China – the Elephant in the Credit room?

China has experienced such huge growth during the last 25 years as the “People’s” (!) Government has been completely committed to boosting the Chinese economy and in the process creating a fascinating hybrid of Communism and Capitalism. In fact, within the next 5-10 years it will become the world’s largest and most important economy as the empire of the U.S continues to wane…

While a boost at the beginning of the cycle is something that many Keynesians would consider as absolutely necessary when trying to create self-sustaining growth, few would find a justification for the continual perpetuation of the kind we have since over the last 10 years by the Chinese Government and directed by the PBOC. Structural changes must occur and for many observers, the sooner the better.

Chinese officials think otherwise however and insist on continuing with the massive infrastructure spending that they have been aggressively pursuing for many years now and which has resulted in a skewed accumulation of capital to those connected to these programs whilst at the same time creating, in an echo of the old Wild West in the U.S., “ghost cities” (as opposed to towns). In other words, there is large scale continuation of capital misallocation and the government is now resorting to the creation of a fictitious second tier economy to keep the veneer of growth going.

Charlene Chu of Fitch

One lady, Charlene Chu of Fitch has been one of the most vocal of the warning voices about the monster credit bubble that is continuing to grow in China. It is her and many others belief that when this bubble bursts, it will have a devastating impact around the globe. What’s more, many think that day us almost upon us… The former Fitch banks analyst believes credit expansion is almost unparalleled in history and that the bursting will make the GFC look like a walk in the park.

What with the advent of the global financial crisis in 2007-2009, Chinese authorities efforts to counter-balance the negative international impact on trade as demand collapsed and the Yuan was seen as a currency to run to were reinforced to such an extent that the banking systems outstanding credit grew from around $1 trillion in 2008 to the current $16 trillion. That’s right, in just five years credit multiplied by 16x and currently corresponds to 4x the Federal Reserve’s balance sheet Mickey Mouse print and be damned balance sheet.

Instead of allowing for a natural business cycle correction in GDP as excess investment with subpar returns gets washed out, the Chinese authorities have in fact added more wood to the fire. Credit conditions should have been tightened a couple of years ago to stop investment growing to the point of creating unnecessary capacity.

With interest rates meaningfully below natural levels that one would expect to be in place at this elongated stage of the cycle, poor investment decisions are being made and capital is flowing to the wrong investments. Until now, overnight interventions by the PBOC to avoid the worst of a crunch have been moderately effective but, as the saying goes, you cannot hold back the tide forever and many believe that a lost decade akin to what Japan experienced in the 90s and arguably what the U.S. and Europe is experiencing now is the fate that awaits the Chinese dragon…

If Ms Chu doesn’t have many doubts about an imminent collapse of the Chinese banking system, opinions regarding the potential contagion effects vary. Some believe in a global financial Armageddon that will hit Japan and Asia first and then, as the global Asian banks like HSBC & Standard & Chartered retrench, domino-ing throughout the Western world and creating a new liquidity crunch. Others believe that it will largely be contained within the Chinese economy. One thing’s for sure, the Shanghai Comp is predicting some type of economic meltdown with the index remaining mired near multi year lows as the chart below shows.

China as a sovereign has a pretty small amount of outstanding debt (different to domestic bank credit) and which has kept the country relatively insulated from the hot money outflows that have been experienced by other emerging economies like Argentina and Turkey in recent weeks. Additionally, the PBOC has built a war chest of almost $4 trillion in foreign reserves – a substantial sum which could be used to inject liquidity into an ailing banking system if required. Still, it seems rather naive to us to think that the problem can be entirely contained within Chinese borders should the proverbial “hit the fan”. Using foreign reserves to pay for banking liabilities of course requires the counterpart to take Renminbi and that would destroy so called base money and hence intensify tightening credit conditions… When that happens GDP growth would suffer once more. It thus seems inevitable that some type of liquidity crunch will occur in the near term, the question is to what magnitude and of course, from a speculators perspective, how to position for it and potentially profit…

China is now the globe’s largest consumer of commodities. If the economy experiences a sharp reduction in its growth rate then demand for commodities can only decrease. Australian banks would be in deep trouble for example as much of the fuel for the housing bubble down under has come about largely as a consequence of the massive commodity boom seen there. One can quickly think of a whole multitude of contagion mechanisms that would flow out such a scenario.

The best solution to the impending credit problems would be to start modestly deflating it right now through accepting tighter credit conditions and a milder growth rate in China. This would impact the world’s overall growth rate but most certainly would not be as lethal as remaining on the track that China looks to be careering down at present.