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.

Source

How To Make Housing More Affordable

It never made sense to me how a country of Australia’s geographic size can have some of the highest property prices in the world. Australian cities are on par with population dense cities like Hong Kong, Singapore, Tokyo and high profile cities like NYC, Paris and London. This raises questions like why haven’t we developed inland Australia? Sure it’s a hot desert with arid land but that hasn’t stopped middle-eastern cities developing or even one of my favourite cities Las Vegas springing up.

There are actually a number of issues explain why property prices are unusually high in Australian and with most economic issues that sees costs rise consistently or quality deteriorate; government has some involvement in the issue.

The following notes have been sourced from the policy monograph released by the Centre for Independent Studies entitled: Price Drivers: Five Case Studies in HowGovernment is Making Australia Unaffordable by Oliver Marc Hartwich and Rebecca Gill (December 2011) ISBN: 978 1 86432 133 3.

Main reasons that make housing less affordable include:

•          Land supply
•          Tax incentives for property investors (negative gearing)
•          Subsidies for owner-occupiers (first home owner grants)
•          Stamp duties
•          Infrastructure levies

Land supply

The population is concentrated in the metropolitan capital cities.

Canberra has a lot of land, and yet its house prices are nearly as high as prices in Sydney and Melbourne.

Housing prices have risen far more than construction costs. One can then conclude that land scarcity has been the main driver of property price rises.

Negative gearing

Property investors whose capital costs exceed their rental income, can offset their net losses against their income tax liability. This incentivises investment in property using debt with the prospect of capital gains. Hence, highly leveraged property investors increase the demand for housing which results in higher prices.

First home owner grants

Unfortunately these grants increase demand since buyers in this segment of the market all have access to the grant and will bid up entry level property prices.

Stamp duties

There is no economic rationale for stamp duty and is set from state to state at an arbitrary level. An interesting fact is that taxes on financial and capital transactions in Australia, which includes stamp duties, are twice the average of OECD countries. The effect of stamp duties is just to make housing less affordable.

Infrastructure levies

Local councils have been increasingly resorting to using levies to pay for infrastructure investment. These levies are borne by property developers, who pass them on to their customers.

Housing is one of the most distorted markets in Australia. All these interventions have made housing unaffordable because the market supply is restrained. Governments respond by perversely boosting demand and making housing less affordable.

Key recommendations:

•          Increase supply by encouraging councils to take on more residents through local government finance reforms
•          Abolish both negative gearing and the first-time buyers grants
•          Abolish stamp duty
•          Abolish infrastructure levies and permit the private sector to own and operate infrastructure

Debt-fuelled buying and a slowing economy

The other issue that tends to appear in most inflated markets is debt fuelled buying. Australian banks have made billions over the years lending to property buyers and investors. In the period during the GFC, prices fell dramatically as the entire economy deleveraged. The Rudd government stimulated the economy and the RBA slashed interest rates to 50 year lows. This resulted in a property market recovery with prices rising from the bottom by 20%! Clearly, movements in interest rates affect property prices since higher rates increase the debt burden and vice-versa for lower interest rates. In the last few years, rates have been steady but have declined in 2012 and are expected to decline further as China appears to be slowing. However, the entire interest rate cut has not been passed on by banks because they claim that their cost of funding has increased. This is somewhat true but we have also seen profits rise at all the banks, which suggests the banks are price makers and not price takers. The market concentration among the big four banks is high and the slow shift from offshore funding to onshore funding over the years should give the banks the ability to pass on more of interest rate cuts than we have seen in the past.

Despite the interest rate cuts we have seen over the past year, property prices continue a slow grind lower. With the economy expected to slow further, the current trend of lower property prices should persist until the government or the RBA decides to stimulate the economy through increased borrowing or lower interest rates.

Going forward

The government imposed distortions are unlikely to be reduced at any time in the near future since there is no political debate whatsoever around the housing market. Should the economy continue to slow, it is even less likely that these barriers are removed since they generate taxation revenue and would be negative for the state budgets. However, a slowing economy will also see property prices decline until the politicians decide it’s time to be Keynesians and stimulate the economy.

Banks Feed Off Inflation

Firstly let’s define inflation. Today’s common usage refers to inflation as rising prices either caused by an increase in aggregate demand with aggregate supply remaining static (demand pull inflation) or a decrease in aggregate supply while aggregate demand remains constant (cost push inflation).

So if there are tax cuts and there is more demand for all goods, is this considered inflationary? Yes by modern definition there will be an increase in aggregate demand causing demand pull inflation.

But my own view of inflation/deflation is the same as the classical definition of inflation which is an expansion of the money supply. The symptom of inflation is rising prices, which is why over time the factoid equating inflation to rising prices exists.

When the central bank adjusts interest rates, this affects the money held in bank reserve accounts and in turn affects a bank’s ability to make loans and increase the money supply.

When banks originate loans the money supply expands since a 10% reserve requirement will lead to banks using a $100 deposit to create a $1000 loan. This means when borrowers repay loans, the money supply contracts and similarly if a borrow defaults, the money supply really contracts. However, banks will use buffers to protect themselves against a default by first making sure the borrower is credit worthy, then requiring a deposit to banks are not taking the full risk, finally collateral will be linked to the loan (e.g. the property will be collateral for the mortgage loan).

As the money supply expands (inflation), asset prices rise since there is now more money chasing the same amount of goods. This in turn increases the demand for loans since people see asset prices rising and believe the economy is growing and additionally collateral value increases allowing potential borrowers to increase the leverage on their loan. Loan serviceability is another important factor when banks assess a potential borrower. Since all prices are increasing, including wages, pretty much all the factors a bank will look at to originate a loan improve in favour of the borrower.

This is the inflationary cycle that causes borrowing to lead to higher asset prices and then more borrowing. The central bank then tries to control this by increasing interest rates which should decrease the demand for new loans. However, there is a time delay in the effect and because the bulk of loans are long-term in nature (longer than a year) the economy doesn’t feel the full effect of a string of interest rate rises until a few years into the future. Eventually the economy begins to contract after a string of interest rate rises result in a fall in borrowing and then it is up to the central bank to re-start the game by slashing interest rates to begin a new cycle of borrowing and rising asset prices. This is how the business cycle works and is why under the current system any deflation is considered bad because if the central banks leaves the economy to contract and allow deflation to take hold, it will continue unabated until prices are so low that demand for loans increases. This could lead to a substantial contraction in the money supply and prices falling more than 10% in a single year.

The problem with this system is that banks depend on inflation the resulting loan origination to increase and maintain their current profits. If there is deflation, people demand less loans and repay their loans faster to reduce debt burdens. This causes a huge contraction in bank profits and when the economy really contracts, collateral values plunge as a vicious cycle of loan defaults and collateral devaluation takes place. One only has to look at what happens when a country has a bubble economy to see this scenario play out. Japan in the early 1990s, the US in 2008 and soon Australia will have its day of debt deflation.

Australia has hitched its wagon to the Chinese growth engine and Asia in general, which is where I fear the economic shock is likely to manifest itself. In many financial and economic crises we see banks come under severe stress and in many cases collapse as their reserves vanish via asset impairment, exposing their leveraged business model. Governments then become involved via bailouts and hence taxpayers are now proud owners of zombie banks.

This is exactly why substantial deflation (>2% deflation) will never be allowed to occur and why eventually rates will go to zero. Banks will not survive unless they dramatically increase their reserves, which I do not foresee happening during extreme economic uncertainty. The government will nationalise banks claiming that the economy will implode if nothing is done.

These are dire predictions and I am sure the majority will disagree with this forecast but is there really another outcome when the current solution to any downturn is to spur spending and borrowing via lower interest rates?

Asset Bubbles

In a capitalist system, the market forces of demand and supply is driven by people. Thus if the market represents the aggregate view of its participants then it is prone to bouts of fear and greed just like its participants. When greed takes over, it will drive the price upwards with many bears asking themselves, "What are the reasons for these higher prices?" The irrationality of greed is the answer to this question.

So how do we spot a bubble? We look at price inflation and see if incomes can sustain those prices. At the top of markets the general populace are the most bullish. Prices appear to be vertical when viewed on a larger timeframe. They are "self-reinforcing" on the way up and brutally fast on the way down as people realise the boom is over.

As with the US housing bubble, many pundits will claim that the price rises are justified for any number of reasons including strong economic growth, population growth/migration, low supply and high demand. What is not talked about is the amount of leverage (debt) in the market. Like any market that uses debt as the primary source of funding, the prices of the market will be affected by monetary policy of the central bank and the lending policy of the banks. Once these two factors put enough pressure on demand, asset prices will collapse. Higher interest rates and tougher lending policies not only put pressure on the housing market but also on jobs and hence average income per person declines.

The Sydney property market has risen remarkably over the past decade. But are the price rises justified by population growth, income or anything the pundits claim? No. You only have to compare median income with median house prices and you will find Sydney to be one of the most unaffordable cities in the world. See here: http://www.demographia.com/dhi.pdf

When this bubble eventually pops not only will banks fail but the economy will grind to a halt as it deleverages in a similar style to the US.
It's not just economic but social and political change that comes about through economic shocks. The rise of the Nazi party from hyperinflationary Germany, collapse of the soviet union and rise of the US, the south American debt crisis giving rise to socialist governments. The world as we know it will change.

Another bubble that is generating a lot of debate is China. This bubble is a mix of inflation and the belief that Chinese growth will continue forever. Who's to say that this isn't another 1980s Japan style bubble inflating in China.

Fixed currency rates have been another problem that has inflated many bubbles as history has shown. Several South American countries during the 1980s and early 1990s had fixed exchange rates that caused their economies to implode as the bubble popped and were forced to float their currencies causing further instability. The Chinese government thinks it can micro-manage a capitalist economy. But only when they wake up to an economic bust will they realise how fraudulent their growth has really been.

Even the Chinese stock market is treated like a casino as the index has been rising at an unsustainable pace. It was not surprising when I read a news headline that the Chinext exchange went up 300% on the first day. It is clear that the Chinese will have a lot to deal with when the house of cards tumble and it will be interesting to see how the single political party state deals with the crisis.

I will end the article with a quote: "There is no means of avoiding the final collapse of a boom brought about by credit expansion.

The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."