soap and detergent prices due to soaring raw material costs.   Although it later allowed those price hikes to go forward, the government leaned heavily on both Chinese and foreign companies to avoid raising their prices.  Such practices continue.  Just last week, the NDRC pressured two Chinese cooking oil producers into postponing a planned price increase for at least two months, and called Nestle in for “consultations” over a recent increase in the price of its baby formula products.

And then there are taxis.  Besides a negligible (1-2 yuan) flat fuel surcharge has been added, that rate for taxi fares in Beijing hasn’t changed since 2006 (six years) even though fuel prices in that period have soared.  The result is a dire shortage of available taxis, especially at peak periods, despite the fact that most people I talk to in Beijing — and I’m talking local people, not foreigners — are able and willing to pay more, if it meant they could find a cab.  I’m told, by reasonably reliable sources, that the reason the authorities refuse to raise the fare is that taxis are in the CPI basket, and it would boost the official inflation figure.

A critic might contend that, because I’ve been warning of the dangers of inflation to China for some time, I’m just reluctant to accept the official figures now that they inconveniently contradict the story I’ve been telling.  This kind of argument is a major reason why I’ve resisted raising my concerns about the official data: once we start throwing out numbers we don’t like, it’s hard to know where to draw the line.  The truth is, however, I don’t feel like I have anything at stake here, one way or the other.  My warnings about inflation (here and here) were born out long ago:  inflation rose higher, and remained higher longer, than either the government or conventional analysts were predicting in 2010.

Now that the monetary expansion has peaked, and China’s investment boom is slowing (more on that in a moment), one would not be surprised to see prices dropping — even collapsing — as a result of the inflationary bubble popping.  In fact, that is precisely what we are seeing in property and property-related inputs.  The -0.3% drop in the Producer Price Index (PPI) matches up well with the the industrial slowdown I’m seeing.  We may yet see a downturn in wages if that slowdown continues or deepens.  But for a number of reasons, including people cashing in inflated assets, as well as the bottled-up pressure from earlier price controls, the everyday cost of living continues to rise.  That suggests that inflation is turning into stagflation, a problem that places serious constraints on the Chinese government’s ability to pump money in to reignite growth.

There is no way to definitively prove that prices in China have risen, and continue to rise, faster than official CPI indicates.  One could, of course, devise a transparent basket of one’s own and collect independent price data from cities across China.  But the Chinese government strongly discourages such projects, to put it mildly.  Absent an alternative measure, we are left with impressions and pieces of data.  However, the fragments I’ve pulled together here offer some basis for asking skeptical questions about whether China’s latest CPI figures fully capture the everyday impact of inflation or the real constraints on Chinese policymakers.

I’ve covered the first of the three assertions in my Bloomberg interview.  In the interests of readability, I’m going to break here for the moment and examine my second controversial assertion — that China’s economy may be slowing more severely than the headline GDP number suggests — in my next installment.

As most readers of this blog will already know, Bo Xilai — the charismatic politician who nurtured ambitious hopes of joining the Party’s 9-man ruling circle next Fall, before the aborted defection of a disaffected lieutenant over to the Americans led to his abrupt dismissal as Party chief of Chongqing last month — was just as abruptly purged from his remaining Party positions on Tuesday night.  But the real shocker — almost too bizarre to be believed — was the arrest of Bo’s wife,  Gu Kailai, on charges of murdering (poisoning, no less!) a British expat who had served as a long-time business confidant of the family.

The New York Times reports that efforts to cover up the murder led to an angry split with Bo’s police chief, Wang Lijun, prompting Wang to seek refuge in the U.S. consulate in Chengdu and — supposedly — hand the Americans a treasure trove of information on China’s internal power struggles.  Wang was arrested by Chinese security forces upon leaving the consulate, and hasn’t been seen since.  If that wasn’t enough, Xu Ming, a billionaire business tycoon with close ties to Bo, vanished without a trace nearly a month ago, and is presumed to be in the hands of Chinese investigators.

Earlier yesterday, Robert Kuhn, the author of How China’s Leaders Think, also appeared on Bloomberg to talk about the Bo saga.  You can watch what he had to say here.  While I agree with him that Bo’s ouster is unlikely to threaten the Communist Party’s hold on power  or lead to broader instability, I don’t agree that the whole thing can be dismissed as merely a “personal issue” that has “no great political significance.”  Imagine, if you will, what would happen in America or Europe if a leading political figure were suddenly forced from office after one of his top aides tried to defect to the Chinese, and his wife was arrested for murder, amid stories of abuse of power and financial misdeeds — it’s kind of like Profumo, Berlusconi, and Vince Foster all rolled into one.  The political order would probably hold together, but it would sure shake things up.

For additional reading, here are two fascinating articles about Neil Heywood, the alleged murder victim, one in the Wall Street Journal and the other in the New York Times.  You can also check out this very interesting article from the Los Angeles Times about how people in Chongqing — where Bo was apparently quite popular — are reacting to his dramatic reversal of fortune.

Many readers, I’m sure, already know that I made another appearance on Bloomberg earlier this week where I made some rather controversial remarks about the Chinese economy.  I intend to post that link, but I wanted to offer some context in the way of some facts, figures, and personal observations that informed my comments.  I’m hoping to have that up shortly.

The picture is part of a scroll entitled “Along the River During the Qingming Festival.”  The original, created by the artist Zhang Zeduan during the Song Dynasty (12th Century AD), is kept in the Forbidden City, and is one of China’s most famous works of art.  The entire scroll is over 17 feet long and depicts a panorama of everyday life as people converge on the then-capital city of Kaifeng (in Henan Province) to celebrate the festival.

As a kid, I always loved those miniature panoramic models they have in museums, showing a market in ancient Egypt or knights storming a castle.  I was fascinated by the myriad of tiny individual scenes playing out — a woman bargaining for vegetables, a boy playing with his dog — that had been composed with what can only be described as loving detail.  You could gaze at it for hours and still discover new secrets, things you had not noticed before.

That is precisely the magic the unfolds on every inch of the Qingming scroll.  I highly recommend checking out various sites on the Internet where you can view the entire scroll and examine it close-up.  You will see merchants setting up their stalls, old friends greeting each other on the street, artisans crafting a wooden wheel, parents taking their child to see the doctor.  (In researching this particular post, I came upon a website that says someone has constructed a 3-D amusement park that reproduces the entire Qingming scroll in life-size clay.  It’s supposedly located in Tangshan, about two hours away from Beijing, so I’m going to have to go check it out).

I was first introduced to the Qingming scroll in an art history class I took in college, and immediately fell in love.  Not only is it my favorite work of Chinese art, but when I started this blog, it perfectly captured the sense of modern-day China I wanted to convey: a place in which so much interesting is happening, everywhere you look, that it’s easy to feel overwhelmed and confused, but excited and enchanted at the same time.  (It didn’t hurt that it’s one of the few great works of art that’s a lot wider than it is tall, dimensions perfect for a web-banner).

When I first launched my blog, a well-meaning web consultant told me, whatever I do, definitely take down that “dirty brown scroll thing” and get myself a bolder, zippier banner.  That’s one piece of advice I respectfully ignored, and now you know the reason why.

A quick announcement, for readers in Beijing.  I will be speaking tomorrow (Monday) on a panel sponsored by Amcham-China, on the topic of “Rising Labor Costs and the Impact on the Foreign Business Community.”  There is a fee, but the event is open to non-members.  You can find the details on the Amcham-China website here.  The other panelists look excellent, and I’m looking forward to hearing what they have to say.

I don’t think you have to whitewash the misconduct that did take place to find this — intellectually, if not emotionally — a deeply unsatisfying explanation.  To me, the more interesting and important question is why so many people — good, bad, and in-between — behaved in ways that seemed rational at the time but ended up producing such a disastrous outcome.  And this, despite the fact there were at least some people who saw it coming.

Over the past few days, I’ve received numerous calls and emails from people wondering what I think about Premier Wen Jiabao’s public criticism of Chinese banks (as quoted below from Reuters):

“Frankly, our banks make profits far too easily. Why? Because a small number of major banks occupy a monopoly position, meaning one can only go to them for loans and capital,” China National Radio quoted Wen as telling local businesses at a roundtable discussion.

“That’s why right now, as we’re dealing with the issue of getting private capital into the finance sector, essentially, that means we have to break up their monopoly,” the radio news service reported Wen as saying on its website.

Now, I don’t think anyone would mistake me as an apologist for Chinese banks.  As I’ve written before on this blog and elsewhere, I think China’s state-run banks have made what will prove to be a barge-full of bad loans over the past several years, financing a property bubble and a whole host of officially-sponsored boondoggles in order to meet inflated GDP targets.  Their reported NPL ratios (approximately 1%) are a joke, which means their supposed profits (which Wen worries are too large) are a lie.   When confronted with PBOC efforts to rein in their lending, and hence their make-believe profits, the banks repackaged risky loans as investment products, which they then sold to the Chinese public with the implied suggestion that they were risk-free.  They have financed guarantee companies which, in turn — much like AIG — purport to insure those very same banks from loan losses, while investing their funds in those same bank-sponsored investment products.  In short, whether anyone realizes or admits it or not, China’s banking system is an absolute mess.

In fact, it’s the dawning realization of the extent of this mess, at China’s highest leadership levels, that likely prompted Premier Wen’s remarks.  Last October, Wen was dispatched to Wenzhou, not to deal with a high-speed train crash (as in June) but with an implosion in the city’s shadow banking system.  This emergency visit, along with the high-profile trial of Wu Ying, an otherwise typical Chinese businesswoman facing the death penalty for engaging in “illegal lending,” have cast a spotlight on the inadequacies of China’s formal banking system.  Reformers have begun arguing that “illegal” lending to small and medium entrepreneurs meets a critical economic need that China’s state-run banks are unwilling or incapable of meeting, and that bringing the sector out from the “shadows” can play a vital role in reforming the broader financial system.  That won’t be easy, but in the long-run, it’s probably correct.

But to be fair to China’s banks, they’re not really the villains here.  They are creatures of the State; they do what they are told, and incentivized, to do.  And what they have been told, and incentivized, to do is to lend generously, without counting the cost, to companies and projects that carry the imprimatur (and implicit guarantee) of the Mother State.  They know that any losses incurred in this pursuit will be forgiven, one way or the other.  They know that, given fixed deposit and minimum lending rates, the more money they lend towards this end, the greater profits they can record, regardless of the eventual outcome.

China’s state banks are not run by  “bad” people, nor are they (necessarily) entrenched and greedy interests, staving off reform.  Some of them fully recognize the problems they are contributing to, and wish they could do things differently, although most find ways to rationalize their doubts, figuring that somebody higher-up must know what they are doing and will make everything alright — deus ex machina as a business plan.

The “monopoly” or protected position that Chinese banks occupy was given to them intentionally, so that they could serve as a slush fund to promote “growth” (in the form of limitless investment) regardless of whether market conditions told them it was profitable or not.  Premier Wen is as much to blame for framing this task as anyone.  At the 2009 National People’s Congress (NPC), he outlined the following vision of how China’s economy should be managed (bold text mine):

We must continue to make use of both market mechanisms and macro-control, that is, at the same time as we keep our reforms oriented toward a market economy, let market forces play their basic role in allocating resources, and stimulate the market’s vitality, we must make best use of the socialist system’s advantages, which enable us to make decisions efficiently, organize effectively, and concentrate resources to accomplish large undertakings.

In order words, the secret to China’s success, Wen maintained, is that it can command (among other things) a captive and insulated banking system to drive growth forward, overcoming the obstacle of market forces.

I think Premier Wen was wrong then, and is right now.  I suspect the cost of playing “the socialist system’s advantages,” in the form of mounting bad debt, persistent inflation, and stagnating growth, are becoming more and more evident to him by the day.  But the solution isn’t to blame the bankers, who are mere functionaries in this equation.  It’s the system, and the system’s priorities, that need fixing.  Getting “private capital” to play a more vital role in China’s financial sector, as Wen proposes, means accepting limits on the government’s ability to define risk and allocate resources as it pleases.  That’s going to be a whole lot harder than fingering “bad guys.”

For further background on the topic, you can check out my earlier posts on China’s 2010 cut-off of supplies to Japan and its immediate fall-out, as well as a similar WTO case that China recently lost and efforts to circumvent China’s near-monopoly.  There’s also this research report by the U.S. Geological Survey (USGS) which provides some useful data on China’s estimated reserves as well as production, export, and policy trends.  And here is a Wall Street Journal article on China’s efforts to build a strategic stockpile of rare earth minerals, one of the things I mentioned on the air.

As I joked to the delegates, this was probably the first and last time they would see a PowerPoint slide devoted to Marx’s dialectic at a conference for CFAs.  I’m about as far from being a Marxist as one could imagine, but Marx stole his thesis-antithesis-synthesis framework from the German philosopher Hegel anyway.  So I’m actually offering a Hegelian take on China’s economy, not a Marxist one, in an attempt to get beyond the conventional bull/bear debate.

At the inaugural CFA Institute Asia Pacific Investment Conference earlier this week, Professor Patrick Chovanec of Tsinghua University School of Economics and Management analyzed the investment thesis for China by taking an unusual tact: he applied the “thesis, antithesis, synthesis” dialectic that is often associated with the work of Karl Marx.

The professor’s synthesis, or conclusion, was that “an imminent correction to China’s economy will create promising opportunities in dynamic new sectors,” including agriculture, logistics, retail, consumer brands, and health care.

Chovanec is a prolific blogger and has analyzed many aspects of the Chinese economy, from concerns about housing market imbalances in 2009 to worries about inflation in 2010. He counts himself among those predicting a “hard landing,” but readily admitted to being conflicted about China’s future, telling delegates: “I don’t really feel that comfortable wearing a bear suit.” That’s because Chovanec sees huge untapped potential in the economy of China, a country he first visited in 1986 (he has since traveled to each of the country’s 31 provinces, as well as Taiwan). Chovanec’s use of the thesis, antithesis, synthesis framework is borne of an attempt to reconcile these competing views.

Chovanec began his presentation by describing the prevailing thesis for China: that the country is on the verge of a profoundly disruptive economic adjustment; in other words, that the old “China story” is over. This story had been based on the premise that China would experience growth for as far as the eye could see, and that the rising economic tide would lift all investors, as long as they had exposure — any exposure. Unfortunately, the dangers of this story became all too clear during the global financial crisis, which showed that China’s export-driven model had reached its limits; that its over-reliance on investment was generating bad debt and inflation; and that any delay in the day of reckoning would only heighten the risk of a hard landing. Chovanec also pointed out that even a “soft landing” for China would represent profound, disruptive change at a micro level.

Of course “hard landings,” otherwise known as economic corrections, are sometimes necessary in order for economies to reverse imbalances and return to health. This observation points the way to Chovanec’s antithesis: that “the very inefficiencies that have provoked a crisis offer immediate opportunities for companies and investors who are smart and prepared.” These opportunities include short positions, private financing, purchasing fire sale assets, and participating in distressed workouts. Short positions are the most obvious way to profit and have paid off for many hedge funds, Chovanec said, but they are not easy to execute in the Chinese market. He noted that private financing remains attractive because of the inefficient allocation of capital in China, and the fact that many companies that could earn a return have trouble obtaining capital. (Conversely, the private equity market in China has been flooded with capital, he said.)

Chovanec then turned to his synthesis, walking delegates through the case for each of the dynamic sectors he identified as offering promising opportunities. Of these, he said, none are garnering enough attention from entrepreneurs or government policymakers. Since the retail sector is largely staffed by unskilled labor, he suggested that the potential exists for companies to add value to the buying experience. He also pointed out that China still has very few national retail brands. In addition, he argued that logistics services and “containerization” were potentially lucrative because they hold the key to “massive productivity gains” in China. And Chovanec noted that health care suffers from a lack of capital even though China’s aging population will create demand for services such as retirement homes and assisted living.  [The other key sector I discussed, but was omitted from this summary, was agriculture].