Grief will steal the Chinese miracle

Behind the funding of part of China's growth is a giant Ponzi scheme based on unsustainable lending.

The two miracle economies during the global financial crisis – China and Australia – are in trouble. As we look back at the various crises over the last 15 years it is clear that, in hindsight, there were clear warning signals, if only we had been smart enough to recognise those signals. Suddenly clear advanced warning signals are emerging from both Australia and China.

Australia’s signal will come later today when Prime Minister Julia Gillard announces that Australia’s tax revenue has slumped. Deep down, Australians know they are in trouble which is one reason why the voters, according to the opinion polls, have turned to Opposition Leader Tony Abbott.

China’s problems are not as widely recognised and the advanced signals are confused – at least, until now.

You may remember that the 1997 Asian Financial Crisis could have been recognised by travelling to Thailand or Indonesia and discovering that they were borrowing vast sums in US dollars with no currency hedge. That practice had to end in grief and it did.

The US meltdown was discoverable by going into the American housing markets and seeing that unemployed people who had no hope of repaying loans were being advanced money. That practice had to end in grief and it did.

Europe’s crisis could have been seen by a short visit to Greece (or similar countries) and discovering they were borrowing money they had no hope of repaying. It would have the same outcome as Asia and the US.

In the case of China we are now also seeing an advanced warning. I have not been to China recently but at last week's ADC China summit and the Patrick Chovanec KGB interview that followed, the warning was signalled – the secondary banking market in China is borrowing short-term at interest rates of above 8 per cent and even 10 per cent. Vast sums are involved. That is an unstainable rate and shows that there is a deep problem that has yet to surface.

China’s secondary banking market and many other parts of its banking system have borrowed money to undertake uneconomic investment and, to continue to finance those investments, unsustainable rates of interest must be offered. In Australia we know where that practice ends – companies that undertake such borrowing can’t service their debts and fall over.

That’s what will happen in China. However, unlike Australia, because of the potential political and social ramifications, the Chinese government will almost certainly pick up these broken enterprises but the rescue effort required will be so large that capital investment and demand for our minerals will be cut back. The Patrick Chovanec KGB interview puts a new light on China.

But Chovanec – a former professor at the Tsinghua University’s School of Economics in Beijing and now a global investment strategist – is merely reporting to Australia that a practice we know to be unsustainable is taking place. It’s just as in Asia, the US and Europe where people saw the bad practices but did not recognise the seriousness of the problem until it was too late.

China will not fall over tomorrow or the next day, but borrowing at high rates of interest always comes to grief because it represents yet another Ponzi scheme. (Wikipedia defines a Ponzi scheme is an investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by organisation running the operation. Such scheme usually entices new investors by offering higher returns than other investments and requires an ever-increasing flow of money from new investors to keep the scheme going.)

The quicker China recognises its vast Ponzi scheme and takes action the better for Australia and the world.