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Focusing On (And Profiting From) The Upcoming Chinese Financial Crisis

Tyler Durden's picture




 

Today's piece of contrarian economic insight comes once again from the strategists at SocGen, this time Dylan Grice, whose piece entitled "Popular Delusions: China's looming financial crisis will provide the next buying opportunity" is somewhat self explanatory. Not surprisingly, Dylan, who quotes the NBER, focuses on the overabundance of cheap credit as the catalyst that will ultimately topple the economy. Mr. Grice's conclusion: buy if you must, but wait for the credit bubble pop. This in itself should be so self-evident, especially in light of last year's events, yet so many speculators are glued to the buy button that the Chinese implosion will certainly not end pretty.

Detailed insights from SocGen:

There’s plenty of long-term upside in China. I think it’ll one day eclipse even the 1980s boom in Japan. But chasing upside can be a dangerous game, especially if it leads one to ignore the downside, and there is plenty of that in China too. Real buying opportunities occur when upside potential is disregarded, usually during a crisis. A newly published NBER paper suggests one is brewing in China right now …

That the tectonic plates of the geopolitical landscape are shifting in China?s direction is widely acknowledged. Less well known is the coincidence of asset bubbles with such shifts (see table below). Similarly, while it?s well known that bubbles are fuelled by rampant liquidity creation, less well known is that financial deregulation usually primes the pump. The recent credit bust was partly caused by the implementation of Basle risk weights. But the 1920s stock market boom, the 1980s Japan boom, and the tech boom of the 1990s can all be similarly traced to earlier financial deregulation.

China, with one of the most heavily regulated financial systems in the world, has barely started down this path. But with the stated objective of having Shanghai as a world financial centre by 2020, and the motivation behind the Chinese government?s bond issue in Hong Kong (to foster the ?international status? of the Renminbi), the writing is on the wall.

So with financial deregulation, when it comes, likely to stoke China?s already heady bid to become the next global superpower, shouldn?t we be filling our boots with all things Chinese now, in anticipation? Probably not. Two NBER economists recently found credit growth to be the best predictor of financial crisis: more rampant credit growth equals more elevated macro risk. As we know, China?s credit growth has exploded this year...?

An anecdotal comparison of fundmentals (what are those again) of two companies which only differ based on what side of the Himalayas they reside:

The upside potential in China is vast. But what about the downside? I was mulling this during a recent trip to Paris where Albert and I saw some clients and presented at the SG Premium Review, an annual event run by SG enabling companies and investors to get together.

One of the companies presenting was Lloyds, the UK bank rescued by the government but now recapitalised and apparently clean. I?d have thought there would have been some interest at least in hearing what they had to say. They are after all one of the UK?s biggest banks and have had an ?eventful? few years which they are now trying to put behind them. Yet only a handful of people attended the presentation (interesting in itself). Trading on a lowly 0.5x book value, Lloyds is clearly unloved, presumably because prospective investors aren?t sure how safe its loan book is and are understandably concerned that an increasingly unpredictable UK government owns a 43% stake. Who, after all, wants to own an asset which the government reserves the right to commandeer for its own ends and which has an opaque loan book?

Well, quite a few people it seems, judging by the situation on the other side of the Eurasian plate. Industrial and Commercial Bank of China, for example, is sitting pretty on around 3.5x book value and a forward PE of 14.7x. Yet as far as I can see, it?s 74% owned by the Chinese government and, so far at least, has been subject to far more political interference than anything seen at the semi-nationalised UK banks. If it wasn?t bad enough for shareholders that Chinese banks ramped up this year?s lending because they were so ordered by the government, they have now been told to submit capital raising plans to preempt the consequent increase in bad loans! Shareholders are essentially paying dearly for the Chinese government?s policy objectives.

And as for the quality of the loan book, the deflationary danger of over-investment is evident in the low returns Chinese firms are making. Believe it or not, RoAs are closer to Germany?s than the more thriving emerging markets (see chart). Bear in mind that those empty cities, unoccupied hotels and vacant shopping malls will be collateral on Chinese banks? books ...

 

Back to those pesky fundamentals that just refuse to matter when central banks know they have to inflate ponzi markets consequences be damned (and that being the case, "investment" merely become a case of knowing you will dump worthless crap before the guy to your right decides to sell).

I’m not picking on ICBC here. I know almost nothing about it, or Lloyds for that matter. I’m just trying to illustrate the point that China is forgiven sins others are punished for. This tendency to view China with rose-colored spectacles is visible in aggregate valuations too. According to FTSE All World data, the Chinese market has a RoE of 17%. And if I set a hurdle rate on the return I want on capital at 10%, then in very simple (probably simplistic) terms, fair value would be around 1.7x book (and ideally, we?d buy a discount to that). But the market currently trades at 3.3x book.

And the punchline:

In a very important respect, the deflationary infrastructure boom currently under way in China is a perfectly normal part of the industrialisation process. In the UK, we had an infrastructure overbuild in the form of a railway mania in the 1840s; the US had one in the 1850s and the 1860s; Germany had one in the 1860s too. So although it?s often said that ?bubbles don?t reinflate ?financial history says otherwise. The 19th century was dominated by one theme -? rail ?- which investors fell for over and over again. I see China as the 21st century equivalent.

So when should we look to buy? We know that distressed macro valuations only really occur during a crisis. And financial history shows that deflationary booms tend to become deflationary busts. So it was with great interest that I read a fascinating paper recently published by the NBER analysing 60 financial crises going back to the year 1870 and asking what the best pre-crisis predictors were. Their answer? Credit growth.

Not the broad money supply, not debt to GDP, not the stock market and not the real estate market; just credit growth. If they?'re right, the following chart suggests such a crisis (or opportunity, as I prefer to think of it) is brewing in China right now ...?

 

What Dylan is too kind to point out, is that if China, whose economy has a ways to get before it catches up with America, has a credit growth problem, just you wait for the comparable scenario playing out domestically. Yet it wouldn't really come as a surprise to anyone: every person who has any semblance of financial acumen is fully aware that the US equity market is an unadulterated bubble. The only question is when does it pop. And as every investor and every hedge fund is fully convinced they will be able to offload their holding in that one nanosecond before the market goes bidless, we wish everyone all the best as ongoing purchases of "dot com 2" stock extraordinaire Amazon at a multiple that even the Kindle's CPU can't calculate, are expected to be unwound in a fair and orderly manner.

 

 

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Thu, 12/10/2009 - 15:48 | 159284 Daedal
Daedal's picture

Thank you. A co-worker has a property (apartment) in China which he purchased for $900k not a year ago. 9 months hence, he has an offer for $1.5m! The bubble is already there, all that is needed is a pin.

Edit: Prices listed in YUAN, so in dollars it's ~$130k initially and now $220k.

Thu, 12/10/2009 - 16:03 | 159317 Rockfish
Rockfish's picture

Your first offer is your best money. Sell

Thu, 12/10/2009 - 15:52 | 159295 Bam_Man
Bam_Man's picture

What is in the water over there at Societe Generale?

Thu, 12/10/2009 - 16:19 | 159335 pivot
pivot's picture

funny i don't remember writing this...

Thu, 12/10/2009 - 15:58 | 159308 nhsadika
nhsadika's picture

Definitely bubble over there, but they are going to keep on partying one more year, buying everything in sight with their depreciating US $.   They are guiding banks to make another $8-9 trillion yuan in loans this year. Watch out as we get into 2011!

 
For more comedy:

The average annual income is $6546 and apartments go for $182000.

An apartment of 80 sq m costs almost 1.25 million yuan, which would require a household of two wage-earners to repay with half their salaries for 30 years -- without interest. But the popular concept of owning a home as a requirement for marriage is driving many young couples apart as the dream becomes unattainable. Professor Wang Fuzhong, of Beihang University finance department, blames the economic structure in which local governments profit greatly from the property industry, lessening their incentive to curb prices.


http://www.chinadaily.com.cn/bizchina/2009-11/25/content_9050756.htm

Thu, 12/10/2009 - 18:38 | 159537 gatopeich
gatopeich's picture

"... their salaries for 30 years...

... owning a home as a requirement for marriage".

Sounds like Spain 7 years ago.

Thu, 12/10/2009 - 22:25 | 159727 Anonymous
Anonymous's picture

Australia has gone from 3 x average wage to 8 or more in a lot of cities and they don't think there's a bubble.

Thu, 12/10/2009 - 16:00 | 159310 Cursive
Cursive's picture

So, a prudent investor might want to rethink buying shares of Chinese solar companies?

Thu, 12/10/2009 - 16:11 | 159328 Shameful
Shameful's picture

Good post.  Have to agree that long term China looks good but that they are going to have problems in the shorter run.  Waiting for the pin to pop that bubble.

Thu, 12/10/2009 - 20:49 | 159655 Anonymous
Anonymous's picture

Perhaps long term their problem is a paranoid totalitarian government. Doesn't look so good to me.

Thu, 12/10/2009 - 21:29 | 159684 Shameful
Shameful's picture

Paranoid totalitarian government...yeah but that could be anybody!  Look at the US and the Orwell State that is the UK and tell me it's that much different.  There is a shortage of high liberty places in the world.

Thu, 12/10/2009 - 16:26 | 159345 carbonmutant
carbonmutant's picture

Apparently this is why China's State Council is re-imposing a sales tax on homes sold within five years.

China’s property prices rose in November at the fastest pace in 16 months, a government survey showed today, reinforcing concern that record lending and a $586 billion stimulus package may lead to asset bubbles.

http://www.bloomberg.com/apps/news?pid=20601101&sid=abDgz7nibV7M

 

Thu, 12/10/2009 - 16:37 | 159368 Anonymous
Anonymous's picture

heard about chinese real estate market being red hot on BBC this morning, so the thing is really overheated

Thu, 12/10/2009 - 16:40 | 159371 Anonymous
Anonymous's picture

Oh noes, China had a ton of reserves and spent it all rather than sitting in cash (including a lot of depreciating dollars.) Schiff talked about this in a video blog recently. So, where does one invest? Here/US? Nah. Europe? No. Long-term, still Asia.

Amazing to me that people can discuss the China bubble with such nervousness, given that the country at least has some fundamentals going for it, unlike the US. T-Bonds, anyone? Get 'yer 30years...4.5% No? 4.75%...5%??

Thu, 12/10/2009 - 16:44 | 159378 trav777
trav777's picture

China is massively screwed.

They are so overdebted in their economy that they must maintain an inflationary peg.

If they decouple, their currency moonshots and all of this debt crushes everybody.  Profitability is already so low that even a minor currency move would slaughter them wholesale.

Nevermind the empty cities, idle factories, and massive overcapacity in everything.  They built stuff just to show GDP, ok?  40% of their GDP a couple years ago was FDI that was intended to generate more GDP.  IOW, GDP to feed more GDP, a clear ponzi.

Thu, 12/10/2009 - 16:47 | 159384 Oso
Oso's picture

bingo.  +100

Thu, 12/10/2009 - 16:44 | 159379 chumbawamba
chumbawamba's picture

Come on, baby.  Cross that line.  CROSS THAT LINE.

I am Chumbawamba.

Thu, 12/10/2009 - 16:55 | 159403 WaterWings
WaterWings's picture

Haha! I've been more intensely watching lines for over a year now - it's like we're in some kind of suspended animation - nothing ever freaking happens!

Thu, 12/10/2009 - 17:12 | 159428 Anonymous
Anonymous's picture

hey chumba,

do you think the chicoms got pissed about those gold plated tungsten bars that got offloaded on them? its not going to go down easy. they remember the united states interference during the opium wars when we sent our warships into their sovereign lands , supporting the british east india company and its chinese opium operations where many of the old money rich, in the northeast united states made their fortunes long ago. they got some payback coming. the chinese have long memories. they intend on screwing us good and that is not the least of it.

Thu, 12/10/2009 - 18:54 | 159533 delacroix
delacroix's picture

japan, fucked china pretty hard in the past too, payback is a bitch, maybe japan will become china's bitch, it looks like we're kicking them to the curb, like an old whore,unfortunately, we're right behind them.   they've spent all the gold they stole in WW2,and now they're broke. the PTB are looking for new fuckage, the younger, the better.   (indonesia?)  there are several sweet young asian economies, ripe for deflowering.  EVIL never sleeps.

Fri, 12/11/2009 - 02:12 | 159854 Hephasteus
Hephasteus's picture

Over the LINE BITCHES!!

Thu, 12/10/2009 - 16:58 | 159410 nope-1004
nope-1004's picture

Everything their gov't publishes is pulled from a hat, anyway.

Thu, 12/10/2009 - 17:09 | 159425 FoolMeTwice
FoolMeTwice's picture

Sorry, I didn't see any solid case here. Just some tidbits put together. China may very well be in bublle and/or it might burst - but this article fails to highlight it.

And if wind blows the other way -> fiat to gold does any of you geniuses care to wager who has more of it (above or under ground).

I am still watching.

Thu, 12/10/2009 - 18:51 | 159551 whacked
whacked's picture

Agree.

 

China has its own manifesto and can print its own monopoly money to aspire to do what it likes. The amount of monies that they are spending on much needed infrastructure is amazing and they do it because they can! 

 

I do not say they have problems but they seem to be willing to press ahead and hope that the expenditures will increase the available cash resources for internal consumption (to take up the slack in export markets).

 

Time will tell, but to say that they will have a bust is easy, it is the timing of the bust and to that question one must ask, how long is a peice of string?

 

 

Thu, 12/10/2009 - 22:14 | 159717 meh1001
meh1001's picture

That would be the USA and the Eurozone then?

http://en.wikipedia.org/wiki/Gold_reserve

Thu, 12/10/2009 - 23:16 | 159748 FoolMeTwice
FoolMeTwice's picture

That's just 'officially' reported central bank. What about citinizery and under ground.

 

Fri, 12/11/2009 - 04:03 | 159876 Rick64
Rick64's picture

I agree and they have less transparency also they are still a communist country which affords them more control over the people and legislation.

Thu, 12/10/2009 - 22:01 | 159705 Anonymous
Anonymous's picture

With 2 billion people, GDP 1/3 of the USA and no social safety net; China can't stop spending to create jobs or there will be massive civil unrest.

Thu, 12/10/2009 - 22:28 | 159729 ChickenTeriyakiBoy
ChickenTeriyakiBoy's picture

i don't know how sound they are long-term. major demographic issues...they will make baby boomer elder-care deficits look swell by comparison.

 

short-term yeah they will correct, and middle-term they will out-perform as they overtake american economy and begin to innovate not just assemble. but that population pyramid is upside-down and cannot be ignored

Fri, 12/11/2009 - 00:39 | 159810 ThreeTrees
ThreeTrees's picture

Link to article about the NBER study Grice mentions:

http://blogs.ft.com/economistsforum/2009/11/credit-booms-gone-bust/

 

Past credit growth spectacularly improves the forecasting power of an early warning banking crisis model in our data. Using long-run historical data, the growth rate of lending emerges as the single best predictor of future financial instability, a result which is robust to the inclusion of various other nominal and real variables.

Fri, 12/11/2009 - 01:27 | 159827 chindit13
chindit13's picture

Though I cannot prove anything due to the lack of transparency, and am only relying on anecdotal evidence, I'm willing to bet that the Chinese Government Balance Sheet makes anything Bernanke and Geithner have done look Scrooge-ish in comparison.

From my own experience I have seen Chinese SOE's put together the most uneconomic deals imaginable in their voracious acquisition of external natural resources.  I appreciate that this sounds odd and perhaps apocryphal, but it is standard for an SOE to commit to a billion dollar enterprise without doing a feasibility study.  Chinese also have this odd belief that capital gains will always grow faster than underlying value (rent), in other words, there will always be a greater fool.  Japanese thought the same thing until 1990.  No matter how much one has in "reserves", idiocy can eat up a seemingly inexhaustible pile of money in a flash.  I look at China as the Mike Tyson of fiscal restraint, and expect a similar end.  Empty cities, empty apartment blocks, paying a massive premium for commodity extraction, and this year's switch from a cash-paying to a debt-accumulating general population all suggest an unsightly end to this bubble.

Of course things can continue for a while, especially since EM fund managers have enlisted as foot soldiers in this new Hopium War, but it probably will not end well.  A large population makes for impressive figures, but China has always had the world's largest population.  Things can and do go wrong.  Just look at China relative to the rest of the world from 2300 BC to 1990 AD, and in particular 1500 AD to 1990.  Will the real China please stand up.

The finances are turning ugly, the degree of environmental degradation unprecedented, the expectations of the populace are lottery-like, and the demographics (age, gender skewing) are chilling (30 million plus extra marrying-age males by 2020). 

Fri, 12/11/2009 - 05:39 | 159900 Anonymous
Anonymous's picture

Only 30 million surplus males? Last time I went to the park to check the boy girl ratio was 2 to 1. Perhaps these figures are being fiddled as well.

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