Things are not alright in the Middle Kingdom. China’s total bank debt has grown from $14 trillion in 2008 to $25 trillion today – more than double the total size of the US commercial banking sector. To support this massive growth in credit, China’s central bank has more than doubled its money supply (M2) by simply printing more money. While rapid growth in credit and large-scale monetary expansion may have softened the blow of the 2008 financial crisis and contributed to renewed growth, history has never seen such a colossal ramp-up of both money and credit without a subsequent period of financial chaos.
All that newly created money has been borrowed primarily by state-owned businesses and municipalities. These entities are not focused on economic profit, but rather on driving employment and meeting the growth targets of their masters in Beijing, in keeping with the nation’s Communist legacy. James Rickards, in his new book “The Death of Money,” offers an explanation for the country’s surfeit of non-productive investment and a further warning for investors in China, estimating that actual Chinese GDP growth adjusted for the cost of malinvestment and corruption may be half the official rate. Visitors to China are often struck by the sight of huge real estate developments sitting unoccupied, roads and bridges going unused, and other examples of state-sponsored overcapacity.
By investing in roads that create jobs but not much economic activity, or in factories that run at half capacity, Chinese borrowers will likely find that repaying their loans may be challenging, to say the least. Many analysts are now warning that Chinese municipal and corporate balance sheets may be hiding “ticking time bombs” just as pervasive and damaging as the subprime-linked instruments that nearly cratered the US financial system. Ironically, though, if US investors are watching Chinese financial news for the same warning signs that preceded the 2008 crisis, many of them could be caught flat-footed again.
Early Warning Signs
China’s growth is slowing. For most of the 2000’s, China’s economy clipped along at a nearly double digit growth rate. Today the economy will be lucky to grow at the government stated 7.5% rate, and some analysts think growth has slowed to 5%. Slowing growth turns questionable loans into bad loans, as borrowers find that they can’t generate enough profit to cover interest and principal payments.
Exacerbating the issue is that labor costs are rising, further squeezing Chinese companies’ profitability. For decades, China’s rapid economic expansion has been fueled by its vast supply of inexpensive labor. As its workforce has aged and demand for labor has increased, however, wage levels have risen, driving down margins and suppressing growth. When labor remained cheap and margins on most projects stayed healthy, borrowers had a decent chance of paying lenders back, even with only modest revenue streams. The current margins and returns on these poor investments, however, cannot support higher wages and input costs, and as a result China’s banks may be carrying enormous levels of non-performing loans.
This Ain’t your Mother’s Debt Crisis; Signals of Strength may Actually Indicate Accelerating Weakness
In 2008, US investors could point to one clear moment when the lurking dangers on financial institutions’ absurdly-levered balance sheets exploded into global disaster: September 15, 2008, when Lehman Brothers declared bankruptcy. In watching for signs of a crisis in China, however, investors should expect no such clarity.
In fact, with China’s centralized mechanisms of economic control and limited transparency, a credit shock there might look like ours in reverse. Investors will need to be closely attuned to particular signals that could indicate oncoming trouble, since the country’s leadership would likely try to keep a crisis out of view for as long as possible.
One sign could be an announcement by the central government of higher GDP growth targets. The Obama administration launched its hotly-debated stimulus package several months after the 2008 shock in order to support demand and, to the extent possible, offset the negative impacts of the downturn. In China, on the other hand, doubling down on growth – in effect, a much larger and systemic stimulus package – would likely indicate that the problem of bad loans has grown so widespread that the only hope for repayment is to artificially drive up domestic demand as a means of soaking up excess capacity and potentially “inflating away” regional and corporate debt burdens.
Investors should also be on the lookout for any move by China’s central bank to devalue the country’s currency. Such a move would be another step (or potentially a precursor) to achieving the higher growth targets mentioned above by boosting exports, and would help to reduce debt burdens in real terms by introducing inflationary pressure, as well. China could devalue its currency relatively easily by expanding its purchases of US Treasuries.
Other erratic behavior by the Chinese government – for example, military moves against Taiwan – may also indicate that the country’s leaders hope to shift attention away from more deeply-rooted and thorny domestic economic issues by playing on regional tensions.
Ironically, the key event US investors typically associate with the onset of a debt crisis – the insolvency of a major financial institution – would likely be a positive indicator in China’s case, since it would suggest that the country’s leaders were confident enough in the stability of the rest of the system to allow a single institution to fail.
Impact on Investors
In today’s global economy, investors would have a very difficult time “China proofing” their portfolios by reducing their holdings in specific stocks or fixed income instruments. We would expect most risk assets (e.g., equities, high yield, etc.) and commodities to struggle during a crisis, while US Treasuries might serve as a defensive bulwark. In particular, commodity producers like ADM could take major hits, with emerging market-focused firms like Vale and Gazprom even more vulnerable.
Moreover, many large US companies that are often considered safe would likely suffer, as well. American consumer companies such as Yum Brands , Kimberly-Clark Corp and Coca-Cola derive a high percentage of their revenue from Chinese markets, and have all seen strong results due to heightened demand there. Investors may be caught off guard as many of these companies could miss earnings and / or cut dividends in the event of a Chinese credit shock.
While protecting their portfolios from the impacts of a debt crisis in China would be a tall order, investors will certainly be better off if they know the signs to look for. And, as we have learned in so many other areas of China’s economy, these indicators may not be as straightforward as many of us would like. By keeping an eye out for the signals above, US investors can put themselves in a better position to shift to a more conservative strategy if necessary, and hopefully minimize the effects of a China-driven debt crisis.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please consult your professional advisor about your specific situation.
