Financial Predictions 2009: The China Syndrome
Today's Financial News - Posted December 11, 2008
Economists and newsletter gurus cast a wishful eye on China’s foreign currency reserves. Will the Commie Cavalry come to the rescue of capitalism? Hold your horses, says TFN’s J. Christoph Amberger. China’s facing pressure on exports, unemployment, and huge internal debt loads…
by J. Christoph Amberger
Baltimore — (TFN): “With the cashed up reserves of the Chinese and Japanese, and with the relative strength of their currencies, do you see them as the next buyers of the depressed U.S. real estate,” asks TFN eNews reader “ramack” this morning: “This could even have a flow on, an increase in Chinese restaurants.”
Also: “Being in Australia, the downturn in commodity prices has caned the AU dollar. Will it recover with the relative bank rates so much higher here at 4.25%?”
Let’s forget about Japan, for a second. Japan, for all intents and purposes, plays a subordinate role in the balance of political and economic power. They shot their wad in the 1980s and will not recover from the 15-year recession they’ve been. Ever.
But if there’s an increase in Chinese restaurants in the United States, I believe it will be the result of yet another swell in emigration from China to Europe and North America. Because China is in a pickle. Beijing may have accumulated currency reserves of (supposedly) $1.9 trillion over the past couple of years. But in a country of 1.3 billion people, this may not quite be what it’s cracked up to be.
Especially when you consider what this surplus depends on.
Notwithstanding the exhortations of armchair economists and American newsletter gurus, Beijing has focused on shifting the Chinese economy from an export-driven economy to an American-style consumer economy. So far, with limited success: There’s only so much consumption that can take place on an average income of $2,000 a year.
Accordingly, $1.216 trillion of the country’s 2007 GDP had to be derived from exports. And when the Yanks were buying and banks were lending, 21% of those exports went into the United States, 18.1% into the EU, 17% to Hong Kong and 12.4% to Japan.
All of those countries are now in recession. All have witnessed major declines in consumer demand… and sensitive bottlenecks in the issuing of credit necessary to pay for the manufacture of goods and their subsequent shipment.
All of them will buy less from China in 2009.
Already, the CFLP Purchase Management Index (PMI) of China’s manufacturing sector has dropped to 44.6 percent in October, down 6.6 percentage points from the previous month. China’s PMI is based on surveys directed at purchase and supply managers of more than 700 manufacturers across the country… and triggers alarms when it goes below 50 percent. In October, all but two of the 11 indices within the PMI showed substantial drops.
Falling demand and the resulting decrease in production has already hammered employment. It’s at the lowest point since 2006. Factories have been closing by the thousands all across the country, but especially in the Pearl River Delta, China’s export-driven manufacturing heartland. Already, railway stations in the area are overrun by underemployed and disenchanted Chinese returning to the provinces.
(I teased you with my recommendation on how to play this phenomenon last week. Today, my recommendation of Guangshen Railway is already up 14%. See, skimping on that $79 subscription fee to Hot Stock Confidential was not such a hot decision after all!)
Meanwhile, I believe the big Chinese Credit Crash of 2009 is building up right now.
If a few billion in shaky U.S. mortgages can trigger a global financial catastrophe, I’d like to point out another crisis brewing that makes subprime look like the broadway version of Shrek.
China Construction Bank, the Bank of China and the Industrial and Commercial Bank of China have launched mega-IPOs in the last couple of years. But after decades of rapid loan growth, they — along with other Chinese banks, state investment companies, credit co-operatives — are now sitting on record nonperforming loans (NPLs).
The Chinese NPL market is one of the largest in the world, with a total outstanding principal balance of over a trillion dollars in 2007. No exact numbers are obtainable, but some experts estimate that they could represent between 20- 40% of China’s gross domestic product.
Not coincidentally, that roughly corresponds to the size of China’s entire export sector…
Every now and then, the big credit rating agencies point out that China’s efforts to clean up the balance sheets of its big four banks have been slow. Worse, they have completely failed to eliminate financial risks for the lenders.
In 1999, China established four distressed debt companies to take loans off the books of the big four banks. Progress has been challenging, especially in the early years. In the past, Beijing has spent the equivalent of 25-30 per cent of GDP in previous bank bailouts.
Accounting firm Ernst & Young calls the main reason for why these bad loans were generated in the first place political. Much like Maryland, China is a one-party state. And that one party is still Mao’s old Communist Party.
The Communist Party relies on the state-controlled banks to maintain an unreformed core of what at the core remains a command economy. And like anywhere else where one-party regimes have mixed business with running the country (Maryland!), waste, corruption and nepotism are running rampant. In the face of triumphant capitalism, the party uses perks and careers in government and state-owned enterprises to keep the party faithful in line.
That includes access to capital
The party still appoints about 80% of the chief executives in state-owned enterprises and 56% of all senior corporate executives, who are under pressure to hit fixed growth targets quickly no matter how. The World Bank estimates that about one-third of fixed investments made in the 1990s were wasted.
(It’s that kind of experience that makes me shudder when I hear the words “Car Czar” or imagine Nancy Pelosi and Barney Franks telling anyone how a business should be run!)
Politically directed lending accounted for 60% of loans in 2000-2001. And in a 2002 survey, over 80% of polled bank employees said corruption in their branches was either prevalent or took place quite often.
As late as 2007, new loan growth had been running at 15%. A healthy supply of nonperforming loans was generated due to the sheer growth in total volume. At least 2% of loans made since 2000 have been reported as nonperforming. The proportion was as high as 60% for older lending. And a substantial portion of the loans that went out were issued to keep bad loans floating.
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China’s banks could soon face a fresh wave of nonperforming loans arising from the rapid expansion of lending in 2003 and the first half of 2004… not to mention the credit that was issued in the venture capital tsunami that took the Shanghai stock index above 6,000 last year.
China’s bad debt issue is a structural problem that Beijing seems ill-equipped to deal with. Japan, whose banks had built up a similar problem in the 1980s, was punished with more than a decade of economic stagnation.
As with all debt, problems do not arise unless there’s a problem with the cash flow that services it. Without an interruption in mortgage payments (due to unexpected loss of employment), there’d be no foreclosures. Without missed payments to the local utility, there’d be no turned-off heat.
But now, there’s tens of thousands of indebted companies out of heat and up to their necks in red ink. They cannot pay their employees… their managers have blown cash reserves on 2007 A-share IPOs… new orders are diminishing by the day… and they cannot service their debt.
In the happy, happy days of Communism, that wouldn’t have made much of a difference. After all, credit issued was a thinly veiled subsidy aimed at aggressively absorbing global business: If your competitive advantage is in undercutting labor and currency cost, you’re willing to write off billions in bad loans if that means trillions in new orders.
But with revenues bound to decline and expenditures soaring—people have to have money to start a consumer economy—the bad debt load is going to come back and haunt Beijing.
That $1.9 trillion in reserves is going to be put to good use. Half of it has already been committed to various stimulus packages. But infrastructure spending has never ended a recession. (Only spending on war has!)
China’s companies and economuc strategists will have their hands full dispensing money on domestic problems. There will be a more aggressive stance toward regional competitors (including Taiwan, South Korea, and Japan) and toward the United States. There will be increased spending on military technology and the shoring up of energy supplies, especially in collaboration with Russia.
But there will be no large-scale spending spree on U.S. real estate.
And the Australian dollar? Geez, look at the time… I have to answer that question tomorrow!
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