While you were off enjoying the Australia Day holiday, which was actually on Saturday, markets around the world mostly went up…again. This is all pretty standard in the era of the omnipotent central banker.
The belief that these guys have engineered an economic recovery and can ward off recession is so deeply ingrained it’s bound to cause trouble. Does it cause trouble now, or does the trouble arise six months down the track and after another 20% surge in the equity market?
That’s the question nobody seems too concerned about, which is why we’re concerned. It’s like 2007 all over again and everyone’s dancing while the music is playing. Only this time we have a far more sinister and tricky bubble…in government debt. It’s a bubble that nobody recognises. Or more accurately, nobody wants to recognise.
After all, government debt is super safe, right? It’s the basis for most of the world’s borrowing – or at least most of the world’s liquidity, in the form of repurchase agreements, or repos.
The repo market is huge, and those holding highly rated sovereign debt can turn it into cash by entering into a ‘repurchase agreement’ and posting the debt as collateral. This is a favourite pastime of the hedge funds. They take the cash and plough it into whatever investment theme is working at the time.
Which is fine while yields are low. But who knows what happens to the whole leveraged system once inflation seeps in and yields start to pick up. The current yield on the US 10-year Treasury is 1.96%. That’s the highest it’s been since April last year.
But who cares…the music is still playing right?
Right now the music is playing very loudly in China. It’s all thanks to China’s credit boom Mark II. China had a crack at economic rebalancing last year, but they didn’t like the results. Now, China’s leaders have gone soft on efforts to normalise economic growth. Instead, they’re back promoting the ‘old’ infrastructure led growth model.
It’s a theme we’ve been on about for a while, and it’s a theme we’ll continue to follow as it’s a crucial one for Aussie investors. China’s economy is horribly unbalanced, and no one wants to make the tough decisions to carry out the painful rebalancing process. Last year’s trial run had no follow through. While state-owned banks withdrew from the property market, the non-bank or ‘shadow-banking’ sector emerged to supply credit to the property and infrastructure market.
Take this story from a property developer in the Chinese city of Erdos:
‘Mr Li, in his 30s, started out as coal mine operator before moving into land speculation and property development in 2004, quickly becoming one of the biggest developers in the region.
‘”It was a market with great prospects back then and land prices were cheap. I built offices and residences and at the time it was easy to get money from the bank and prices rose rapidly,” he says.
‘He accumulated plenty of capital early on. His latest project is a large multi-function entertainment centre. Construction has been completed but he has run out of liquidity to finish fitting out the interior and other aspects of the project have stopped completely.
‘”The problem is that national policy changed and it was practically forbidden to lend money for property development any more. Before it was easy to get money from the banks. Now it’s not possible at all,” says Mr Li.
‘Like many others in his position, he turned to the trust firms.’
The ‘trust firms’ are non-bank lenders and form the backbone of the ‘shadow banking’ system.
Wang Tao, China analyst at UBS, reckons trusts account for more than a quarter of the country’s estimated US$3.35 trillion in non-bank lending, or about 45 per cent of China’s GDP.
According to the Financial Times, trust firms, who obtain their funds from ordinary Chinese savers looking for a higher return on their money than regular bank accounts, had 6.3 trillion yuan of assets under management at 30 September 2012. This is up 54 per cent from a year earlier and five times more than at the start of 2009.
That’s some rate of growth. Bubble like, even.
And in another sign the credit market is booming in China, the Financial Times reported over the weekend that:
‘In the bond markets, Chinese property groups have accounted for six of the 10 biggest deals in a record January that saw $7.8bn of high yield bonds sold – about four times the previous record and more than half the total deals in all of last year. Add in equity raisings and property groups have between them raised more than $6.5bn of fresh funds.’
These are the property groups that the government tried so hard last year to curb. From where we’re sitting, it looks like they have lost control, or given up trying. Credit bubbles pop after all credit-worthy borrowers, and most non-credit worthy borrowers, have had their fill.
What makes China’s credit bubble epic is the all-pervasive view that the government will step in to rescue any loan that goes bad. This creates ever greater numbers of ‘credit worthy’ borrowers, which expands the bubble higher and higher.
Extending credit to someone, no matter how useless or useful their project is, creates money and boosts economic activity. It’s why you saw China’s industrial companies increase profits 17.3% in the year to December.
The less reported number was industrial profits growth of 5.3% for the year. (We’re not sure what accounts for the difference between the numbers…leverage?). Anyway, power generation firms were the standout sector, increasing profits by 69%. Steel firms didn’t fare so well, with profits plummeting 37%.
To us, this is a clear sign of China’s uneconomic economic growth, which will ultimately prove disastrous. Property developers are borrowing and infrastructure spending is getting back to boom-time levels. But the companies who feed this monster, the steel mills, cannot make a profit…not collectively anyway.
This is a boom still directed towards full employment and reporting glamorous economic growth numbers. It’s an experiment. It will end badly.
Before we depart today, one more thing on China. Shanghai Daily reported last week that, ‘China’s securities regulator published provisional rules for the operation of gold exchange-traded funds (ETF) on Friday, paving the way for introducing such business into the country’s financial market.’
But we think this is a ‘Western’ way of thinking of things. ETF’s are a second-rate way of gaining exposure to gold. All they do is provide ‘exposure’ to the gold price. They are not insurance against a breakdown in the monetary system.
Our guess is that any new Chinese-based ETF will prove only mildly popular. The preference in the Middle Kingdom will still be to own physical gold, held in much closer proximity to the owner than an ETF with custodians and trustees separating the owner from their gold.
We could be wrong of course. After all, the Chinese are blindly following their Western counterparts in playing with easy money and letting credit run wild. Could they join them in buying false insurance in the form of paper gold too?
Speaking of gold and insurance, the premium for the ultimate protection against a monetary bust keeps falling, in the face of the financial world getting crazier.
It’s not the first time the market has presented us with such a dazzling irony. But it’s an attractive one. You can either ignore it, or take advantage of it.
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