There’s a bit of friendly biffo going on in the office over China’s economy. We think the country has deep structural problems, is horribly unbalanced and is about to suffer an almighty credit-induced hangover. For Australia, the fallout won’t be pretty.
My mate Alex Cowie, editor of Diggers and Drillers, thinks otherwise. In Money Morning earlier this week, he made a very bullish (if somewhat flimsy, IMO!) case for China. To paraphrase, he reckons ‘even if the bears make some valid points, the government will be able to kick the can down the road and keep the whole urbanisation thing going for years to come’.
We think this is dangerously complacent, although complacency is all the rage as we head into autumn 2013. It’s a similar kind of complacency shown by our venerable Reserve Bank – although at least Alex is trying to make money for his readers, rather than central banks that are trying to destroy money.
Never one to incite fear about China or look into the source of its incredible growth (credit), RBA assistant Governor Christopher Kent recent delivered a sanguine speech on China’s economy and its effect on Australia.
Such a blasé attitude might, and probably will, seem sensible in the short term. But we think it’s important to understand the problems brewing in the Chinese economy . They are immense. And the implications for Australia are huge. When China’s credit bubble bursts, so will our housing bubble. It’s been a long time coming. So long in fact that just about everyone has stopped waiting for it. They’re going about their business and buying property again.
Well, we think 2013 will mark the end of the phony war. Forewarned is forearmed.
One of the biggest misconceptions about China’s economy is that it has ‘avoided’ a hard landing. We would argue the opposite. To explain why, let’s go back a few years.
In 2008, as you know, global demand plummeted in the face of the credit crisis. This hit China, a trade exposed economy, very hard. In response the government unveiled a huge fiscal stimulus package and commanded its state-owned banks to lend heavily. The aim was to maintain social harmony, keep the people employed and away from Tiananmen Square, and keep themselves in power.
The policy worked a treat. Chinese economic growth boomed as steel-intensive infrastructure investment became the main growth driver. The explosion of Chinese credit (see chart below) provided an exclamation point on Australia’s long commodity boom. Although it narrowed it too. Only coking coal and iron ore enjoyed the ‘benefits’ of China’s policy desperation.
The 2009-11 credit boom flooded Australia with cash as we sent our coal and iron ore to China. While the rest of the world struggled to recover from the credit crisis, Australia’s economy enjoyed the fastest growth in national income in years, which kept unemployment low and handed us successive pay rises.
It was a genuine resource boom, driven by an explosion of credit in our largest trading partner. But it was a sly boom, in that it occurred while Australia’s credit growth slowed to near all-time lows. It gave rise to the two-speed economy, a rising cost of living, the mining tax (if you could call it that) a weak government beholden to special interest groups, and a political atmosphere that is at its lowest ebb in a long, long time.
In short, it was a massive boom that didn’t really feel like a boom to a large proportion of the population.
By mid-2011, China’s credit boom has revealed an overheating property market, overcapacity in a range of industries, most notably steel, and rising inflation. The economy showed signs of extreme imbalance, where infrastructure investment – or ‘fixed-asset investment’ – accounted for around 50% of economic growth, while consumer spending accounted for just 35%. From a historical perspective, these readings were on the extreme end of the scale.
With these various credit boom ailments beginning to show, the government tried ever so gently to slow the boom by tightening monetary policy. It did this, and by late 2011 and into 2012 the economy began to slow.
Inevitably, the slowing economy came with an increase in social friction. Large scale protests increased as people lost money on falling property prices, or were just outraged by the amount of corruption at the highest levels. The receding tide unveiled the detritus that easy money leaves behind.
The painful process of rebalancing wasn’t much fun for China’s leaders. They didn’t really have the stomach for it, not in a change-of-leadership year. They did attempt to rein in lending, and cracked down on the traditional banking sector. But they stood by while the unregulated shadow banking system provided finance to local governments for another round of property and infrastructure spending. According to a recent Forbes article…
‘Credit Suisse estimates that the so-called shadow banking system now totals Rmb22.8 trillion or 44% of GDP, making it the second largest asset class in China!’
If you look back at the chart above, you can see that total credit outstanding was at an all-time of high of over 190% of nominal GDP by the end of 2012. Following a 50% month-on-month rise in credit growth in January, the ratio will soon approach 200%.
What does such a high ratio really mean? Well, if credit growth grows faster than GDP, the ratio increases, and it’s usually a sign that the growth in credit is unproductive. That is, projects undertaken with the proceeds of credit don’t generate much in the way of economic growth. Hence the ratio of credit (debt) outstanding increases relative to the size of the economy.
A recent article in the Wall Street Journal elaborated on this, citing studies from the Bank for International Settlements and the IMF. Referring to the sharp growth in private debt levels, it said:
‘On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.
‘The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.’
The ratio is probably closer to 200% now. As we wrote to subscribers of Sound Money. Sound Investments this week,
‘Total Chinese credit grew by US$400 billion in January alone. That’s 4.8% of the size of its economy…in one month. Annualised, it represents credit growth equivalent to nearly 60% of GDP. If you can show me any economy in the world that has had such massive credit growth relative to the size of its economy and escaped without a crisis, let me know.
‘It’s only one month, I know. But it’s the crescendo of a credit-driven policy to support economic growth at all costs. And it’s bound to end badly.’
Correction: it WILL end badly.
That doesn’t mean a China bust is imminent. But based on historical precedents, it does tell you that trouble lies ahead.
It should also make it clear that China’s economy hasn’t avoided a hard landing. It has increased the probability of one by doubling up on its credit induced growth path.
Clearly, some people don’t want to come to terms with China’s growth policy. Christopher Kent of the RBA called his mid-February speech ‘Reflections on China and Mining Investment in Australia’. Having read through it, we couldn’t find much reflection at all. There was absolutely no mention of China’s credit boom as being responsible for Australia’s mining boom. We find this astounding…it is similar to the Fed making no mention of the rapid growth in credit (and expansion of the shadow banking sector) in the lead-up to the US housing bust in 2007.
China’s credit boom and Australia’s mining boom go hand-in-hand. When the credit boom ends, the flow-on effects for Australia will be huge.
for Markets and Money
High Tide on Main Street?
22-02-13 – Bill Bonner
The Fed’s Funny Money is Losing its Mojo
21-02-13 – Dan Denning
Resurrecting BHP, the ‘Big Australian’
20-02-13 – Dan Denning
End of the Australian Boom?
19-02-13 – Satyajit Das
Bond Guru Still Likes the Unthinkable: US Treasuries
18-02-13 – Chris Mayer