Thank you for boarding today’s Daily Reckoning. Welcome aboard. Today’s tour of the ‘rim of fire’ takes us to rising economic superpower, the People’s Republic of China. All electronic devices must now be switched off, unless you’re reading this on a mobile phone, in which case, carry on. Our reading time today is approximately 15 minutes so please sit back and enjoy the tour.
Before we take off for Australia’s most important trading partner, though, two final warnings from the cockpit. First, please don’t send any complaints that this tour of the ‘rim of fire’ is too much reading or too much work. Figuring things out IS hard work. If you want a convenient explanation of things that shed no real light on Australia’s economic future, watch the evening news. Nothing worth having comes easy, especially knowledge. So suck it up and keep reading.
Second, ignore my ‘lethal weakness’ warnings at your peril. I’ve seen this happen now so many times that each stage of the process is almost predictable. My research uncovers an unpleasant and apparently unlikely conclusion: a rise in the gold price, a crash in the US dollar, a housing market bust, or a recession ahead. The research gets published in clear presentation with specific investment action to take provided. The research is roundly ignored by most investors until after the predicted events occur, at which time it’s too late to profit from it or avoid losses.
Now we come to the business bit of today’s reckoning. The expansion of credit by banks is one of the drivers of asset price inflation, including Australian house prices. In fact, Phil Anderson has said repeatedly that banks will create as much credit as society allows. What makes that statement even more interesting today is a list of the top 100 banks in the world, by assets, and how many of them are Chinese banks.
Two of five largest banks in the world are now Chinese banks, according to data published today by financial research firm SNL. The world’s largest bank, by assets, is the Industrial and Commercial Bank of China, with $3.174 trillion in assets. London-based HSBC is next with $2.758 trillion. Then comes China Construction Bank Corporation at $2.596 billion, Paris-based BNP Paribas with $2.595 trillion and Tokyo-based Mitsubishi UFJ Financial Group at $2.507 trillion.
You’ll notice there are no American or Australian banks in the top five. Bank of America comes in at number twelve with $2.15 trillion assets. And there are eleven American banks in the top 100 along with all four of Australia’s ‘Big Four’. NAB is 40th, with CBA at 44th, ANZ at 45th and Westpac at 36th. China has four of the top ten spots.
You could argue that the growth of China’s banks is directly related to China’s enormous over-investment in commercial and residential real estate — a misallocation of capital the scale of which the world has never seen. I’ll argue just that, and show you the implications for Australia, in a moment.
But let’s take another quick look at China’s rise up the global rankings. There are 95 Chinese companies on Fortune’s ‘Global 500’ list. That list measures the world’s biggest companies in terms of revenues. The Chinese companies on the list — including Sinopec and China National Petroleum, the third and fourth-largest companies overall — totalled $5.8 trillion in revenues, according to Fortune.
The US is still at the top of the table with 128 companies racking up $8.6 trillion in sales last year. Wal-Mart was number one and ExxonMobil was fifth. British firm Royal Dutch Shell took out the number two spot and the UK placed 28 firms in the top 500. What about Australia?
All the usual suspects from the ASX 200 showed up: BHP at #142, Wesfarmers at #158, Woolworths at #161, Rio Tinto at #201, NAB at #216, CBA at #226, Westpac at #288, ANZ at #352, and Telstra at #453. Of the companies that currently make up the top ten on the ASX 200 in terms of market capitalisation, only CSL missed out on the global 500 list.
There were 55 banks on the list, 40 oil and energy companies, and 33 car makers and parts manufacturers. Those were the industry groups with the largest representation on the list. That’s a bad sign if you see bankers as thieves, oil as evil, and cars as 20th century anachronisms. But is there any useful investment takeaway form the data? Yes!
If you think diversification in your portfolio is valuable, you need to look at some of the world’s biggest firms not listed on the ASX. The Aussie firms have a fair enough diversification amongst them: banking, materials, retail, and telecommunications. But if you only have Aussie companies in your portfolio, and not foreign businesses that operate all over the world to generate revenues, you’re missing out. More on that next week.
Now, since we’ve finally reached cruising altitude, let’s talk specifically about China. China is normally Greg Canavan’s beat. For the sake of brevity, I’m going to focus my analysis on three specific areas: metal-backed loans in the financial system, China’s relationship with Japan, and China’s military aspirations vis-à-vis the United States. Each impacts Australia in a different way.
First, metals-backed loans. This is one of the more fascinating and poorly-understood stories of the last few months. But to keep it simple, the key issue is how much exposure Chinese and Western banks have to the issue. If the losses are minor, it’s not a systemic problem. If the losses are not so minor, and the problem is more widespread than it first appeared, then we may have a problem.
The problem itself is the still-growing Chinese financial system. Firms or speculators that can’t get finance from state-owned banks have to find other ways. One way is to get a loan to buy commodities like alumina, copper, iron ore, and gold…and then pledge those commodities (multiple times, it turns out) as collateral for additional loans. Goldman Sachs estimates there are around $160 billion worth of ‘commodity financing’ deals.
The trouble is it now appears some of the firms that borrowed money from Chinese and Western banks with metal as collateral don’t have the metal. Most of the warehouses where the metals pledged as collateral were supposed to have been stored are in the port of Qingdao. Banks like Citigroup and Standard Chartered PLC have dispatched investigators to see if the metal is there.
The existence of commodity financing in China exposes how much loose lending is going on in that market. To be fair, it happens anywhere and every time interest rates are low and speculation pays. The difference here is the role of commodities — metals from Australia — in the scheme. But it does raise the question of how robust China’s financial system will be in the next banking crisis.
Let’s move on to China’s relationship with Japan. Historically, it’s not good. In fact, Monday marked the 77th anniversary of the second Sino-Japanese war, from 1937 to 1945. Chinese historians put the number of casualties during the war at close to 35 million. And don’t think China has forgotten.
‘The future can be inaugurated and peace can be maintained only if lessons from history are kept in mind,’ said Chinese Premier Li Keqiang at a press conference with Germany’s Angela Merkel on Monday. China is warning the rest of the world that Japan can’t yet be trusted to act responsibly on the world stage.
All of the countries in Southeast Asia suffered at the hands of Japan’s attempts to create a ‘Greater East Asia Co-Prosperity Sphere’ by invading its neighbours and brutalising them. It’s what makes this week’s statement by Tony Abbot that Japan should be recognised as a ‘normal country in the family of nations’ so significant and hotly contested.
It means Australia views the past as the past. Its security-partnership with Japan is the future. And now Australia must balance a security partnership with Japan and the US against an economic dependency on China. Let’s hope our leaders have good balance.
China’s military aspirations with the United States are the last stop on our tour. It is not surprising that a Great Power, with a solid industrial base, would seek to expand its regional influence, project force, and generally boss its way around. It’s what the United States and Britain have done for the last 300 years.
But US and British trading power was built on naval power. China does not yet have a ‘blue water’ navy to back up its claims in the East and South China Seas or the Indian and Pacific Oceans. It’s working on it. But in the meantime, it’s also working on building an anti-ship ballistic missile that’s an ‘aircraft carrier killer’.
I’ve also written about that weapon in my new report. It’s the future of conventional warfare — a weapon that can unleash utter devastation anywhere on the planet in less than an hour and can’t be shot down by missile defence systems. It’s the core of China’s strategy to oppose US financial and military power asymmetrically. It can also, in theory, destroy the US carriers patrolling the Straits of Malacca.
Australia is caught in the middle of this great Pacific power game. And the game gets more complicated each day. The stakes couldn’t be any higher. And the truth is, all the nations involved are dependent on each other for trade, technology, food, and raw materials. A major conflict is in no one’s interests. It’s also possible the demography — ageing populations in Japan and China — might make both countries less militant towards one another in time.
Armed conflict never seems to be in anyone’s interest but madmen. Yet it happens with historical regularity anyway. As China’s economic growth model of fixed investment peters out, we reach a critical point.
If the Communist Party of China can’t deliver rising standards of living and more growth through consumer spending and liberalisation of the financial system — if, in fact, the financial system has a crisis — China’s growth will hit a wall. And Australia, which has been sailing along in the slipstream of the greatest industrialisation and urbanisation in human history, happily selling iron ore and coal the whole way, will find itself suddenly vulnerable.
And we haven’t even gotten to the Russians yet! More on them tomorrow. Comments on the ‘rim of fire’ tour can be sent to firstname.lastname@example.org
You can also read my new report here.
for The Daily Reckoning Australia