By Cullen Thompson
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| || Courtesy of Bienville Capital|
Recently, a number of industry veterans have expressed concerns about the Chinese economy, including noted macro investor George Soros, financial market historians Edward Chancellor and James Grant, as well as a few highly successful and independently-minded hedge fund managers, such as Jim Chanos of Kynikos Associates and Mark Hart of Corriente Advisors. The alignment of these individuals alone should give pause to investors whose portfolios are levered to the China growth story.
Outside of the ongoing sovereign debt crisis, China is arguably the most important variable in the global economy, having made a quantum leap in terms of economic significance during the past decade. Presently, China is the world’s locomotive. When accounting for both the size of the Chinese economy, as well as the volatility of its growth, it is now more impactful to global growth than both the United States and Europe combined. It affects commodity prices, as well as risk appetite in general. And since the financial crisis erupted in 2008, the consensus view has been that China, with its high nominal growth and expanding middle class, will bail out the global economy, particularly the over-levered developed world constituents, as it seamlessly reorients itself toward more consumption.
Unfortunately, this has not occurred. Investment, fueled by copious amounts of credit, remains the principal driver of China’s growth while consumption, as a share of the country’s gross domestic product, has continued to fall for the past 20 years (see chart below). With consumption now representing a mere 35% of growth, it’s difficult to envision it rising quickly enough to compensate for the inevitable decline in investment. And, to be clear, we’re not the only ones who believe this. Just last fall, Premier Wen Jiabao commented that “in the case of China, there is a lack of balance, co-ordination and sustainability in economic development.”
| Source: International Monetary Fund|
When voicing our concerns about China to other investors, we often recognize that either more evidence of a credit bubble is needed, or the timing of a potential crisis is too uncertain to warrant consideration. On the first point, we believe that evidence of excessive credit and resource misallocation is now abundant. As for the second—that is, the timing, which is always impossible to predict with any precision—the past few weeks have, at the very least, delivered some interesting warning signs. First, analysts have recently noticed a substantial increase in innovative financing, largely in retaliation to The People’s Bank of China’s quantitative credit controls. Deprived of their ability to borrow, private companies began to import materials such as copper, regardless of whether they were necessary, to use as collateral for lines of credit. Because the borrowing was structured as a line of credit rather than a loan, it remains outside of the purview of the PBoC.
Secondly, over the past several weeks, revelations of fraud seem to have escalated. Examples have been various and far-reaching, including numerous Chinese stocks (e.g. reverse-mergers) that have been either halted or de-listed to companies accused of accounting irregularities. Very recently, a report produced by the PBoC, which was released by accident, concluded that 10,000 corrupt Chinese officials have collectively embezzled more than $120 billion during the past 15 years, a not insignificant sum relative to the size of the economy. All of this is highly reminiscent of what John Kenneth Galbraith referred to as “the bezzle” in his classic book The Great Crash of 1929 when incidents of fraud rise quickly at the end of a bubble. For another example, consider the subprime crisis here in the U.S.
Finally, and most tellingly, there was the May 31 report from Reuters suggesting between 2 trillion to 3 trillion yuan (up to $463 billion) in loans may be lifted off of local governments by the central government. Surprisingly, and although the comment apparently came from a low-level official in the Ministry of Finance, the report received little attention—that is, until Societe Generale strategist Dylan Grice added a touch of needed perspective. “Think about what just happened. A bailout of $463 billion is half the size of TARP...for an economy which is only one-third the size of the U.S. So adjusted for GDP, China has just announced an emergency bail-out of one and a half TARPs!!” he wrote in a June 7 report. Yet to date, there has been no evidence of collapsing real estate prices, leaving one to wonder why loans are souring so quickly and providing a glimpse into the potential scale of the forthcoming credit problems.
The consensus view maintains that even if China ultimately has a nonperforming loan problem, they will once again simply sweep the problems under the carpet. We find two problems with this theory. First, the magnitude of the issue far exceeds anything ever witnessed. And secondly, because of the math described above, we believe it’s unlikely that China will be able to maintain recent trend growth rates, which historically assisted in dealing with problem loans.
In the summer of 1999, Alan Greenspan, former Chairman of the Federal Reserve, famously remarked that “bubbles generally are perceptible only after the fact. To spot a bubble in advance requires a judgment that hundreds of informed investors have it all wrong.” Perhaps even more damning, particularly in the case of China, he concluded that “while bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy.” Given China’s wide-ranging influence, we doubt such a sanguine view is justified.
Cullen Thompson is chief investment officer of Bienville Capital Management, a research-focused investment advisory firm serving high net-worth, family office and institutional investors.