China’s Looking Scary

Bubble? What Bubble?

It’s been a strange year in the world of market-watching. There are as usual, quite a number of ructions that make you wonder about the health of markets or in fact there is any sanity prevailing in markets. Crimea has grabbed headlines and so Australian stocks have followed the lead of the world, up and down, with the news cycle surrounding Ukraine and its coup. Ukraine of course is a basket case waiting to blow up, but it’s not like it’s even in the top 30 economies of the world. Even if there was a full economic meltdown in the guise of a default, there wouldn’t really be too much of a problem short of a shooting war breaking out.

China on the other hand is the world’s second largest economy, warts and all. And there are a lot of warts and other nasty lesions that mark the Chinese economy, one of which is the size of the debt it has created since the GFC. If you tally it up, it is larger than the combined debt of the USA, the Euro zone and Japan combined. The criticism has been that much of this debt has been pumped into general construction companies that have built ghost cities of luxury apartments while other parts have gone into a shadow banking system that has blown this easy credit on god-only-knows-what. Of course, this being China, the debts were collateralised with commodities such as copper, rubber, nickel, iron ore silver and of course gold. Which is all well and good if the commodities are going up, but they have instead been falling in value for some months now. This, has logically led to loans being called in, bank runs on minor banks and a general drying up of liquidity.

As I mentioned last week, the Chinese market has experienced a number of defaults this month – something unheard of prior to this leadership group coming to power – and all of a sudden things are turning a little hairy over there.

In that light I’d like to share a few links so you can have think about what this might mean. The first link is here:

After Hong Kong, the UK takes the lead by far. (As a note, banks in several countries, particularly in emerging markets like Russia or Latin America, aren’t listed, because they don’t report to the Bank for International Settlements):


Total-loans-to-Chinese-companies-US-billions_chartbuilder
Some UK banks’ long historical ties with China—HSBC and Standard Chartered, in particular, have roots in Hong Kong—mean they have been lending there for decades, though in recent years, loans to Chinese companies and banks have also grown steadily. Neither will be a good thing if analysts’ worst fears about China come to pass.

Right. Of course Australia is on that list with US$28.7billion which is about AUD$ 30bn right now.

Keep that in mind as we have a quick look at what the AFR is saying about Australian banks, courtesy of Pleiades who gave me the heads up as I was telling him about whats reported as going on in China.

A study by funds management giant AMP Capital presented to the ­superannuation funds at an industry conference this week, showed that a typical fund has more than 12 per cent of total assets invested in the banks, but banks accounted for a quarter of their investment risk.

Industry averages suggest a fund’s value shouldn’t move by more than 8 per cent in a given year. However, more than a quarter of that volatility risk in Australian funds is driven by the banking sector, demonstrating just how sensitive our retirement savings are in the continued health of the big lenders.

“The system is quite exposed to these four banks. From an equity point of view, the weight in financials in ­Australia is at a peak,” AMP Capital’s head of credit markets Jeff Brunton told an audience at the CMSF conference in Queensland this week.

At 30 per cent, Australian’s index exposure to the banks is the highest its ever been – doubling since 1993.

Worryingly, in United States, Japan, Germany and United Kingdom, the weighting of banks had fallen sharply from their peaks.

Yes. That means, it’s a bit like we’ve put all our eggs into the property basket twice. Once through taking out huge mortgages in a property Bubble, but also through our superannuation accounts that own dirty big lots of banking shares which are exposed to real estate., and are also over-priced The scary bit is over here:

AMP also presented controversial findings about the ability of banks to withstand stress. The banks and ­the prudential regulator had conducted stress tests – based on a 40 per cent fall in property values and 4 per cent ­foreclosure costs – which AMP ­replicated. “We get the same number – $17 billion of losses,” Mr Brunton said.

“That’s nothing. That’s why the banks and APRA say our system is safe.

“But the insight we put on the table is that the remaining mortgages, those who haven’t defaulted, will actually be at a very different loan-to-value point than when they took out their ­mortgages. More than half of ­Australians will be in negative equity and a lot of us in significant ­negative equity.

So it seems there’s AUD $17bn sitting there on the ledger as potential losses that’s separate to the AUD $30billion mentioned above, but linked together by the health of the Chinese economy. All this robust property valuations and auction prices and what have you are sitting on a bubble that is the Chinese economy. When the music stops, there are going to be tears.

Just how exactly is China doing? Here’s a glimpse:

Over the past month, we have explained in detail not only how the Chinese credit collapse and massive carry unwind will look like in theory, but shown various instances how, in practice, the world’s greatest debt bubble is starting to burst, resulting not only in the first ever corporate default but also in the bursting of the associated biggest ever housing bubble. One thing we have not commented on was how actual trade pathways – far more critical to offshore counterparts than merely credit tremors within the mainland – would be impacted once the nascent liquidity crisis spread.

Today, we find the answer courtesy of the WSJ which reports that for the first time in the current Chinese liquidity crunch, Chinese importers, for now just those of soybeans and rubber but soon most other products, “are backing out of deals, adding to a wide range of evidence showing rising financial stress in the world’s second-biggest economy.”

While apologists of China’s collapse have been quick to point out that China’s credit collapse would be largely a domestic issue, with little foreign creditor exposure at either the public debt, or private – corporate – debt levels, one thing nobody can deny is that if and when Chinese trade routes grind to a halt, the downstream impacts would be devastating, and spread like wildfire as the offshore supply chain is Ice 9’ed.

The fact is, it’s just starting. The way it’s going is that the importers of commodities have run out of liquidity so they’re cancelling and tearing up contracts.  The unsold glut of commodities is leading to the collapse in the price of commodities. Because the shadow banking system uses commodities as collateral, a lot of loans are going to get called in as result of this collapse. it’s pretty much as people have predicted the collapse of the Chinese credit bubble. When this collapse moves on to property, there’s going to be knock on effects to Australia and suddenly that $47bn problem is going to come home to roost. If that doesn’t scare you, its probably because you don’t have a mortgage and you don’t own bank shares.

Just watching the share price movements this week, it appears that twice this week, people bought in hoping for a stimulus package to be announced by the communist party bosses. Except they have made it explicit that they won’t be doing any more stimulus packages because it only kicks the can down the road. That means China will test a market downturn and all the people buying up shares this week were exercising what can only be described as irrational exuberance.

That’s really not great news.

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