Making the new sub prime – Part 2: What’s in store


by David Malone

Read Part 1

In the first part, The Backdoor to China, I suggested how the central Chinese authorities had effectively lost control of bank lending and property speculation within mainland China and argued that the new and rising power in China now lay in the growing relationship between China’s regional governments and international finance operating in Hong Kong.

In this second part I want to look at what has been going on in Hong Kong.

What the bankers have been up to

Like most things that succeed what has happened in Hong Kong has been part planned and part a confluence of quite different interests. At the centre of it all are the bankers who are happy to service anyone’s agenda they can profit from, but have also had their own agenda for years – and that has been to ‘open’ China. One of the organisations at the centre of these efforts in Hong Kong is the Hong Kong Monetary Authority.  In its archives you can find documents which, when you connect a few dots, tell you the history of the bankers plans. I’ll refer to only a few of them here. There are many more.

In the handover of Hong Kong to China, I feel quite sure the Hong Kong Monetary Authority and the global bankers would have told the Chinese government that preserving Hong Kong’s off-shore, arm’s length, ‘light touch regulation’ status and reputation would give China privileged access to Western Capital. What I suspect they did not make quite as clear, is that it would, in time, and once all the proper facilities were in place, give Western Capital, particularly its off-shore, off-balance sheet, shadowy part, the ability to access China via its own private backdoor.  Nor that once that happened there would be little the Chinese central government could do to stop or even regulate it. I believe we are at that point.

A rather revealing 2005-6 document from the Hong Kong Monetary Authority laid out quite clearly what the bankers wanted to achieve in Hong Kong and the steps to do it. The first page says that opening China, as far as they are concerned, is all to do with “developing the Asian Bond Market”. In other words it’s not about getting permission from the central government to open branches inside China nor even about having permission to run businesses inside China. It’s about wiring China into the world of debt – bank controlled, printed and run debt.  Like us in the West. Step one, page one of the plan as the document says is “Not about increasing sales…”  but about “helping buyers and sellers meet.” Sounds innocuous. Page two is entitled “Securitisation” and details all the different kinds of debt backed securities as well as Collateralized Debt Obligations (CDOs). Page 3 gives a basic flow chart/diagram of what needs to be set up at the centre of which is a box called “Special Purpose Company” and the next page is off into the land of derivatives.

Put these pages together and it is clear this isn’t just offering China some friendly high street banking alternatives, nor trying to get a license to bank in China. It is about trying to create a new source of securitisable debts and doing so using all the off-shore, outside of regulatory control methods that have created our present financial catastrophe. And remember 05-06 is when the CDO market in the US and Europe is at its height but also beginning to seize up. The banks with branches in Hong Kong would have been all too aware of the coming crisis as they were already talking about it in their US and European headquarters. What the banks were looking for then, and even more so now, is new cash for helping their capital holdings, new debts to securitise and new buyers for securities. All three are potentially available in China.

Ironically it was not the success of western banking but its massive failure beginning in ’07 which opened the door to China. The collapse in securitisation in the West produced a titanic glut of bail out money which, as the months of ‘recovery’ have staggered by, has become ever more desperate to find a place to speculate for an outsized return. While in China, due in part to the inflation that the huge glut of printed money has exported around the world, China’s central authorities have been trying to reign in inflation by curbing bank lending. That effort has ‘pushed’ all those in China’s regions who want to become rich from speculating on land, the developers, banks and regional governments as well as wealthy individuals, all running for an exit from China.

As a recent and very good article in the FT put it,

‘This year, with inflation running at almost 5 per cent and expected to rise, the government has signalled that it is serious about adopting a more restrictive policy.’

But can it? In response to the heavy hand of the regulators, a host of grey-market institutions and arrangements has sprung up precisely to get around formal restrictions in China’s heavily controlled financial markets. Analysts say annual flows could involve Rmb2,000bn ($305bn) – equivalent to about one-third of gross domestic product.

The two desires, to borrow and to speculate, the buyers and sellers, who the bankers were so keen to bring together, have now met in Hong Kong. And the amounts of money involved are fairly epic.

So what is Hong Kong Off-shore banking providing, for whose benefit and what consequences will it have?

Tax evasion

At the simplest level Hong Kong provides a bolt hole for any person or any company wanting to avoid taxation.  Simply open a subsidiary in Hong Kong or if you are a wealthy individual create a Trust, shift your cash into it and from there it can be moved wherever you wish. This will mean China will, like western governments lose the ability to tax its wealthiest citizens. Whether as a result of collusion with them or by accident matters less than the fact that tax will from then on fall disproportionately on those the government still can tax, the poor, who cannot move their wealth off-shore.

Tax evasion is not the only reason to move money off-shore. Businesses, corporations, banks and regional governments will certainly move their wealth off-shore as a way, ironically, of being able to get around the government’s limits on lending within China. China is, after all, where the highest returns are to be made. The easy way to get around China’s limits on bank lending is to go to Hong Kong where there are no limits on how much the market will lend to you.

If the law won’t allow you to get a loan from a bank inside China, you go outside China and get someone in the Bond Market, maybe the same bank, to give you  the same money, only this time it is not a loan (they’re regulated), it is a payment in return for a bond or a security you have ‘issued’ or sold to them. Already by April mainland Chinese companies have borrowed over $12 billion in Hong Kong. making a mockery of the central government’s desire to cool lending and borrowing.

As the FT reported in Capital Markets: Chinese companies go on a global bond spree,

Half of the offshore bond issuance this year has come from privately-owned property companies – such as Evergrande, Country Garden and Longfor Properties – that have seen funding channels dry up on the mainland.
All you have to do is set up a  company to sell bonds/securities based on profits from investments it has ‘acquired’ within China. Many of which will be land developments. The money raised from selling those bonds/securities will provide the unregulated funding above and beyond the limits set by the central government. All that is different is the language in which the deal is done. Banks lend. Bond markets buy your debt.

You are happy because you have more money than those bumpkins who stayed in China and obeyed the limit on lending, and the bank is happy because it is doing more lending.  The government issues some more limits which you ignore.

The evidence is the amount of money coming from China to Hong Kong is growing very fast.  From page six of a Goldman Sachs conference held in February with the Hong Kong Monetary Authority called Hong Kong’s Expanding Role as an Offshore RMB Centre you find that private deposits of Chinese money in Hong Kong have grown steadily but corporate deposits have rocketed from near nothing to 150 billion yuan just this year.  This is money escaping China.

[A word of explanation. The Chinese currency is called the Yuan when inside China, but outside it is known as and denominated as the Renminbi RNB.  Just to confuse.]

The amount of lending and therefore the amount of debt being taken on in China, provided through Hong Kong is beyond government control and will only grow.  This will ensure a truly vast lending and property bubble is set to grow bigger still.

Property developers, their banks and the regional governments are all coming to Hong Kong to raise money which they will do either by creating trusts in which they will sell shares or they will create bonds which they will sell.  The next question is who is going to buy them? The answer so far is people with Yuan.  What I see happening is Hong Kong creating and selling Chinese sub prime bonds and securities and China buying them.  I strongly suspect we will find that Chinese banks will buy much of the sub prime securities themselves and then hold them as ‘assets’.  They will like the high return they get on them and, if as happened in the West, the junk is rated AAA, they will be able to claim the assets are proof of how solvent they really are. Many investors will follow them soothed by the notion that the Chinese Authorities have already bailed the banks out once, at public expense and they will bet the government would do so again if it came to it.

Of course the good question to ask at this point is, since the central authority’s ability to tax and to regulate lending, are both being seriously compromised, why doesn’t the Chinese central government just shut the door from Hong Kong by bringing it within mainland regulation?

The threat to the dollar

And the answer is that the central authorities get something as well.  What they get from Hong Kong is the ability to project its currency, the Yuan/RMB into the global financial world as what is called a settlement currency.

Please don’t panic. Like all things I write about it’s actually simple.  International deals have to be bought and paid for in some currency or other that both nations find acceptable.  The dollar and the Euro are currencies accepted for settlement. Recently China has signed agreements most notably with India to allow the Yuan to be used as a settlement currency. That means banks in India and businesses in India can accept and pay in Yuan. The banks in India can trade the Yuan with Banks in Hong Kong.

The reason China needs Hong Kong to do this is because the central government wants to keep tight control of what happens inside China while  projecting its currency outside. It is trying to use Hong Kong as a way of keeping the  two parts of its finances separate. The banks in Hong Kong are saying to the Chinese “Sure we can help with that” while using their inside/outside role as a way of relieving the central government of effective control.  Neat work!

Being a ‘Settlement’ currency is not quite the same as being a ‘Reserve Currency’ like the dollar, but it a major step in that direction. It is, in fact, a very large step.  Which currency large international trades are done in matters. It is a fact that in 2000, Iraq signed an agreement to sell its oil, all its oil, in Euros. Iran was contemplating doing the same at around the same time. The Iraq decision involved the large French bank PNB-Paribas. France was not one of those who supported the war and Washington led a hate campaign vilifying the French.  The worry was that a switch from dollar to Euro settlement might gain momentum. Any major move away from dollar settlement would cripple the US.

In January of this year the India Times reported that India was talking to Iran about moving out of dollar settlements so as to be able to buy Iranian oil despite a US embargo.  India said it was discussing settling in Gold. Remember, India has just signed a settlement agreement with China to use the Yuan.

So the reason the Chinese central authorities won’t shut down Hong Kong’s activities is because they too are getting a valuable service from Hong Kong. Whether it will be worth the price they are paying remains to be seen.  The emergence of the Yuan from China as a settlement currency is going to gain pace and as it does the dollar will tremble more than it is already.  Moreover the more things are settled in Yuan the more the centre of gravity of global finance and each bank’s business will shift from America and Europe to Hong Kong.  Witness HSBC already toying with the idea of moving.  As more international trade is settled in Yuan so the Yuan will, I think, threaten the dollar. Were it not for the fact that the dollar is being weakened from within, I would have said the threat to the Dollar was some time off yet. However, the rise of the Yuan as a settlement currency added to the weakening of the dollar says to me that a very large loss of value, power and status of the Dollar is not far away.

China will not need nor want as many dollars once it can settle its trade in its own currency.  China has already started to talk about selling over a trillion dollars of dollar holdings at the same time the Japanese are starting to sell some of theirs as well.

So what’s in it for us?

The new sub prime

So far, I have concentrated mostly on China and Hong Kong and the Chinese Yuan. To end I want to suggest that China’s sub prime will not stay in China any more than America’s stayed in America.

What makes think this is the amount of money coming in to Hong Kong from Western off-shore centres such as the Cayman Islands, the fact that many of the companies being set up to raise investment and sell bonds in Chinese property ventures are set up in western off-shore centres and that Western banks are not only involved with this business but are also, themselves, looking for new sources of securities to sell just as they once sold US securities.

In another Hong Kong Monetary Authority paper called, “External use of RMB” you can see on page 6 the already huge amount of money coming IN to China via Hong Kong from the Virgin Islands.  Now the native Virgin Islanders are not that rich. But they do have a lot of off-shore banks and trusts.

Then there are companies like EU-Asia which deals specifically, as it says on its web sire, in property in Weifang a third-tier Chinese city.  The company is Chinese, with a Board of Chinese sounding people, has ‘assets’ in China but, as the company name implies, has interest in raising investment from outside China. The company itself, as it says in its company history, is registered in the British Virgin Islands.

And lastly we have European banks like LGT Bank in Liechtenstein AG who you might remember from part one of this article, are Hong Kong’s most recent banking arrival. They join banks like HVB (another old friend I have written about often) who I also find cropping up offering off-shore ‘services’ in the region.

What all this says to me is that Western money will be sucked in by the offers of large returns. Western money being used to buy up high risk, high return bonds in Chinese developments. Surely they wouldn’t be so silly? The longer our ‘recovery’ in the West continues to resemble a recession with high unemployment and low growth, then the greater the pressure is going to become to find returns elsewhere.  Those investment bankers and fund managers who buy in to China’s growth will proclaim their outsized returns. Those who are cautious will be nest years losers in the dog eat dog competition for growth.  What do you think will happen?

I think Chinese sub prime bonds, and securities will be sliced, diced, bundled, rated, insured, swapped and housed in off-shore registered Special Purpose Vehicles (SPVs) with innocuous names which Western banks, funds and maybe eventually even pensions will buy shares in.

And the worst of it is that many many billions of the money the banks will use that is already sloshing around off-shore hungry for somewhere to get a return, is actually money we gave to the banks in the bail outs.

David Malone is the author of the book Debt Generation. You can read and listen to excerpts from his book here: