Chinese credit crunch sets up another attractive entry into the Stock Market

If you remember the beginning of the Lehman Brothers collapse that led to the credit crunch in 2007 which led to the FED’s policies of using QE-bazookas, you’ll no doubt be experiencing a deja vu sensation when looking at China in recent weeks. The economy, which averaged a 9.3% GDP growth rate between 1970 and 2011, has been preparing for a soft landing during the last few quarters with GDP growth expect to drop to 7% by next year. For the first time in quite some time, the Chinese authorities are prepared to tolerate a lower growth rate as the rebalancing of their export dependent continues apace. Similarly, government-led investment is being reigned in. The consumers role in GDP growth is growing in importance as the economy continues to transition from developing to developed.

As the transition of the Chinese market enters a maturation stage then this means accepting a more balanced growth rate. With a bubble still in place in housing, will the PBOC engage in the same errors as the Western economies or will they in fact allow for a cyclical downturn as a necessary side effect for a more medium-term balanced growth?

There’s no doubt the latest economic data coming out of China points to a cooling that may turn into something wider if nothing is done. PMI numbers released a few days ago printed a nine-month low at 48.3, a number that is lower than May’s final reading and which points to a contraction in manufacturing. Faced with a deterioration in economic data and with no intervention from the government or the PBOC, investors have been selling their equity holdings driving the Shanghai Composite Index down 20% YTD, with most of this occurring during the last 30 days.

The Chinese economy is highly leveraged with Credit-to-GDP amounting to 170% last year, a measure that has increased at a dramatic rate as it was just 110% in 2008. With the PBOC putting the brakes on money supply growth, an atmosphere of distrust has been growing amongst each other with the various banks and which has culminated in a rise in the overnight repo fixing to over 25% during this last week. That’s a record high and a prohibitive level for banks to borrow any amount which means that without any intervention many will most certainly collapse. The yield on government bonds expiring in January 2016 rose from 3.1% to 3.75% and the 7-day interbank repo also rose to 12%. This is a situation that echoes the Lehman-era. Before imploding, the US economy also saw TED spreads rise this fast and when the FED finally did provide the much needed liquidity it was too late.

The problem which the Chinese authorities currently face isn’t easy to solve. For now, they have been prepared to tolerate this credit squeeze, most probably providing direct bailouts to the most stressed banks but, if the situation develops further, the decision will be between letting the financial system collapse or injecting money into the system and so providing the much needed liquidity. Of course, the latter seems to be the obvious option but such a decision in fact add to the credit problem the country has experienced in recent years and which is most obviously apparent in the housing market. Still the alternate of not stepping in is a situation similar to which the US and the Western world experienced in 2009-12 and which would likely cause even more damage. That’s why the PBOC must actually act.

Many analysts have already been downgrading GDP growth prospects for China, and although they expect it to be nearer 7% than 8% in 2014, that’s still a healthy growth level when compared with the pale rates the rest of world and in particular Europe will record. A s relayed above, we don’t think the PBOC will tolerate the credit squeeze to turn into a banking crisis and so derailing the economy. We  believe they will look to oversee a more measured deleveraging process. The Chinese stock market may be out of favour during the next few weeks/months, but if it continues to drop, we will be adding to a small position that we have taken in the FXI ETF enter as valuations prove very attractive once again.