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In China We Trust: Will US Notes Be a Source of Funds?


China might have to sell a chunk of its US notes and bonds if it has to raise physical cash to enact its own version of TARP or some other form of a bailout of its financial system.

China has been trying to orchestrate a much-needed bout of reform and re-regulation of its financial lending markets for the better part of a year. In doing so, it awoke a sleeping giant.

Back on January 6, I wrote a piece for Minyanville's Buzz & Banter entitled "Economic Slushies" (subscription required) whereby I analogized the impact of too much excess capital to what happens when you drink slushies (aka Slurpees) too fast or in excess.

I was indirectly speaking to the impact of US tapering on global markets and their ability to function -- as they have for the past four years -- without it.

The action in emerging markets equity, credit, and FX markets back in May and June of 2013 gave you a sneak preview and a very good hint. Economies with current account deficits that had been funding their growth with cheap and plentiful access to credit would have a problem if either rates or easy access to ample capital changed.

Now that the movie is in theaters, the markets have decided to re-focus on its effects again.

In that column, in addition to mentioning that China's markets were giving technical sell signals in my work, I also mentioned "China is also still in the midst of going through its own version of financial re-regulation in order to quell the less than healthy (or sustainable) real estate and lending markets over there."

What you are beginning to see happen in China right now is not much different than what the US and Europe went through when unorthodox lending and excess leverage came home to roost. There is/was an incredible amount of off-balance-sheet lending going on via alternative lending products and methods, not to mention the ongoing "bubblicious" real estate market over there. This is not new news.

What is finally coming to the forefront of people's minds (again) is the impact that type of lending and leverage can have on an economy dependent on credit and credit growth when existing credit goes bad. Virtually every major global country has learned this lesson over the past six years; now it's China's turn to visit the confessional. The problem is that China is less than transparent with anything, so no one knows how to measure the size of the problem because very few are privy to real factual information.

With the roughly 4 trillion rmb (which is about $661 billion US) in Chinese trust products due to mature in 2014 (according to The Financial Times), the effective bailout of the $500 million China Credit Trust product will not be the last. The only question is, do they let some fail and risk a Lehman type of event, or do they step up to the plate?

I do not think you are going to see much difference in how the country will have to come to the rescue of its own financial needs with its own capital (more on that below). China likely already showed its hand with the "unidentified buyer" who is offering to buy the paper back at par via ICBC.

It might take a little bit of tough talking and positioning, but I seriously doubt China will jeopardize its financial system by allowing the shadow banking markets (both current and future forms) to completely implode. Remember the movie Jerry Maguire? Many large and well-connected Chinese investors will be saying the same thing…"Show me the money!" Unfortunately that is not today's business, and it will likely take a lot of pain and time for that outcome to emerge.

Here are a few rhetorical questions for you....

We all know that the China Credit Trust product will not be the only bailout the Chinese government will have to do in its financial system going forward (not by a long shot). That being said, will China have to sell a nice chunk of its US notes and bonds it owns if it has to raise physical cash to enact its own version of TARP or some other form of a bailout of its financial system? How much will it need to raise? And most importantly, how will the bond market digest that paper for sale with QE3 tapering?

Things that make ya go hmmmm....

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