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Making the New Sub Prime – Part 2 – What’s in store

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 any one’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 organizations 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 hand over 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 securitizable 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 securitize 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 securitization 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 ‘aquired’ 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.

24 Responses to Making the New Sub Prime – Part 2 – What’s in store

  1. Pat Flannery April 29, 2011 at 4:07 am #

    Another thought provoking piece Golem.

    One question though: does not Wall Street perform the same function vis-à-vis the U.S. government as does Honk Kong vis-à-vis China, only more so? Is this not also true of the European governments vis-à-vis their bond markets? Is not this dependence on inside/outside duality the root cause of the inability of all governments to regulate their finances? It has become the system.

    Maybe the world governments will wake up all at the same time. Maybe their inability to tax all but their most vulnerable citizens will alert them to the unsustainability of the system they have created.

    While competing nations now gleefully watch their neighbors house engulfed in flames those same fires are beginning to kiss their own roofs. Maybe it will take the scorching of China's thatch to finally give birth to a worldwide financial fire brigade.

  2. Fungus FitzJuggler III April 29, 2011 at 6:04 am #

    Very interesting.

    They undoubtedly,(having invented paper money!) know the fiat game. Is there a trend of not investing in certain countries? They may be palming them off with the same rubbish GS provided to Europe?

  3. john May 1, 2011 at 7:45 am #

    I don't get whether this is the chinese using western banking methods to attack western banks, western banks trying to bounce the chinese into having a private central bank and joining the bis or buisness as usual?

  4. Hawkeye May 4, 2011 at 9:16 am #


    Good summary of the possible underlying causes.

    Either way it certainly seems to be a creaking tension in the murky world of international finance. This excerpt from Karl Polanyi about the tensions leading up to Word War I provide a foreboding about the current global system:

    “For another seven years peace dragged on but it was only a question of time before the dissolution of nineteenth century economic organization would bring the Hundred Years' Peace to a close…….The true nature of the international system under which we were living was not realized until it failed. Hardly anyone understood the political function of the international monetary system; the awful suddenness of the transformation thus took the world completely by surprise…..The dissolution of the system of world economy which had been in progress since 1900 was responsible for the political tension that exploded in 1914.”


  5. Golem XIV - Thoughts May 4, 2011 at 9:29 am #


    Sorry for the dealy replying to you.

    I think the Chinese have no intention of joining the BIS. If they do join it will be to change it while disregarding whatever of its rules and functions they don't like. Much as they have with the WTO.

    I think teh balance of power in Hong Kong at teh moment lies with teh calition of interests between the Reginal Chinese governments with their attendant developers, and the Big Banks.

    The Banks want to draw China into the world of securitized debts. The Regional governments are all for it as tey see it as a way of becoming even more independant of the Central government. The old guard of the central government does not, I don't think, quite understand what is happening (perhaps some in the Central bank do and are secretly in favour), and the people will set out on the path we have already travelled.

    They will get 'richer' while the debt bubble inflates and be all in favour of the 'things can only get better' world, until the debt bubble bursts and they are handed the bill as unwitting lender of last resort for their banks and wealthy elite. Just like us.

    That is what I see at least.


    Great quote. That's how I'm thinking as well. A political and financial point of systemic transformation which we will only know has happened after the fact.

  6. john May 4, 2011 at 7:15 pm #

    thanks for the link Hawkeye quite a challenging read,
    Golem are the chinese selling the securities mainly for other currencies or their own if its not their own this could run on for a long time as there share of value added manf. goods grows and their currency appreciates whilst our doohpy politicians try to cure our economic ills through unemployment, state aid for the bankrupt and printing fiat.

  7. Dan Hot May 4, 2011 at 9:46 pm #

    Yes, thanks for the quote Hawkeye.

    I have worked in a public library on and off over the years and have always been surprised at the ratio of WW2 history on offer as compared to WW1. It's as if WW2 is popularised (probably not the best term) to hide the secrets of WW1. I was fascinated by Rob Newman's take on the railway from Berlin to Basra and it's tie-in to oil being a reason for the start of WW1. If that were true it seems that it's coming full circle with the unrest in the middle east again.

    Whatever it was that started it, there is definitely a feeling of something ominous coming again.

  8. Hawkeye May 5, 2011 at 3:58 pm #


    I wholeheartedly agree. Incidentally, there was another comment about the railway from Sinclair, I think, last week. Here is the link:


    Rob Newman certainly understands the big picture, from the role of energy in economics to history and geopolitics.

    I’m currently reading Karl Polanyi’s Great Transformation (cited above), and I can’t quite believe how prophetic it is. Essentially he sees WWI as the culmination of the breakdown of international finance and a rise of nationalism. We often forget how the 19th century was quite a major period of “globalisation”, which serendipitously held the world together in relative peace.

    Perhaps we can only understand how events will unfold for us, by drawing parallels with this forgotten period of economic history.

  9. shtove May 5, 2011 at 5:34 pm #

    Not sure if this is a double post …

    Saw this on Mish today – excerpt from Michael Pettis on the use of imported copper in China to raise credit:


    Mish's comment:

    "Note that those companies holding copper, especially those new to this wild financing scheme, are very vulnerable to a decline in the price of copper. Alternatively, those companies taking out loans based on copper collateral then selling the copper back to the exchanges have managed to get loans with no collateral.

    "Interestingly, Pettis insists that credit cannot really be considered tight in China, rather demand for credit has gone through the roof.

    "In my model, rapidly expanding credit is a sign of a huge inflation problem. For comparison purposes, many forms of credit are still stagnant or declining in the US.

    "This is supposed to end well? For who?"

    If they're having to do this, then HK certainly hasn't slipped into gear.

    p.s. Wonder when you'll get back to Ireland on the blog. After listening to Enda Kenny on Bloomberg a couple of weeks ago, my guess is Anglo and INBS bondholders are going to get smashed.

  10. Dan Hot May 5, 2011 at 11:52 pm #

    baghdad it was! thanks for the link.

  11. Robin Smith May 8, 2011 at 9:13 pm #

    How to avoid tax evasion? Tax something that cannot move.

    Hong Kong do this already. By capitalising the annual rental value of the high value locations there into into leases, auctioned up to every 50 years or so. Collected for public revenue.

    Taxes on production, investment and saving are relatively low. It thrives for this reason in the main.

    So if anyone ferrets their cash into Hong Kong, does that increase the location value there. YES! Does that get collected as a tax. YES!

    Its a pretty poor way to use the principle of taxing things that cannot move. But it works ans is better than what he rest of the world insanely does.

  12. Golem XIV - Thoughts May 8, 2011 at 10:43 pm #


    that's an interesting notion. I need to think more about it. It's late and my brain is ready for bed but I would like to learn a little more. Can you possibly point me to a good source or tell me a little more?

  13. Hawkeye May 9, 2011 at 8:18 am #

    David / Robin

    Sorry to chip in. I think that the most prominent advocate for land tax was Henry George:


    His ideas clearly seem to have an impact on Michael Hudson who seems the most well informed and articulate person on this subject (to name but one):


    Also worth mentioning is former Renegade Economist, Fred Harrison, who shares similar ideas. Here’s an interview with Hudson:


    Also, this 10 minute interview is highly recommended general viewing:


    I think this is the one where they reveal the secret of where the Bundesbank’s gold is actually held!

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