In today’s Markets and Money, I’ll resume the ‘rim of fire’ tour of Asia-Pacific.
Speaking of that tour, let me re-create a conversation I had last night with a long-time Markets and Money reader and faithful confidant.
‘Your tour is lousy mate. I want my money back.’
‘Your “rim of fire” tour. Yesterday was China. It’s the most important country in the world when it comes to Australia’s future. But you spent half the tour time prattling on about bank stocks. You said nothing useful about China except right at the end. I want my money back.’
‘You do know Markets and Money is free, don’t you?’
‘Of course I do. I’m not an idiot like you. But that’s my point. I know I can’t get my money back. What bothers me is that I can’t get my time back either. Quit wasting it! I pay you guys to tell me what matters about investments. Get it done.’
‘But you don’t pay me at all.’
‘I’ll buy you another beer if you shut up. How’s that?’
And so on. But point taken. Before I move to Russia, let me re-iterate the point about China that matters most to Australia’s future: China is screwed.
‘Screwed’ is a fairly technical term. But what I mean is that the growth model of the last 30 years — heavy state planning directing credit to targeted industries to promote growth by investing in fixed assets — has reached its use by date. The transition to a more open market, driven by consumption and business investment, won’t be easy. And it’s going to be hampered by huge level of corporate debt and an emerging market financial system.
First, take the chart above from the World Bank’s Financial Markets Outlook report published in June. Chinese debt as a percentage of GDP is now among the highest in the world. Local and central government debt remains relatively low. But the huge spike in corporate debt shows how leveraged the Chinese corporate sector has become. Remember what I showed you yesterday, that of the top ten banks in the world by asset size, four are now Chinese? This has massive credit bubble written all over it.
But you don’t have to take my word for it. Here’s how the World Bank puts it (emphasis added is mine):
‘In China, total debt, at 240 percent of GDP, is one of the highest in the world making companies extremely sensitive to weakening demand or interest rate shocks. Meanwhile, corporate profitability and cash flows are under pressure due to slowing growth and high refinancing needs. In addition, a residential and construction boom—a key driver of growth in recent years, and a major source of revenue for local governments— is cooling and could lead to a sharp correction as credit standards are tightened.
‘Given large fiscal buffers available to the Chinese government, tight capital controls and limited foreign debt ownership, the country retains significant policy space for crisis mitigation in a stress situation, but the tight interconnection between a highly leveraged corporate sector and financial stability remains a source of concern. Risks of a credit crunch intensifying existing pressures on the corporate, property and financial sectors cannot be excluded.
‘Chinese authorities recommitted in May to a series of capital market reforms aimed at encouraging a more efficient allocation of capital, increasing foreign investment and improving market transparency. If fully implemented, these reforms should help rein in shadow banking activity and help contain the concentration of credit risks.’
Let me make two quick points. First, official analysts (like those from the World Bank) and official policy makers (like those at the Fed, the ECB, and the RBA) always overestimate the usefulness of policy to solve a credit crisis, and they always underestimate the probability of a crisis. This time will be no different.
In fact, you could argue that in Europe and the US, the policy solutions (lower rates, quantitative easing, and the long term financing operation of the ECB) have restructured the term of liabilities, not eliminated them. The debts are still there. They’re just owed at a later date.
The liquidity problem has been ‘solved’ by cheaper credit. The solvency problem — too much debt invested in assets generating too little income or productive use — will be with us for years. The result will be Japan-like levels of GDP growth. It takes a loooong time to grow out of that much debt.
The second point is that the command-economy nature of China’s financial system doesn’t make a crisis less likely. It’s what caused the misallocation of credit and resources to begin with. The ‘fatal conceit’ of planned growth is that you can dictate human behaviour and business investment by picking and choosing winners (industries to invest it) for some greater social good. You do get nominal GDP growth that way. But what you also get is epic mal-investment, fraud, and corruption.
That’s where we are in China’s growth phase right now. That’s not to denigrate the stunning achievement of so many people being lifted out of poverty. But why do you think so much Chinese money is flooding into Australia through the Significant Investor Visa program?
Private Chinese citizens can legally only move US$50,000 per year outside the country, under capital control laws. But if you put $5 million into Australian government bonds, you can effectively buy Australian permanent residency. More than 95% of the participants in Australia’s ‘golden visa’ program are Chinese, according to a report in today’s Australian.
There’s absolutely nothing wrong with a country making itself an attractive place for capital to flee to. But ask yourself why Chinese money is pouring into the country. The Australian reports that the Bank of China is actively and illegally laundering money for wealthy Chinese who wish to get it out of the country and into places like Melbourne and Sydney.
Insiders or members of the Communist Party who see the writing on the wall with the end of the debt-fuelled fixed investment growth model have every incentive to take their private fortunes — ill-gotten or otherwise — and get them out of the country while the getting is good. Melbourne is the new Zurich and Sydney is the new Geneva.
But you don’t have to assume criminal activity, money laundering, or corruption to see why people would want to get their money out of a closed financial system. The Chinese economic model has favoured government directed investment into government owned enterprises. Savers trying to provide for their own future have seen their interests sacrificed for ‘the greater good’.
Thus far, their only way to beat inflation has been to invest in property. But that now looks like a dangerous bubble. Can you blame them for looking out for themselves and moving their money before it’s wiped out in a banking crisis?
The issue of Chinese money moving into Australian houses and government bonds is bound to pop up again. But the bigger issue is how Australia will fare if China falls on hard times. I began addressing this issue three years ago when I published my Exit the Dragon report highlighting the internal contradictions and limits of China’s growth model.
But the conversation is starting to pop up in policy making circles. In the recent Quarterly Essay, you’ll find an article called Dragon’s Tail: The Lucky Country after the China Boom,by Andrew Charlton. In it, Charlton re-proves many of the points about China’s growth model that Greg Canavan and I (and others) have made for the last few years. He finishes his essay with this:
‘Few periods have been luckier for Australia than the two decades of China’s industrialisation. As the world’s most mineral-rich continent, situating right on China’s doorstep, Australia has been well placed to supply the raw materials China can’t do without. We were among the biggest beneficiaries of China’s manic manufacture of steel vertebrae for everything from cars and trucks to railways, apartments and office towers. China was a big reason why Australia’s economy has grown by four per cent a year for about twenty years, why we avoided the Asian financial crisis in the 1990s, why our house prices rose in the 2000s, why global financial imbalances crashed the global economy in 2008, and why Australia alone among the major nations escaped the ensuing recession.
‘Understanding China’s growth model helps explain why Australia has done so well in the 21st century. But it also explains why, at the same time, our economic anxiety is reaching a zenith: why Holden is leaving, why the budget is in such an apparent quagmire, why house prices are soaring, why the dollar is so volatile. China’s growth has brought us a windfall, but it it’s a precarious sort of prosperity.
‘We haven’t helped ourselves in this regard. In the boom years, Australians embraced the windfall of China’s growth without preparing for the aftermath. We allowed the non-mining economy to wither and failed to save resource profits. As a nation, we have to be smarter than this. If we are happy to leave our prosperity to luck, we can continue to bob up and down on the tide of global circumstance; but if we want to be a successful country, we need to learn to surf the waves.’
Charlton has written a great essay for anyone who is new to what China has meant to Australia’s past and what it will mean to Australia’s future. But I’m not sure there IS much anxiety about what’s happening in China, and what it will mean for Australia’s economy. Most investors seem willing to ‘leave their prosperity to luck’. This is a mistake you should not make.
You can’t do anything about the success of the country. But you can prepare for the ‘aftermath’ of China’s rise. Having an investment portfolio that is less ‘growth’ oriented is a start. But I’ll leave it that for today.
Mother Russia will have to wait until tomorrow. She’ll take her turn with America, which is appropriate. The two Cold War adversaries are now primarily facing off in two realms: financial warfare and energy production. Tomorrow, I’ll show you the role Australia plays in the spying game, and how US and Russian gas production could impact off-shore and on-shore LNG producers. Until then…
for Markets and Money