Bear in a China Shop

Photo: Wen-Chun Fan - CNN

It’s been a few months since I placed China firmly in my crosshairs. Since then, the evidence continues to portray a mind-boggling debt bubble, not only in the property and construction markets, but also in corporations financed by the shadow banking sector.

Initially, I thought the main problem was the property market but after realising how leveraged the corporate sector is, my attention turned to the copper, coal and iron industries with connections to the shadow banking system. My updated thesis is that the overleveraged corporates (specifically the coal mining, iron ore, copper, cement and property industries) will be the first to crack causing defaults in the shadow banking system. Loan defaults inevitably lead to tighter credit conditions and further defaults, falling asset prices and collateral impairment. The vicious cycle is complete and suddenly the economy is in free-fall.

There is no question in my mind that the defaults will occur but what will the policy response be? The Chinese government will respond with bailouts, debt guarantees and more fiscal stimulus. Despite the financial firepower that Beijing has, the scale of the problem is so vast that it will overwhelm the economy before Beijing reacts.

But let’s say that Beijing is successful in preventing a few defaults initially. The distortion of risk will perversely cause investors and speculators to pump more funds into bad investment products as any losses incurred will be recovered via a bailout (increasing moral hazard).

The main catalysts for the China collapse in order of most likely to least likely are:

• Government inaction (no bailouts) that results in tighter credit conditions or intervention to deliberately depreciate the Yuan (reversing leveraged carry trades)

• Falling commodity prices causing collateral impairment, forcing collateral liquidation which causes further falls in commodities in a self-reinforcing cycle

• Defaults relating to property market speculation occur causing a downturn in the economy and falling demand for commodities

In this post I will provide evidence for the aforementioned conclusions. You can decide for yourself if this is just doomsday permabear talk or if China is on the precipice of the abyss.

Chinese banks and bad loans

The borrowing binge of the last couple of years has seen a rise in Non-Performing Loans (NPLs) for the largest Chinese banks. Beijing has tried to clamp down on the leveraged banking sector and the reports of rising NPLs is seen as a pre-emptive move to mitigate a future surge in NPL ratios amid rising defaults in 2014.

This raises suspicions that if the largest banks are reporting rising NPLs, one can only imagine the amount of bad loans in the opaque shadow banking sector. To illustrate the relative size of the shadow banking sector, the five largest state owned banks and the 12 largest national lenders control more than 60% of China’s banking assets with other financial institutions owning the rest. There is cause for concern with NPLs rose by 28.5bn Yuan in last quarter of 2013.

NPL ratio rising since Q3 2011 (time axis reversed)

Despite the worrying trend in NPLs, this has not dampened confidence in lending. In fact, total social financing increased by the largest amount in history:

Credit boom continues

Shadow banking

At the heart of the excessive credit is the shadow banking system in China. Essentially, the shadow banking system refers to the unregulated financial intermediaries and the investment trust products they produce. These trust assets are marketed as “wealth management products” (WMPs). A good analogy for WMPs is the mortgage backed securities that went bust during the GFC. But instead of institutions buying these products, it is small retail investors and instead of mortgages backing these trusts, it is loans to corporations and local governments. The growth in these trust assets and WMPs have been enormous to say the least, with growth in the last few years averaging 40%p.a.

Trust asset boom is unsustainable

Bailouts and moral hazard

One of the counterpoints put forward by the China bulls is that the government can just expand credit and bail everyone out. Unfortunately this creates huge moral hazard and encourages reckless risk taking throughout the entire system.

Wealth management Products (WMPs) offering double digit returns are presumed by investors as being guaranteed by the issuers. Avoiding the default has misleadingly confirmed that presumption leading to that perennial distortion of risk… Ye Olde Moral Hazard.

In a JPM report they conclude, “Avoiding defaults will only delay or even amplify the problem in the future.” Get ready for the first wave because in the short-term there are a large volume of WMPs maturing which poses substantial rollover risk.

To summarise, bailing out losing trust products creates moral hazard and exacerbates the risk of further volatility. The lack of perceived risk will entice further investment, further inflating the bubble and worsening the inevitable crash.

Chinese commodity collateralised loans

While the central government is aware of the accumulation of leverage in the system, the crackdown on lending has driven companies to use raw commodities such as iron ore, copper and coal as collateral. These schemes increase the risk on loans by exposing lenders to a fall in commodity prices which will impair collateral. This creates the dual risk of either loan defaults causing collateral to be liquidated or commodity prices falling first and the value of collateral being insufficient, leading to lenders calling for more collateral.

Given the above, the record build-up of iron ore inventory at Chinese ports is a worrying sign and could precipitate a collapse in commodity prices:

Inventory piling up and does not bode well for prices
Source: Unknown

Already iron ore prices are declining as inventory is at all-time highs. Adding to the pessimism is falling industrial demand and speculative activities by commodity traders. There is anecdotal evidence that commodity importers have been using their inventories as collateral to bet on Yuan appreciation. Some have even borrowed dollars, converted them to Yuan and invested the money in “high yielding” accounts.

Iron ore prices at new monthly lows
Source: Barchart

From SoberLook, “With banks cutting back lending to this sector and the recent decline in the Yuan, traders are being forced to dump inventory and that is sending prices lower and causing some mills to close. All of this points to tighter credit, weaker demand and slower industrial activity going forward.”

China upcoming trust defaults

There have already been reports by the media of potential trust defaults. The upcoming trust defaults seem to be concentrated in Shanxi province and in the coal mining industry. Repayments may be extended to avoid default in the near term and Coal mine trusts are most likely to default because coal price has fallen recently.

The maturity wall is fast approaching

Chinese housing market

Residential property in China’s 70 largest cities is also coming off the boil. It is still early days but if the fall in property prices gain momentum, this will dampen the speculative frenzy. A rapidly cooling property market and falling coal and iron ore prices will compound the contraction in credit growth as trust products default.

Chinese households have invested vast amounts in property and are now massively exposed to a housing bubble. China housing prices have increased substantially with households holding on average 65% of their assets in real estate and 90% of households already owning a home. Supply is coming to market at a rate of 15mil new units per year.

Chinese house prices in a speculative fervour

Impact on the world

I remember watching an episode of NCIS and the veteran detective saying, “I don’t believe in coincidence.” There is a link between Chinese capital flows and the US Federal Reserve’s QE program. We have seen the effect QE tapering on emerging markets (EMs) as the carry trade unwinds. Tapering will speed up the withdrawal of capital causing financial conditions in China to tighten. This is relevant because the Chinese trust sector is partly financed overseas. Low global rates and expectations of perpetual Yuan appreciation have resulted in higher investment returns promised by trusts. Part of the debt raised overseas is probably invested in the trust carry trade. Hong Kong banks are big participants and if China goes bust, you can expect the Hong Kong banking system and property prices to come under pressure.

Honk Kong financials are heavily exposed to Chinese borrowers

BAML says if China blows up there will be safe haven bids for developed market (DM) government bonds, overseas property and precious metals. One of their alleged smartest clients said, “The main theme in the past 5 years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” This is an important reminder about the immense global implications of any crisis given China’s contribution to world economic activity.

Yuan leveraged bets

The “managed economy” that China espouses has resulted in massive speculation in property, commodities and of course the currency. China has steadily allowed the Yuan to rise and has gradually allowed increasing volatility over the years. Corporations have taken out derivatives known as target redemption forward contracts to bet on the increasing currency in what many have described as the “easy money, no risk, no brainer” trade. Unfortunately, the government has ended the party in recent weeks with the Yuan depreciating significantly during a short period of time. While in absolute terms the move is not dramatic, it does cause the problem of huge losses for corporates who are exposed to these leveraged derivatives.

To summarise the problem, the longer the currency depreciates the more losses are sustained. Even if the currency remains below certain loss thresholds, collateral or margin calls will be used to reduce the risk of positions for banks. This means corporates will have less cash and will become more leveraged. You can read in more detail about the derivatives here.

Arguments against a China collapse

Another argument against a major crisis is that China runs a“non-commercial” financial system, that there is no counterparty risk since it’s just one giant state run labyrinth and bailouts will flow at the first sign of trouble.

Such a system is not immune to shocks and is in fact more fragile and more susceptible to adverse events. I have already mentioned that avoiding losses will result in moral hazard and lead to more risk taking and leverage. Eventually the boom will become too inflationary (as seen in 20%YoY property price increases) and they will be forced to tighten, which then causes tighter credit and eventually defaults that further destabilise the system.

The “China is immune view” also emphasises that market forces deal with problems and governments do not. Loss making decisions are eventually purged from the market, while they are perpetuated and exacerbated in a government controlled system.

Picking the top in the market

There’s that old adage in the investing world that the markets can remain irrational longer than you can remain solvent. This is especially true for bearish investors and traders calling the top in any bubble. I have previously said I expect Australia to be in recession before 2016 based on many risks including a Chinese financial crisis. That is still my base case. In making this prediction, I am committing the cardinal sin of picking the top of the market or trying to time the collapse. Jim Chanos (runs a short-selling hedge fund) has been predicting the Chinese collapse since 2009 and five years later it still has not happened! I am happy to be wrong on timing the crash because I am convinced that it will happen given all the facts listed above.

Conclusion - warning signs

We all know that inflationary debt bubbles burst eventually because central banks and governments understand the instability caused by rampant leverage and speculation. By then it is too late, and the economy must undergo a remedial recession to purge the malinvestments.

China’s highly leveraged economy has numerous risks that would trigger a chain reaction throughout the entire system. The property market, the commodity market, the currency market, the banking system and leverage corporations form a powder keg that will soon find a spark.

When someone says, “China is immune”. What I hear them saying is, “this time it’s different”. The same denials you hear when history has proven that credit fuelled bubbles never last. You will always hear the same bubble mantras that defy logic like, “property prices never go down” (US sub-prime 2007), “earnings don’t matter” (Tech boom 2000), “they have a super-productive economy and are different” (Japan 1990) etc. When central planning and debt is involved, nothing ever changes and you can expect history to repeat again and again and again.

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