Chu Got It
After this week’s Barron’s Cover titled, China’s Looming Credit Crisis, it’s safe to say that the risks to the Chinese economy are well reported. However, after reading through various reports on the recent cash crunch, it’s more difficult to conclude that the risks are well understood. The importance of China to global growth means that increased stress in the Chinese economy translates into elevated risk levels for asset prices in the rest of the world. Conventional wisdom is coming around to this view, but we still question if the consensus truly understands the magnitude of what we have been watching develop for the past three years. This post is a recap of what we know, what we’ve discussed, and what other reliable sources have shared with us.
How We Got Here
In the first quarter of 2009, we published a letter titled, Blowing Bubbles, in which we argued that as long as China and friends continued to peg their currencies to the Burning Buck and as a result, continue to import US monetary policy, short term interest rates in the emerging world would remain at levels far below GDP growth. At the time, we suggested that this was a powerful driver of emerging market asset prices:
“This is exceptionally bullish for emerging market assets as suppressed rates will ultimately over-stimulate growth, driving risk assets higher along with local currencies. While it may still feel premature to consider the next financial mania as the ashes of the Credit Crisis are still falling, the evidence suggests that this is exactly the time to do so. Bull markets flourish on easy money and credit, often encouraged by policy responses to the previous bust. This time will be no different. The Great Reflation will inevitably spark another financial mania and massive bubble.”
Four years later, we have more clarity on the financial mania that has developed in response to central bank policy. The chart below from SG shows this dynamic, but falls short of identifying The Bubble With No Name. Bubble’s, it would appear, are quite similar to Project Mayhem in that they only have a name in death. This is a man and he has a name. His name is Robert Paulson. This is a bubble and it has a name. It’s name is the EM Credit Bubble.
The Shake Out
China’s recent Credit Crunch may prove to be an early warning that this party is coming to an end. As we’ve said in the past, gradually letting the air out of a bubble is quite difficult. Consider “gradually” trying to let a fart out at a party. It simply can’t be done, at least without raising some eyebrows. This month, China farted, raising the eyebrows of credit investors around the world. The first week of June marked the largest emerging market bond outflow in years. Weak hands are jumping ship. So called “strong” hands are soon to follow. We discussed the risk in lopsided market positioning in Q3-11 as it related to the threat of European bank deleveraging. While that particular catalyst has yet to emerge, when you’re sitting on a pile of dynamite, we have come to realize that determining precisely which spark ignites the crisis is less important then recognizing the very real risk of blowing up. In that issue of The Broyhill Letter, we explained:
“Few emerging economies suffer from the debt and deficit issues plaguing the developed world, but we believe it is dangerous to assume that they are immune to the deepening debt crisis. Europe is the largest market for many emerging Asian exporters, but the economies of Eastern Europe boast the most obvious vulnerabilities to deleveraging by their western neighbors. The regions banks are heavily dependent on financing from the largest banks in the Eurozone. Weaker export demand, reduced capital flows and deteriorating bank financing conditions have the potential to create a severe headache for the region.
“As bank credit dries up, it is likely to put pressure on emerging market currencies reliant on foreign capital. Weakening currencies has the potential to reverse capital flows given extremely crowded investor positioning as the consensus has flocked to the relative safety of emerging market balance sheets in a world of western debt crises. Commodity producers are particularly exposed to weakening demand since any decline would be compounded by falling prices. The consensus view is that continued demand from China will prevent a steep fall in price despite deteriorating global financial and economic conditions. This is inconsistent with past experience. We think there is a sizeable overhang here as the PIMCOs of the world hide out the “ring of fire” in emerging market currencies. We suspect a shake-out is overdue.”
Come Here Often?
That shake-out appears to have started in June. While this may seem like a New Normal, in fact, it is the same Old Normal we’ve lived through repeatedly over the course of history’s market cycles. As we discussed three years ago in A Cautionary Fable, it is important for investors to understand that the concerns surrounding the rise of China today are not new. In fact, they are quite similar to past threats faced by our great nation – the Soviet Union in the 60s, Japanese Superiority of the 80s, and the Asian Tigers in the 90s. The lessons learned, from an investment perspective, are no different than the countless experiences of bubbles past – if something can’t go on forever, it won’t. 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 today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial. Barron’s echoed this sentiment in this week’s cover story:
“The primary fault line in the Chinese economy that worries many has been the explosion in the credit-to-GDP ratio since the onset of the 2008 global financial crisis and economic slowdown, as China sought to stimulate its economy in the face of a lag in its longtime growth engine, exports. This total societal debt load has followed a similar growth trajectory to that of the U.S. and British economies in the six years leading up to the 2008 crisis; Japan’s credit orgy from 1985 to 1990, a prelude to two decades of stagnant growth punctuated by bouts of deflation, or Korea prior to the Asian financial crisis (see charts below).
“According to a report from analysts at Fitch, China’s recent credit bubble has topped them all with total debt (a broad measure which includes business, household and local government debt but not central government debt) rising from 130% of GDP in 2007 to 210% in the first quarter of this year. In Japan, by comparison, during the fateful six-year credit bubble, the jump in the ratio was just 45 percentage points, from about 150% to just over 195%”
The problem in China is not only the massive amount of debt, but the misallocation of this capital along with the structure of credit in the system. GMO’s Ed Chancellor described it best in a recent letter appropriately titled, Feeding The Dragon. If you haven’t read it already, take the time to read it now.
“China’s thriving shadow banking system has much in common with the American version, which thrived before Lehman’s collapse: trust loans that finance cash-strapped property developers have a whiff of the subprime about them; wealth management products that bundle together a miscellany of loans, enabling the banks to generate fees while keeping loans off balance sheet, bear a passing resemblance to the structured investment vehicles and collateralized debt obligations of yesteryear; while thinly capitalized providers of credit guarantees are reminiscent of past sellers of credit default insurance.”
“Many assets underlying the wealth management products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations,” Xiao Gang, chairman of the Bank of China, wrote in China Daily. “China’s shadow banking is contributing to a growing liquidity risk in the financial markets. In some cases short-term financing has been invested in long-term projects, and in such situations there is a possibility of a liquidity crisis being triggered if the markets were to be abruptly squeezed.”
“In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme,” he writes. “Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs.”
Nice call Xiao. Unfortunately, judging by recent action in the credit markets, the music has stopped (perhaps because somebody farted). Bank Everbright recently defaulted on an interbank loan amid wild spikes in short-term “Shibor” borrowing rates, a sign that liquidity has suddenly dried up, according to The Telegraph. The street is quick to dismiss this development as having been the result of a conscious decision by the central bank to curb China’s credit growth. Analysts claim it is unlikely that the PBOC would allow systemically important banks to get into serious and sustained liquidity problems. We wonder if they really have a choice in the matter? Does anyone choose to experience a financial crisis?
Chu Got It
Charlene Chu, head of China financial institutions for Fitch, sees things somewhat differently, and is getting increasingly vocal in her non-consensus call. A recent Bloomberg article did an excellent job highlighting her concerns. We met with Charlene in Beijing last year and have followed her work closely since. Prior to moving to Beijing to work for Fitch, she worked at the Federal Reserve in New York, as part of an emerging markets group focused on crisis management. Consequently, we’d say she is worth listening to. According to our conversations with Charlene, the banking system is quite different today relative to China’s last crisis, when banks were funded by deposits. Instead, the rate of deposit growth is slowing today and wealth management products have disintermediated the banking system. In other words, deposits are much more mobile today, as savers are constantly surveying the landscape for better returns and the best products. This is a classic asset-liability mismatch which we have seen time and time again, and it is not sustainable. Liquidity is the pillar of the whole system. The Chinese banks have been insolvent, but liquid, until recently. And we know from experience that liquidity is fickle. Without it, there is Big Trouble in Little China.
More than 1.5 trillion yuan of wealth management products will mature in the last 10 days of June, according to Fitch. Most of this debt will have to rolled over, which will be increasingly difficult as credit dries up. There may be real trouble rolling over some of these short-duration products, given the huge maturity mismatch in funding. Think this precarious equilibrium could last a bit longer but will not go on forever. SG’s China Economist Wei Yao concurs. “The logical conclusion has to be that a non-negligible share of the corporate sector is not able to repay either principal or interest, which qualifies as Ponzi financing in a Minsky framework.” We’ll have more to share on Minsky tomorrow, from our favorite Chinese rock-star.