Wednesday, December 9, 2009

China's Spending Bubble

In an earlier post on double dip probability, I discussed leverage and how Japan, the US, and now China appear to be moving in the same direction.  It is an area of growing discussion as the links in my prior post indicate.  Another research report has been published, "China's Investment Boom: the Great Leap into the Unknown", by Pivot Capital Management.  The naked capitalist blog has done an excellent synopsis of the study.

The Pivot research study is not as comprehensive as some of the other papers I have previously referenced, but it is succinct.  Here are a few excerpts:

"In our view investors have underestimated both the maturity of the Chinese growth cycle as well as the degree to which recent growth is a direct extension of the global credit bubble. This bubble had two major manifestations. The first, which started unraveling globally in early 2007, was evident in excesses in real estate, consumption and private equity. The second manifestation, which has yet to fully deflate, was a boom in capital expenditure, led primarily by China."

"However, the decreasing efficiency of investments will ultimately lead to a pullback in capital expenditures. In a soft landing scenario, China is likely to shift to a lower growth trajectory for the next decade. In a hard landing scenario, which is entirely feasible, there would be an abrupt decline in capital spending exacerbated by a banking crisis."

"If loans continue to grow at the current 35% rate, credit to GDP ratio will be close to 200% in China already in 2010, even with GDP expanding at 10%. This is a level similar to the pre-crisis Japan in 1991 and USA in 2008. All this points to that credit in China is not going to be able to grow for much longer without risking a
major crisis."

"In the period from 2000 to 2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favorably with the peak $4 of credit for $1 of GDP in USA in 2008. However in H1 2009 in China this ratio was already at around $7 to $1. Credit might be going into the luxury property and stock markets, but the trickle down to the real economy is very poor."

"The Chinese government also explicitly guarantees $400bn worth of debt of the three “policy banks”. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China’s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average."

"Price to income ratios have reached 15-20 times in major cities and around 10 times in regional cities. This compares with 9 times in London and 12 times in Los Angeles at the peak."

"It is hard to over-emphasize what this shift to consumption-driven economy means for China’s overall growth rates. On a simple mathematical level it means that average growth rates are going to be capped at 7-8%, so that the overall economy grows at 5-6% for the foreseeable future, and probably slowing down even more later on. It also has enormous consequences on what China imports from the rest of the world as it shifts from commodity and capital goods heavy into (most likely locally produced) consumer goods and services driven economy."

"Anything that is cyclical and dependent on Chinese investment demand would obviously be the most vulnerable to a Chinese growth disappointment. That would include industrial commodities as well as equities and credit of industrial and consumer cyclicals. There would also be a general rotation into more defensive areas taking place across most asset classes. The biggest uncertainty relates to what China means for the debate on deflation versus inflation. In principle, a Chinese slowdown should initially be deflationary, especially given the overcapacity currently building up in various Chinese industries. This should be negative for credit in general and also for most equities. However, depending on how aggressive the policy response will be in China and elsewhere, investors may very well start focusing on the inflationary risks again."

My rationale for posting is to inform and provide the means and some incentive for people to dig into issues and deal with the different viewpoints.  Proper investing is not about relying upon a financial guru or political or economic bias.  Proper investing methodology is about research and developing the ability to critically analyze information from many different sources.  Will there be a China bubble?  Given the developing pattern of credit leverage it is possible.  There is no predicting when and it could be delayed or even turned into a more positive soft landing with proper economic policies, but it would require China doing what Japan did not do in a timely fashion and acting more decisively than the authorities in the US, who are still struggling with turning the rescue of the financial sector, for the benefit of the financial sector, into a stimulus which benefits the citizens of the US whose participation is required for a real sustainable economic recovery.

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