It’s not going to be a good day.
This morning, an apple fell out of your editor’s mouth, bounced off our desk and landed in a full mug of coffee. Foam flew everywhere because the coffee machine is abusing the milk instead of heating it up, creating a lot of foam instead of warm milk.
Our apple looked mouldy and tasted like milk. The coffee was sour. Our apple became collateral damage with a white cap on top and so did our jumper.
All of this relates directly to the topic du jour, China...somehow.
To be honest, we’re getting sick of the China bust story. It’s everywhere these days. Every analyst and his dog is onto the story. And every financial journalist is interviewing each of those analysts and their dogs, which leads to a heck of a lot of doubled up content.
Over at FT Alphaville, the journalists pointed out that no two analysts can agree on the data, what’s going on, or what the Chinese policies amount to. For all their analysing, everyone is completely baffled. But everyone does agree that there is a risk of a crisis in the Chinese financial system.
Here’s the important part though: If things do get dicey, it’s going to be an enormous shemozzle. Robert Preston, the guy who exposed UK bank Northern Rock’s shaky finances, interviewed Charlene Chu, a leading banking analyst in China. Here’s part of what she told him:
‘At the beginning of all of this in 2008, the Chinese banking sector was worth US$8 to $10 trillion in size. Right now it’s on the order of $24 to $25 trillion. That incremental increase of $14 to $15 trillion is equivalent to the size of the entire US commercial banking sector, which took more than a century to build. So that means China will have replicated the entire US system in the space of half a decade.‘
Holly crap, Batman. As Preston points out after the quote, this sort of boom doesn’t happen without a bust. That’s why it’s called a bubble.
But isn’t the China story all about resources as far as Australia cares? Sure, a banking crisis might cause a problem in China’s construction industry, lowering demand for our red dirt. But in the end, the economy is going to grow and the production phase of the mining boom will continue.
Here’s the problem with that narrative, straight from Bloomberg:
‘Iron ore stockpiles in China, the world’s biggest buyer, climbed to a record as traders increased imports to use the steel-making raw material as collateral for credit and domestic demand remained weak.‘
That’s right, even resources are caught up in China’s lending boom. Dan Denning sent around this email with his take:
‘Hmm. So iron ore stockpiles are also at record highs in China. Is iron ore the new copper as the collateral for getting loans in the shadow banking system and fuelling speculation? Well that would be bad…for iron ore.
‘Having read yesterday’s AFR, I would like to assure you that the risks in China’s financial system are well contained. The Chairman of the China Construction Bank, Wang Hongzhang, tells Mr Stevens that ‘The risks have been contained and even if in future a problem appears I think it will be localised.’
‘I give you Ben Bernanke on May 17th, 2007: ‘The subprime mess is grave but largely contained.’
‘ANZ Chief Economist Li Gang Lu, speaking on the risks of a collapse in Chinese wealth trusts, says, ‘It is very difficult to imagine a failing in a trust product will create systemic risk.’
‘Hard to imagine a collapse in confidence, a liquidity crisis, and bank runs in a system in which interest rates on savings are so low that trillions of dollars/yuan have been poured into high-yielding securities backed by unproductive debt or overvalued assets? Somebody needs to hit the opium pipe to develop a more vivid imagination…or recollection.
‘Can you imagine that ever happening…again?‘
It’s déjà vu all round. But the fact that everyone is onto this story brings up the question of whether it’s priced in. And whether it will cause a serious crisis.
The problem is certainly big and bad enough. But everyone is aware of it by now. Then again, if analysts are differing on their analysis, perhaps there is enough confusion and obscurity in China to surprise the financial system.
Another possibility – this is getting confusing – is that the world is pricing in a major intervention by authorities around the world if another financial crisis does start. As we explained yesterday, a financial crisis without a Lehman Brothers’ style failure isn’t much of a financial crisis. And if the Chinese authorities can contain the crisis, it may never get over what’s left of the bamboo curtain.
Our theory is that a crisis will start elsewhere and go viral, surprising us all. But where? Our submission for the trigger of the next financial crisis is Geelong.
Measures of economic activity in China that sceptical economists bother with include electricity consumption. And by that standard, Geelong is in trouble. Alcoa’s Point Henry aluminium smelter shutdown leaves a surge of excess power hitting a grid which is seeing oversupply and falling demand. Maximum capacity is already around 22% greater than peak demand.
Now you might think it’s good news that there’s falling demand and a surge in supply. Basic supply and demand economics dictates that prices must fall. And that would be much needed relief.
But this is the Australian power industry we’re talking about. Higher supply and lower demand means higher infrastructure costs per person, more blackouts and, yes, higher prices.
So while the electricity industry’s turmoil is causing trouble for other industries, it’s a two way street. Industry shutdowns are making the power industry suffer too. In other words, the shift in Australia’s economy is wreaking havoc on Australia’s power infrastructure. And that means more trouble, more costs, and more shutdowns.
Of course, as always, it’s a political problem. Alcoa’s power was subsidised by the state government in the first place, and that subsidy was set to end just as the smelter is shut down. What a coincidence.
The back story is even more ridiculous. The state guaranteed Alcoa ‘mates rates’ on power and then sold its power infrastructure. The difference between the market rate and Alcoa’s is footed by the taxpayer. Of course, just to make things more absurd, the government also decided to levy large power users.
You can’t make this stuff up.
If you’re wondering how this is going to trigger a global financial crisis, you haven’t been reading about Australia’s secret subprime scandal. In short, the loss of jobs in Geelong is beginning to get serious. The government is in crisis talks. The worsening situation poses a serious risk to house prices in the area.
If house prices take a hit in Geelong, that could prove to be the canary in the coalmine for the rest of Australia. It has the potential to trigger pretty much the same subprime crisis here in Australia as in the US by making people realise what’s brewing for the rest of the country. Remember, subprime and the housing bubble broke out in a select few states in the US before going national, and then global. These crises always break out on the fringes and then go mainstream.
So how could Melbourne’s satellite city trigger a major financial crisis? And is there really a sub-prime style crisis hidden away in Australia’s housing industry? Yes, and it’s not just overpriced homes that are the issue. Australia has many billions of dollars in sub-prime loans. It’s just that they’re masquerading as prime ones in an even cleverer way than the Americans managed to pull off.
The Americans securitised the mortgages and turned them into AAA rated CDOs. Here in Australia, mortgage brokers simply changed people’s loan applications to get them past lending standards. They added some income here, and some assets there, until their client got the loan. The result is that nobody knows a prime loan from a subprime loan.
As long as house prices rise, that isn’t a problem. People just sell out if they get into trouble. But if house prices fall in Geelong, the problem could be exposed as it was in California and Nevada. People will realise that the marginal property buyer cannot afford what they are buying. And once property investors realise that much of the demand for housing around Australia comes from people who would never get loans without document fraud, they will panic.
Worse still, the courts have decided the banks should bear the losses when borrowers are victims of manipulated loan applications. People are walking away with a home and no mortgage as the courts and ombudsmen services wipe the slate clean. So if the law were applied to all mortgages, the Australian banking industry could face billions in write downs. Using one estimate from the consumer watchdog that exposed all this, it could be around $200 billion in mortgages affected. That’s easily enough to cause a major banking crisis.
To find out more, and discover how to protect yourself from the crash that will happen as a result, click here.
for The Daily Reckoning Australia