China risks out of the shadows

PORTFOLIO POINT: If problems of politics, debt and economic imbalance were isolated to Europe and America, I'd say we’re at the bottom of the market.

Occasionally, news from Europe can be good. The weekend’s indications that European leaders will beef up the banks via low-interest ECB credit, and maybe even increase the European Financial Stability Facility's mooted recapitalisation program, has been greeted with optimism. Of course, the underlying crisis in Europe remains unresolved – this would require a comprehensive bailout or orderly restructure of Greek sovereign debt, the issue of Eurobonds, or both – but considering that Europe has no choice but to save itself (see Continental drift and Europe’s two tipping points) I see this as the first of many incremental steps in the right direction towards and beyond next month's G20 summit in Cannes.

With that in mind – and considering the latest data out of the United States suggesting that it will probably avoid a double-dip recession, the Republican Party's political skullduggery, Wall Street protests and long-term deleveraging notwithstanding – I'm relatively optimistic about the global economy.

Despite what will likely be a continuation of volatility over the coming months, until all the problems of Europe and America are resolved to the satisfaction of the vigilantes in the bond market and the ratings agencies, I'd even be so bold as to recommend a return to “risk” assets such as commodities, the Australian dollar and large-cap Australian equities.

But there's a big cloud of bearishness that prevents me from pushing the button. And that cloud is the economic uncertainty in China: fears over which have now gone mainstream.

In the past few weeks, unusually bearish notes have been issued by the research powerhouses of Deutsche Bank, Société Générale, UBS, Bank of America-Merrill Lynch, the International Monetary Fund and Standard & Poor’s, backed up by mainstream economic commentary in the Financial Times, the Wall Street Journal and Bloomberg. This has coincided with a number of political and business developments too – some of which I covered last week (see The East is green) and the week before (see Nouveau riche get theirs) – which has sent local Chinese markets into a panic.

Having got used to being a relatively isolated long-term bear on our greatest trading partner, however, this recent barrage has made me slightly claustrophobic, triggering some of my contrarian instincts (was China now a “buy”?). Still, having trawled through much of the analysis I sadly cannot help but agree with it.

Two weeks ago I wrote that China's myriad challenges fall into five broad categories: corruption, imbalance, inflation, totalitarianism and ecological collapse. Within these categories any number of trigger points may exist that could turn what is now an economic challenge into an economic crisis, which would have a detrimental impact on the world economy in general and Australia in particular. Personally I have nominated China’s looming water shortage (see The world’s real liquidity crisis) and the 2012 power transition (see Pincer closes on China) as the two most likely trigger points. Yet while I’m not alone in these concerns, there are plenty of other issues that are being looked at in other places.

Bank of America-Merrill Lynch analyst David Cui, for instance, has identified four other areas at risk of unravelling: shadow banking; property prices; bad debt; and “hot money” outflows. UBS strategist John Clemmow, meanwhile, worries about China’s dependency on grain imports (see Food for thought) and its increasing reliance on bold hydroelectricity schemes (one of which, last week, was surprisingly cancelled by the Burmese government). Economists and analysts elsewhere have identified dissatisfaction with government policy, a weak consumer sector, a looming currency war with the United States, wage inflation and slowing manufacturing as key areas of concern.

It is BoA-Merrill Lynch’s analysis of economic imbalances, especially in the country’s property and financial sector, though that deserves particular scrutiny at this time, especially considering the risks of a prolonged crunch until Europe categorically solves its banking crisis. In addition to evidence of Europe-style contagion spreading to the burgeoning market for Chinese government credit default swaps (see the chart above), there are signs that fear is spreading to China’s RMB14–15 trillion ($US2.2–2.4 trillion) “shadow banking” sector or the growing number of financial institutions that play a critical role in lending business money, which Société Générale China economist Wei Yao meanwhile estimates could now be contributing to an larger share of property development funding than traditional bank loans, yet which does not enjoy government scrutiny, regulation or protection.

Unsurprisingly, as shown in a separate research by Merrill Lynch and Standard & Poor's, the credit outlook for Chinese developers has significantly worsened. Two of China's largest property development groups, Greentown China and Evergrande Real Estate, have seen bond yields explode to over 30% in recent weeks.

Within this unregulated shadow banking sector, which investors like hedge fund manager Jim Chanos believes is contributing to total Chinese debt levels of up to 200% of GDP, it is difficult to get beyond the anecdotal as reliable data, naturally, does not exist. Yet while the anecdotes are fascinating – a string of prominent businessmen in the boom city of Wenzhou are believed to have fled in recent months, with China's central bank estimating that almost 90% of households and 60% of local enterprises in the city deal with the sector – there is perhaps another way to analyse the phenomenon and that’s through old-fashioned flow-charting, courtesy again of Merrill Lynch:

None of this looks good for Australia’s mining sector, the outputs of which have gone into building some of the economically unsustainable schemes and projects much of this shadow banking cash has been lent against. And we can see how this fits into the potential dynamics of Merrill Lynch’s second systemic risk, a Chinese property bubble, which has been discussed in greater detail before (see China at the precipice).

It doesn’t take an expert in macroeconomics to see how the risks of either a shadow banking or property price collapse might feed into the official banking sector, which has otherwise tended to focus on state-owned enterprises (SOEs) and local government financing vehicles (LGFVs) (but in turn driving households and private entrepreneurs into the shadow banking sector). Additionally, with a string of failures in the SOE and LGFV sector already apparent, and mal-investment as much a problem (see The end of the affair? for examples), the flow-charts don’t look good for this sector either.

Finally, considering the role of speculative “hot money” in propping up China’s economic boom for the past few decades, it’s not hard to see the dangers of a crisis emerging there, whether for any of the three reasons above or an external credit shock in the manner of 2008’s Lehman Brothers collapse. And whereas China may have had plenty of fiscal and monetary fire-power in 2008, resultant inflation – whether as a consequence of such stimulus measures and easy credit, US asset purchases (keeping the value of the Yuan low), the property bubble, or quantitative easing in America – such policy tools appear increasingly unlikely this time around.

Whether or not any of these events pan out the way Merrill Lynch’s Cui has suggested, China’s too-high level of fixed asset investment as a proportion of GDP and the existence of a large, unregulated, corrupt and inefficient shadow banking sector doesn’t bode well, nor does China’s inflation-causing policy of accumulating foreign exchange to keep its currency competitive for a steadily decreasing export sector. Indeed, the Peterson Institute estimates that it costs China $US240 billion each year to accumulate foreign currency against a trade surplus of only $US183 billion. The interest earned on those annually accumulated reserves, equal to approximately 4% of GDP, is furthermore below the rate of interest paid to finance them.

As the tiresome morality play of Europe continues, where austerity-seeking neo-Calvinists seek to blame the victim (the German word for debt, Schulden, unsurprisingly has its roots in the word for guilt, Schuld), investors should take a look at China, where the word for Schadenfreude is apparently xìnÉ¡ zāi lè huò. Whereas few economists – as Alan Kohler pointed out on Saturday – predict a recession for America in 2012, a disturbing 59% of investors, analysts and traders polled by Bloomberg recently believe that China’s GDP growth will drip to below 5%pa by 2016 – a level that will require a dramatic shift in China’s economy lest it provoke the political unrest that high growth has so far put a cap on.

Whether or not investing in China or mining proves to be a sound investment strategy over the coming months, ultimately such investment would rest on a series of very unsustainable dynamics – dynamics I am not be comfortable with. And after all, anyone who lives in Australia, spends with Australian dollars or has the majority of their investments here – indeed, most Eureka Report readers – is already very exposed to China; investing directly in its economic drivers pushes this exposure into overdrive.