One of the enduring justifications for the bullish China view is that it is an emerging superpower. ‘The 21st Century belongs to China’ is the mantra, in the same way that the US dominated the 20th Century.
This is a plausible assumption. But should you base your investment decisions on a big picture trend spanning 90 years into the future.
We don’t think so.
It is worth looking briefly at the experience of the US in the 1920s to show how a nation’s rise to great power status is anything but linear.
There are some interesting parallels between China today and the US in the early 1900s. To borrow a phrase from Mark Twain; history doesn’t repeat, but it sometimes rhymes.
In the early 1920s the US was emerging from a short sharp depression. (They were short in those days because governments didn’t try to fix the problem). At the same time, the British were in poor economic shape. They were emerging from WWI and (unwisely) preparing to go back to the pre-war gold standard rate for the pound sterling, which was dramatically above the market rate prevailing at the time.
In order to achieve this, the British needed to increase interest rates to deflate their economy and increase the value of the pound sterling. Instead, they pursued an easy credit policy, which led to gold flowing out of the bank of England and into the US.
So the Brit’s turned to the US for help. Bank of England boss Montagu Norman and NY Fed Chief Ben Strong were close allies. Back then, the NY Fed was in charge of monetary policy and the Board of Governors operating out of Washington (where Ben Bernanke resides today) had little say in monetary matters.
The British convinced the US to inflate its money supply in order to support the pound’s return to a pre-war gold standard parity. An inflationary policy in the US in1924 helped achieve this aim. But the British economy remained woefully uncompetitive because of the high value of the pound and unemployment persisted.
Furthermore, gold was again flowing out of the Bank of England. This loss of reserves dictated that credit should have contracted. But instead, the British again turned to the US for help.
In July 1927, Norman and Strong organised an inter-central bank conference in New York. Representatives from the Bank of France and the German Reichsbank also attended. (Strong did not permit his own Chairman to attend the meeting. Nor was the Fed Board of Governors invited!)
The intention of the conference was to get all four central banks to expand credit and inflate their money supply. This was intended to help the global power at the time, Britain). Germany and France were having none of it. Germany had just endured hyperinflation and France was a creditor nation and didn’t want to print money to help Britain out.
This left Norman and Strong alone to agree on a massive US inflationary attempt. Unbelievably, at the conference Strong told French Representative Charles Rist that he was going to give a little ‘coup de whiskey to the stock market’.
Indeed he did. As a result of the credit binge he unleashed, the US stock market exploded in a speculative bubble. By mid-1928 though, he appeared to be having second thoughts about the inflationary policy. In the words of his assistant:
‘He (Strong) said that very few people indeed realised that we were now paying the penalty for the decision which was reached early in 1924 to help the rest of the world back to a sound financial and monetary basis.’
The penalty was heavier than he could have imagined. The bubble popped and the whole British/US scheme was uncovered for what it was, a series of short-term remedies designed to paper over large structural cracks in the monetary system.
The US’ fledging emergence as a dominant global power was halted. The world turned insular and protectionist. Those betting on the US as being the place to be in the 20th Century were right…they just had to wait many years for the predictions to pay off.
China’s role in the recovery
The parallels with China today are of course very different. Unlike the US and UK last century, the US and China are not close allies. They are economically mutually dependent.
But China’s position is similar. It is the emerging power that other nations see as having the ability to bring the world out of its economic malaise. And like the US last century, it is inflating (expanding money supply and credit) in order to do so.
But China is inflating for its own benefit, and certainly not to help the US. As an export dependent country, China was hit very hard by the 2008 credit collapse in the US, Britain and Europe. Its response to the crisis was equally massive.
According to a recent World Bank Report, Chinese government led spending equalled 5.9% of GDP in 2009. The economy’s total growth for the year was 8.7%. So government stimulus was responsible for nearly 70% of China’s economic growth last year.
More concerning for longer term stability, bank lending accounted for two-thirds of the stimulus. Total net new lending for 2009 amounted to RMB 9.6 trillion, or nearly 30% of GDP, compared to new lending of around RMB 2.5 trillion in 2008 (RMB means renminbi yuan, the Chinese currency).
That’s the equivalent of the Australian government telling the banking sector to increase loans by around $300 billion in a year! For some perspective, total credit in Australia in the year to February 2010 expanded by just $26 billion.
As the accompanying World Bank chart shows, most of the lending went to local government run infrastructure projects. Given the raw material needs of such projects, it is little wonder commodity prices have increased so much. This is especially the case for the steel making inputs of iron ore and metallurgical coal.
The chart indicates only a modest portion of the bank lending stimulus went to real estate. But if you consider the growth in lending to the sector, you will understand why fears of a property bubble are emerging.
The total stock of real estate related loans rose 38% in 2009 to a total of RMB 7.3 trillion. Such a surge in credit has obviously pushed prices rapidly higher, which is bringing more speculators into the market.
The chart below (source: World Bank) shows that property prices in 36 big cities have increased by 32% year-on-year. At a national level price rises have been far more modest. But in a country with the size and variation of China, the big city index looks more representative of recent credit excesses.
As does growth in floor space sold. The three month moving average has surged by around 70%. No wonder there is so much anecdotal evidence of empty housing blocks in China!
Returning to the increase in infrastructure spending, there is a disturbing trend occurring in China. That is the continuing increase in fixed asset investment as a share of GDP. (See chart. Source: GMO)
As GMO consultant Edward Chancellor points out in ‘China’s Red Flags’:
‘In a market-oriented economy, investment might be expected to fall during a period of uncertainty and economic turbulence. Yet in 2009, Chinese fixed asset investment climbed by 30% and contributed 90% of last year’s economic growth.’
As we saw above, infrastructure accounted for a large portion of this spending. But while this might be good for Australia’s raw material producers, we question the productiveness of the investment. Chancellor again:
‘China already possesses a highly developed infrastructure, given its current state of economic development. Last year, highway usage in China was estimated at 12% of the OECD average. Many smaller airports were running at half capacity. Plans for a national high-speed railway may appear impressive on paper, but the investment returns are questionable. A transport researcher at China’s own National Development and Reform Commission has recently warned that the proposed 18,000 kilometres of high-speed railroads would face problems in recouping costs and “might not be able to achieve its minimum passenger loads to break even.” ‘
All this stimulus spending has had a major impact on the Australian economy, obviously through the massive boost to commodity prices but also through the flow-on effects to employment, incomes and consumer confidence.
Just as importantly, a strong China signals to the rest of the world that Australia is a sound investment destination. As a capital importer, the confidence of our lenders is extremely important. China’s growth provides this confidence because Australia is seen as a low risk play on China.
When will the cracks appear?
One of the main problems we have with China’s stimulus, as effective as it was in the short term, is that it was forced lending. This type of lending tends to be totally unproductive. There is little time or consideration given for the risks involved in the projects being undertaken. Money is simply advanced with little regard for the future economic return on that money.
In recent commentary on China, strategic forecasting group Stratfor stated:
‘When you have an unlimited number of no-consequence loans, you tend to invest in a lot of no-consequence projects for political reasons or just to speculate.’
The result is a massive increase in non-performing loans (NPLs). It doesn’t take long for loans backing ‘no-consequence’ projects to go bad. The projects simply do not generate enough cash flow to service the debt.
A recent story appeared on the ChinaStakes website indicating that the domestic banks are looking to raise capital to offset these emerging NPLs:
‘China’s commercial banks, especially those that are very large and state-owned, are preparing for the rainy day of ever-accumulating NPLs by looking to raise 600 billion yuan from both the mainland and Hong Kong markets.’
Some of the banks looking to raise capital include Bank of China, Bank of Communication, Industrial and Commercial Bank of China and China Merchant Bank.
So as far as we are concerned the cracks are already starting to appear. Massive credit growth (see accompanying chart, source: GMO) rarely ends well. New lending of nearly RMB 10 trillion in 2009 saw credit growth surge 30%. The government is attempting to reign in growth to RMB 7.5 trillion in 2010, implying total credit growth of around 18% for the year.
Contracting credit growth usually leads to deflating asset prices. But we doubt the government will be successful in limiting the growth in credit this year. Many projects already underway will need more credit to see them through to completion.
With credit growth remaining buoyant in the short term at least, there does not appear to be a catalyst to pop China’s credit bubble. But all credit bubbles have their aftermath and China will be no different. We don’t buy the argument that China’s central planners will be able to ‘manage’ credit growth lower.
Most people point to China’s huge foreign exchange reserves as a source of wealth and firepower to deal with any emerging problems. As we have stated in previous reports, we do not agree with such an assessment.
China based economist Michael Pettis says that only twice before in history have nations built up foreign exchange reserves similar in size (as a proportion of global GDP) to China’s current hoard. Those two lucky countries were the US in the late 1920s (despite Britain’s attempts to stop the US accumulating gold) and Japan in the late 1980s.
Pettis says rapid expansion of domestic money and credit were responsible for these two countries’ subsequent malaise.
‘It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.’
This doesn’t mean China will suffer a decade or so of deflation and falling asset prices. But it does mean you should be cautious about the country’s prospects and the expected impact on your investments.
Another area of concern for China is the approaching trade antagonisms with the US. Like Britain last century, the US is now ‘top dog’. It will use this position to pressure China into opening its markets and strengthening its currency.
Stratfor argues that the Bretton Woods currency system that has allowed the US to be consumer to Japan, Germany, and Asia’s producers is coming to an end. The US’ trade policy will therefore change and become more protectionist.
At a guess, we would expect China to feel the effects of much slower credit growth and lower government involvement in the economy by the final quarter of the year, if not before.
None of this expected risk is priced into the Australia equity market at the moment. And that is not surprising. All we hear is how the Chinese are on the hunt for resource projects, and how demand for steel inputs is going through the roof. But that demand is the result of past stimulus.
Meanwhile, inventories of most base metals are at or near their peaks (and above 2008 peaks) suggesting that basic raw material supply is more than adequate to satisfy demand. After all, the global economy is only just emerging from recession and is not expected to bounce back strongly.
The biggest concern for Australia is that China has brought forward much of its raw material demand via the 2009 stimulus measures. When the impact wears off, commodity prices may correct and give back some of the very large gains achieved since the 2009 lows.
For this reason we are avoiding the resource sector until prices move back to more favourable valuations. This may take months, and we may look like idiots in the meantime, but we view preservation of capital as more important that jumping on momentum trades.
When the inevitable correction comes and good value appears, we look forward to making some quality recommendations. We are not predicting China to endure a nasty, drawn out depression like the US and Japan experienced previously.
But it will go through a post credit boom hangover. The result will likely be another round of extreme equity market volatility. Be sure you have cash on hand to take advantage.
for Markets and Money