The Pressure is Building in China’s Economy

Yesterday we discussed how financial conditions were becoming tighter across the globe as markets responded to US Federal Reserve Chairman Bernanke’s attempts to pull back on the scale of quantitative easing. Right now, the Federal Reserve is monetising around $85 billion per month in Treasuries and mortgage backed securities.

Bernanke is trying to tell the market he wants to ease off on the rate of those purchases at some point. His communication policy hasn’t gone down too well, and market interest rates are heading higher as speculators panic. This could threaten weak US economic growth in the coming quarters. It’s already under pressure from a roughly US$400 billion contraction in the Federal budget this fiscal year.

While the risks to the US economy are well known, the impact of tighter US monetary conditions on China are not. So in today’s Reckoning we’ll take a look at what Bernanke’s tapering, real or otherwise, means for Australia’s largest trading partner.

If you’re sick of hearing us bang on about China’s economy (and we know some people are) you may want to stop reading now. We got this in our inbox the other day:

The impossible challenge would be for Greg Canavan to write just one page on anything without trying to empty a bucket of shit on China!!

Give it a rest Greg and try to peddle your newsletters by other threats.

Well, we gave it a rest yesterday. Today we feel rejuvenated. So we’ll get stuck into it.

But don’t mistake our China bashing for anything more than concern for the enormity of the problems there and the potential impact on Australia. Because the impact will be huge. It’s just that we’ve had it so good for so long, the Australian commentariat have no imagination when it comes to the potential economic problems we face.

We’ll give you a small example of Australia’s economic complacency. Our New Zealand colleague recently visited the office here in Melbourne. He stayed at a hotel about 4kms away. One morning, in trying to get in to work, about four cab drivers refused the fare. Only a belligerent concierge eventually forced a cabbie to take the fare. Not every trip is a ride to the airport, boys!

And as economic clouds begin to gather on Australia’s horizon, there are increasing calls about the possibility of Australia slipping into recession for the first time in over 20 years. These ‘doomsayers’ have elicited a patronising response from people like Treasurer Wayne Swan. They’re accused of inciting fears, talking down the economy and — this one is our favourite — ‘talking the country into recession’.

You know the saying ‘ignorance is bliss’, right? Well, the politicians and entrenched interests in this country (or any country for that matter) want to keep you in a blissful state so they can stay right where they are. Enlightening you is not a part of their job description. And they really don’t like it when others try to enlighten you. It upsets their narrative.

So getting back to China. We’re not trying to fear-monger or drop a bucket of faeces on the place. We’re trying to dig deep into the morass created by a credit boom and trying to work out what it means for you.

The rise of China’s economy began around 2003. Ultra-low interest rates in the US kick-started the boom. Because China pegged its currency to the US dollar, it effectively imported easy US monetary policy.

You can see the effect of this in China’s accumulation of foreign exchange reserves (mostly US dollars, and euros too). China began 2003 with reserves of around $US350 billion. In the space of just 10 years, those reserves have ballooned to around US$3.5 trillion — a 10-fold increase.

These reserves, purchased with newly printed yuan in order to keep the exchange rate low, provided the fuel for China to engineer its own credit boom in response to the 2008 credit crisis. The boom got underway in 2009 and is still going. Fitch ratings agency says it’s ‘unprecedented in modern world history’.

Credit bubbles can continue for longer than nearly anyone expects them too. And they go on so long that most observers simply cannot see a catalyst to end the boom. But Fed tapering, or simply threats to taper, could be the catalyst that sends the China boom bust.

That’s because the threat of tighter monetary policy, or, to be more precise, the threat of ‘less loose’ monetary policy, causes a reversal in speculative capital flows. Such a reversal puts pressure on the most fragile parts of the financial sector.

And you’re seeing evidence of that pressure in China’s economy right now. A key measure of banking sector liquidity, the interbank lending rate known as SHIBOR, has surged in recent weeks. That tells you that cash is tight, and no one really wants to lend to each other at low rates. The higher lending rates reflect the higher perceived risk in the system.

And it’s not just perceived risk. A few weeks ago, there was a technical default in the banking system as China Everbright Bank couldn’t come up with the cash to repay a loan on time.

These are warning signs, in the same way that the failure of various sub-prime lending vehicles in 2007 was a warning sign of the looming credit crisis. If it follows the same path China’s economy will have a very hard landing and Australia will feel the full brunt of it. For better or worse, we’ve hitched our iron ore wagon onto the tail of the red dragon. What happens in China will matter here…big time.

That’s not fear-mongering. That’s reality. If you think China can manage the fallout you’re not thinking. The US, with the most sophisticated capital markets in the world and a huge amount of self-interested parties trying to save the system, only just managed to pull it off. How is it that China will avert a similar fate?

We don’t know how events will pan out from here. We just know it’s better to have your eyes wide open than eyes wide shut. Ignorance is bliss while the going is good…but it can be a wealth destroyer when things change.

Greg Canavan
for Markets and Money

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From the Archives…

Truth or Dare Time for the Investment Industry
14-06-13 – Vern Gowdie

The Launch of Revolutionary Tech Investor
13-06-13 – Kris Sayce

The Architecture of Oppression
12-06-13 ­– Dan Denning

The Upside of a Dive to 85 for the Australian Dollar
11-06-13 – Dan Denning

Courting Controversy Over Australian Property
10-06-13 – Dan Denning

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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