Digging a debt hole to China

The next cataclysmic jolt to global markets is likely to come from a sharp slowdown in Chinese growth, rather than problems in Spain or Portugal, according to high-profile hedge fund manager Hugh Hendry.

In his latest market commentary, Hendry, who is partner and chief investment officer at Eclectica Asset Management, argues that we are about to witness the third and final leg of the economic crisis. "It has long seemed to us to be the case that this economic crisis would start in the US and make its way to Europe. That has happened. However, we also think it will end in Asia.”

According to Hendry, this year could be the time when "panic over Chinese economic growth comes to replace the market's morbid fascination with the travails of the European continent and the year in which we see that the US is not giving way to China in terms of global economic leadership.”

Hendry argues that the Chinese economy is at risk due to its massive housing bubble. For the past decade, the Chinese central bank has engaged in a massive money-printing exercise in order to keep the Chinese currency from rising. Huge quantities of yuan were printed to buy the foreign currency flowing into the country.

Ordinarily, money printing on this scale would lead to inflation. But the Chinese authorities were able to keep prices steady because they engaged in financial repression on a massive scale. The interest rates that banks were allowed to pay on deposits was kept extremely low, well below the rate of inflation.

This policy created a huge incentive for Chinese to pour their savings into real estate, and led to a colossal real estate bubble.

According to Hendry, "by mid-2010, the share of residential properties purchased across Chinese cities as an investment hit an extreme peak of 40 per cent and even the central bank estimated that 18 per cent of households in Beijing owned two or more properties. Many of these lay vacant.

"It should not be surprising to learn that as a result of all this, the ratio of household debt to income rose by almost 20 percentage points between the end of 2008 and the end of 2010. This was an incremental change greater than the one witnessed during the wilder years of the US boom. China has spent twice as much as the US relative to the size of its economy on its property bubble.”

At the same time, a huge shadow banking system – estimated to total at least $US1.3 trillion – developed that channelled funds from borrowers seeking higher returns to smaller private companies that often found it difficult to borrow from China's state-controlled banks. Large state-owned enterprises also found that they could easily boost their profitability by developing financial subsidiaries and providing high-interest loans to cash-starved borrowers. Although Chinese banks require a 40 per cent deposit in order to qualify for a housing loan, it is likely that many Chinese borrowers financed their deposits by borrowing from the shadow banking system.

Hendry argues that the Chinese economy is also at risk because of its high levels of government debt. Government debt levels soared after Beijing responded to the global financial crisis by launching a massive investment spending program. Hendry calculates that local government debt is probably sitting at around 25 per cent of GDP, and although central government debt is difficult to ascertain, it's likely to be around 80 per cent of GDP.

He notes that Chinese government deficits, which averaged $US23 billion between 2006 and 2008, have increased five-fold in the past two fiscal years. At the same time, he notes, the result of the "2009 spend, spend, spend policy was to funnel huge amounts into worse-than-useless job creation projects via a broken financial system which, thanks to negative real interest rates, provided little financial incentive for rational behaviour.”

Hendry argues that Beijing probably thought that soaring budget deficits could be quickly remedied once the United States and Europe emerged from recession, and recovered their appetite for Chinese exports. But, he argues, "perhaps China miscalculated: its leaders mistook a prolonged period of balance sheet deleveraging in the west, a rare bird, for a typical recession.”

China, he argues, will feel the brunt of a protracted period of sluggish Western demand. Mercantilist economies, such as China, which export their surplus savings to the rest of the world and import excess demand, get an outsized benefit when global growth is expanding. "But when world trade stumbles they are always surprised by the severity of the resulting slump.”

In contrast, debtor countries are less hard hit by an economic downturn. They respond by importing less and buying more locally-made goods, which cushions the fall in their output levels.

At the same time, high levels of government debt puts the Chinese economy under additional stress. According to Hendry, the Chinese authorities "have compounded the dangers from their operationally leveraged economy with a financially leveraged sovereign. And in doing so, they may have jeopardised their country's economic future.”

Hendry points out that China's largest customer, Europe, is locked in a perpetual round of austerity, at a time when Chinese costs are rising due to wage inflation. If the US dollar were to start appreciating, the Chinese would no longer have even benefit from a cheap currency.

"What then for China's exports? And what value for those worse-than-useless investment projects, the vintage of the 2009 credit cycle which have always struggled to cover even their operating costs (capital costs will never be met)? It seems to us that under these circumstances hot money would depart China in droves. This has probably already started.”

China, he points out, will likely be reluctant to sell its huge hoard of US Treasuries because this would push its currency higher, as US dollars are sold, and huge amounts of yuan are repatriated.

"With their largest overseas customer, the Europeans, in a funk just as the domestic economy is rolling over, I am very pessimistic on the Chinese authorities' grounds for manoeuvre.”

This means, he argues, "that when we look at where the next market crisis will come from we should be looking to China.” At present, he notes, most global funds managers have their portfolios centred on stocks that benefit from strong Chinese growth. A sharp slowdown could trigger a shock "as the world fumbles to imagine a world less reliant on China's breakneck pace of economic growth and cuts the price it will pay for a large group of stocks.”