‘China has failed to curb excesses in its credit system and faces mounting risks of a full-blown banking crisis, according to early warning indicators released by the world’s top financial watchdog.
‘A key gauge of credit vulnerability is now three times over the danger threshold and has continued to deteriorate, despite pledges by Chinese premier Li Keqiang to wean the economy off debt-driven growth before it is too late.’
That’s a quote from the UK’s Telegraph, reporting on research released by the Bank for International Settlements over the weekend.
Of course, you don’t get this news in the Aussie mainstream press. It doesn’t want to upset the narrative about Australian economic exceptionalism.
But just maybe, China’s economy is the exceptional one here. The rate of debt growth in the Middle Kingdom since the 2008 crisis is a historical anomaly. As The Telegraph article explains:
‘China’s total credit reached 255pc of GDP at the end of last year, a jump of 107 percentage points over eight years. This is an extremely high level for a developing economy and is still rising fast.’
‘Outstanding loans have reached $28 trillion, as much as the commercial banking systems of the US and Japan combined. The scale is enough to threaten a worldwide shock if China ever loses control. Corporate debt alone has reached 171pc of GDP, and it is this that is keeping global regulators awake at night.’
The only good news here is that China losing control is a low probability outcome. The banking system is state run, and there are many ways to avert a banking panic or credit crisis in such a situation.
The flipside to this is that the household sector will likely have to subsidise the banking system. Most likely via financial repression, or by inflation wiping out the real value of excessive debts. There goes China’s supposed consumption boom…
But inflation may take more time to emerge. When you have such a huge amount of non-productive debt growth in a short space of time, it leads to a deflationary environment.
This means that while China won’t likely have a banking crisis, its economic growth rate will continue to slow. This in turn makes it harder for China to service its growing debts, which again puts pressure on the growth rate, and the cycle continues…until Beijing feels enough pain and comes out with another stimulus program.
But at some point another stimulus program won’t be the answer, not even in the short term. It will simply cause more pain. Unfortunately, I don’t know where that point is.
The best indicator for how the Chinese economy is tracking is the iron ore price. That’s because Beijing’s stimulus program was all about reigniting the property boom, which increases demand for steel and iron ore.
Yesterday, the price fell to a two-month low of around US$55.30 per tonne. I’ve long held the view that China’s economy would slow in the second half of the year as the effects of the stimulus wear off. If I’m right, you should continue to see the iron ore price trend lower in the months ahead.
There’s another reason I’m concerned about China’s economy as we head into the back end of the year. An anticipated rate rise from the US Federal Reserve will put upward pressure on the US dollar. As China’s currency is loosely pegged to the dollar, this will impact China’s trade competitiveness at a time it can least afford it.
Have a look at the chart below. It shows the US dollar index against its major trading partners. It recently broke out of a consolidation pattern, which indicates the trend is likely to continue higher.
Of course, the Fed could reverse this with a dovish interest rate outlook this week, but the recent move is an indication of what the currency market thinks the Fed will do.
[Click to enlarge]
A rising US dollar is an indication of tightening global liquidity. The last time the Fed raised rates (in December 2015) the dollar index surged in anticipation. The dollar at elevated levels led to a sharp stock market sell-off. This was only reversed when central banks got together early in 2016 and decided to coordinate a ‘hold’ of US rates rises, and refrain from overt currency war activity.
The dollar then proceeded to sell off sharply into April, before rising on safe haven buying in the lead up to and aftermath of Brexit. It then corrected again in August, but the upward trend looks like reasserting itself.
That means we could be in for a period of tightening global liquidity, which wouldn’t be good for stock markets around the world. Just how tight things will get depends on what the Fed has to say this week. And who wants to bet on that outcome?
Well, plenty of masochistic traders out there will no doubt put their money down, hoping to make a windfall from ‘betting right’. Personally, I’d rather wait for the outcome of the meeting and assess the market reaction. That way you don’t have to guess.
My concern is that for so long now, the Fed has taught speculators to position themselves bullishly prior to these meetings. After all, the Fed ALWAYS drives the market higher, right?
Well, nearly always. Except when they don’t. And this time, my feeling is they are going to disappoint the bulls.
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