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What’s Ahead for the New Decade: China Trouble

January 12, 2010

One of the great virtues of China’s hybrid capitalism is that in a crisis the communist party can reach into the economy and pull levers not available to governments in Western economies. For instance in the past 18 months while the rest of the world has been literally pleading with banks to lend more aggressively and restart the economy, the Government of China has been hard at work behind the scenes priming the pump through its political control of the banking sector.  

The problems with this kind of political interference in banking are pretty obvious, according to Michael Pettis: “Every time that (Chinese) banks have engineered a policy-induced surge in lending, they have followed up with a surge in NPLs,(non performing loans) and it would be pretty extraordinary if this time were any different.”

And as dangerous as NPL’s are for the Chinese banking sector, they are not the only problem. The banking surge has contributed to a massive misallocation of capital in the Chinese economy that is creating some of the world’s biggest bubbles. Take Chinese stocks for instance, according to London’s Financial Times they’re trading (on an adjusted basis) at 50 times earnings, and Chinese real estate is even worse, in major cities real estate is trading at values of 15 -20 times average household income, an eye popping multiple.

The reality is this, the Chinese economy is on a debt driven investment boom, with fixed asset investment approaching 50 per cent of GDP, creating a massive over capacity largely in export manufacturing and real estate. It is worth noting that just before it collapsed in the 1990’s, Japan’s fixed investment numbers were 30 to 35% of GDP.

All of this creates a China bubble waiting to burst. When it does it will not be the end of the Chinese miracle – that will likely continue for decades. But a China crisis could have dramatic short to medium term effect on the global economy depending on when it takes place. At the moment, and for the foreseeable future, Chinese growth and demand is about the only good news on the economic scene. Certainly it is critical to underlying assumptions behind longer term economic recovery, and therefore market confidence.

Should China come unstuck before the Western economies are fully recovered, it could create another crisis equal or greater than the one we’re just climbing out of.  Not a happy thought, but one which we all need to consider and prepare for.  

Things to think about:

  1. It is important to realize that markets are not perfect, market signals are not objective representations of value. It is imperative that you know the true underlying values and plan accordingly. In other words, have a counter cyclic strategy ready to go at a moment’s notice; otherwise you may be caught like everyone else.
  2. Take your own council and watch the signals. There is a great desire these days among the Powers-that-be to paint a positive picture of the economy. Don’t believe everything you hear, even (especially) from central bank chairmen, politicians or those Lords of the Universe in investment banking. In other words, keep your head up and your stick on the ice.

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