Easy Money

With all eyes on European bond markets, few investors are paying attention to growing risks to the Chinese growth miracle.  Concerns are growing, but most of the work we’ve seen boils down to, “Yes, we know it is unsustainable, but we don’t think we need to worry for a few more years because . . . . blah, blah, blah.”  We think this is a mistake. The lesson learned from prior manias is simply that if something can’t go on forever, it probably won’t.  And if it seems too good to be true, it probably is.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in the Chinese growth miracle and so many economies, investment strategies, and corporate managements almost solely dependent on the Chinese for growth, we spent some time last week exploring the growing cracks emanating from Beijing.  Slides from our investor call are available for download below.

Bulls claim that current weakness in the property market has been largely driven by government tightening.  We would agree, but they also contend that as policy reverses and addresses weakening fundamentals, markets will respond accordingly.  Fed tightening ultimately busted the US housing bubble, but subsequent easing hasn’t had much of an impact.  The oversight in this argument is sentiment.  Once Chinese buyers awaken to the reality that house prices can move in two directions, we believe the genie is out of the bottle.  This article from Caijing suggests the genie might be a little upset about falling prices, as investors storm the offices of property developers after 25% price cuts.  Optimists also point to varying regional dynamics to support the notion that national market is holding up well.  Entirely possible, but California, Florida and the rest of the sunshine states were more than enough to wreak havoc on our banking system.  We doubt the Chinese capital cities (or Australian “regionals” for that matter) will avoid similar repercussions.

While many agree that a property-led hard landing is likely “in the next few years,” few are willing to acknowledge that it could happen sooner rather than later.  We wonder how long a country can go on building ghost towns and empty housing projects, before the bill comes due.  I suppose they need to create demand for all their Expressways of Excess.  Signs of misallocation are everywhere, but the most unsettling is the affect unregulated mining is having on one of the world’s great wonders.  Apparently, part of the Great Wall is now collapsing according to China Daily. Investors are also aware of the issues that the Chinese banks are facing, but point to declining NPLs as “proof” that the banks are well capitalized or that the deterioration will remain manageable.  History is not on their side. Didn’t American banks boast miniscule NPLs prior to the collapse of US housing?  It would seem the street is confusing cause and effect.

Finally, even those willing to admit that the banking system may be insolvent (trust us . . . it is), argue that an insolvent banking system is not an issue for China’s command economy as the problem is ultimately a fiscal issue and will inspire a fiscal solution.  This is perhaps the most misunderstood and ridiculous claim by consensus today. China’s reserves do not make its economy bullet proof by any means.  They simply represent assets on the PBOCs balance sheet for which there are offsetting liabilities.  The dangerous assumption underlying a bullish China thesis today is that these capital inflows will continue.  In an economic slowdown, particularly one driven by a credit freeze, capital flight is a significant risk.  Importantly, we have begun to see this already in the third quarter as outflows were more intense than even those experienced in 2008.  Increasing this risk, is shifting sentiment within China as 60% of the rich are already looking to take their money elsewhere, according to the FT.  Victor Shih has highlighted The Fragile State of China’s FX Reserves repeatedly.  But perhaps the most disturbing development we’ve recently heard, is this quote from a Chinese banker with close ties to powerful political parties: “There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers . . Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today than it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing , and  there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

We have written extensively about the link between China and Australia over the past year.  We think now is a good time to revisit these Predictable Surprises we outlined in June 2011, and the potential for an abrupt reversal in Australia’s terms of trade.  On November 2nd, Governor Stevens explained the following after cutting Australian interest rates: “The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.”  What he means by “very high” is illustrated below.  The rise in Australia’s terms of trade over the past decade is the biggest in a very long time.  In the five major mining booms in Australia’s history since 1850, the exchange rate has played an important role in each of them.  In the current episode, the only period with a floating rate, it has risen by a large amount.  If the terms of trade has now peaked, as the RBA (and Chinese growth) suggests, the implications for AUD are massive

But don’t take it from us.  This recent interview with Jim Chanos touches on all the main points of our thesis.  Here’s a quick summary of his points along with a link to the video well worth a few moments of your weekend:

  • The Chinese were supposed to get involved a year ago, that didn’t happen.  They were supposed to save Greece months ago, but that didn’t happen.  China will do what’s in China’s interest.
  • Big misconception regarding Chinese reserves.  FX reserves have liabilities against them. They arise when exporters earn income in other currencies and turn them in for RMB. Like any central bank liability, there are RMB liabilities against their dollar reserves.
  • China is on a bigger and faster treadmill to hell than ever.
  • Chinese are beginning to realize that property prices can go down.  Numerous reports of investors thrashing property development offices.
  • Take Chinese bank profits with a grain of salt.  American banks recorded record profits prior to 2007. It’s all about credit.
  • In the last two banking crisis in 1999 and 2004, Chinese banks had 40% non performing loans without recession.
  • Real estate transactions are down 60% year over year.  The property slow down has started.
  • Chanos is short Ag Bank of China.  They are holding onto restructuring receivables from previous bailouts at 100 cents on the dollar.  Those receivables account for more than 100% of their tangible book value.  They are probably worth 10 or 20 cents on the dollar.
  • Most China observers weren’t talking about any “landing” three months ago.  The fact that they are not admitting that the plane is not staying aloft says something in itself.
  • Chinese consumers are shrinking as a percent of the economy. Fixed asset investment is driving everything – up 24% versus 9% economic growth in the year.
  • The inherent problem China has it two governments. Central government is hitting the breaks, but local governments who are in bed with developers have every incentive to keep building.
  • There were 30-40% rallies in credit-sensitive sectors for three years in the west.  Chanos didn’t cover his shorts until things stopped deteriorating in 2008. We are not anywhere close to that in China as things have just begun to unravel.  The property slow down started in the third quarter of this year. The fundamentals have just started to deteriorate.
  • No numbers of visas in your passport will substitute for lack of judgement.  Plenty of people who lived in Miami all of their lives lost everything.

Easy Money (Nov-11)