Underestimating the Black Swans and Fat Tails of the Chinese Economy

It’s been a rough start to the day. It took us a record amount of time to get to Sydney Airport this morning. The rain was torrential. Roads were cut off. As a result, Sydney’s already clogged main arteries got worse as the morning wore on.

There was no way we were going to make it to the airport on time. Traffic was at a crawl. So we checked the flight departure information on our phone and happily noted the flight to Tullamarine was cancelled. That saved us having to fork out for another one.

But the good folk at Virgin couldn’t be bothered telling us via email or SMS. If they had, we wouldn’t have left the house in the first place. So we were stuck at the airport. The next flight available wasn’t for another few hours.

And now the departure time has come and gone…which gives us some time to write today’s Markets and Money. Because we won’t be taking off for some time yet.

Neither will the Aussie economy, if yesterday’s economic growth data is any guide. In the final three months of the year the Australian economy grew just 0.4 per cent versus expectations of 0.8 per cent.

Still, Treasurer Wayne Swan had time to take off the boxing gloves (from swiping alternately at greedy billionaires and green simpletons) to label the figures as ‘solid’.

We love that word. It’s probably one of the hardest working words in the corporate world…along with ‘underlying’ and ‘non-cash’ preceding ‘write-down’. Solid is a euphemism for: rubbish, poor, average, surprisingly weak, worse than expected, should’ve done better and ‘is that the best we could do?’

The Wayner tried to reassure everyone that Australia is still on track for economic growth of 3.25 per cent in the coming year. Apparently the investment boom will see to that.

We’re not so sure. Actually we’re not sure at all. Ominously, the terms of trade fell 4.6 per cent during the final quarter of 2011. They’re coming off the highest levels in history. The Treasury, the Reserve Bank and the government all expect the terms of trade to settle nicely – and then plateau at a permanently higher level – in the years to come.

That sounds like Irving Fischer’s statement about permanently higher share prices just a few months before the great stock market crash of 1929.

There is some justification for expecting our terms of trade to remain permanently high. But it’s the same for all bubbles and manias – there’s always a fundamental reason for believing it in the first place.

But if you look deep enough, there’s always a reason to have doubts. And history shows the doubters are often vindicated. Although their vindication often occurs after they have lost their jobs and all professional credibility.

In poor Irving Fischer’s case, he lost much of his credibility before he did his best work…writing about the perils of debt deflation in the early 1930s.

In Australia’s case, the doubt has to remain over China’s economy. As we’ve pointed out many times before, it is our view that Australia’s historic terms of trade boom was a direct result of China’s historic credit boom.

In late 2008, China’s central planners halted more than a decade of financial market reforms and effectively brought the banking sector back under strict state control. They used the banks to execute their policy – stability at any cost – and ordered them to lend money.

Credit growth exploded in China in 2009 and 2010. In a few years time, this policy will show up in rising NPLs (non-performing loans) in the Chinese banking system.

China’s leaders began to tentatively liberalise the banking system back in the 1990s. This was because of the bad debt debacle brought about by state-directed lending in the late 1980s. Another bout of ‘state finance’ saw more bad loans and the collapse of investment corporation GITIC in 1998.

As a result, the reform process stepped up a gear. The major banks transferred their bad loans to (undercapitalised) asset management companies and prettied themselves up for a partial IPO in the mid-2000s.

But since the global credit crisis shattered the credibility of the Western banking model, the all-powerful party halted these reforms. It is now back to using the banks as a tool of the Party. That is, lend at all costs. Create growth (no matter how unproductive) and keep society ‘harmonious’.

All this (and more) is chronicled in a book called Red Capitalism – The Fragile Foundation of China’s Extraordinary Rise, by Carl Walter and Fraser Howe. It tells the story of how warped China’s financial system is. How the state uses the financial system to play pass the parcel with bad debts, how bond markets don’t trade properly and, as a result, why the cost of capital is completely distorted.

It was this dysfunctional system that led to Australia’s booming terms of trade over the past few years. Has China now reverted to its past, a victim of misguided state planning that creates lending booms and an associated jump in NPLs a few years later?

We think it has. While it doesn’t mean a China bust is imminent (although it wouldn’t surprise us either) it does raise big question marks over China’s ability to move seamlessly from investment-led growth to consumer-led growth.

If the banks get bailed out again, the household sector will implicitly subsidise the financial sector. The funds must come from somewhere.

Our thesis is that a centrally planned economy will always run into trouble. The law of unintended consequences is iron clad. A hard landing in China is routinely dismissed by the mainstream as a low probability event …largely because China’s planners ‘won’t let it happen’.

But black swans and fat tails (i.e, a China hard landing) arise precisely because people underestimate the probability of their occurrence.

And in financial markets, that means no one is positioned for such an outcome. Not the government, the RBA, the Treasury department or investors.

Are you?


Greg Canavan
for Markets and Money

From the Archives…

Carry Trade Currencies and the World’s Most Expensive Cities
2012-03-02 – Joel Bowman

Why the ECB and the Fed Have China Laughing
2012-03-01 – Greg Canavan

Burma’s Economy: The Next Big Story in Asia
2012-02-29 – Chris Mayer

Anatabloc – A Game-Changer in Medical Treatment
2012-02-28 – Patrick Cox

How Australian Banks Use Covered Bonds to Play a Dangerous Game
2012-02-27 – Dan Denning

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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