The Chinese Economy’s Death Cross


Before going to bed last night, I checked in on European markets. The German DAX and British FTSE were off more than 1%. It was a sea of red. Awoken at 4:30 am by my two-year in need of a dummy, I checked again and the screen on my iPhone was green.

You can put that down to a healthy open in the US, where the pre-market release of strong third quarter economic growth figures got everyone excited. The Dow finished the day up over 200 points.

I’ll get to the US growth story in a minute. First, what ails Europe?

Who knows? Maybe it’s the rise in Greek bond yields as the political situation there looks dicey — again. Maybe it’s the laughable European bank ‘stress tests’ conducted earlier this week, which showed European banks are still woefully undercapitalised.

Whatever is it…something is brewing. In 2015, Europe is likely to be the flashpoint for global markets again. Keep an eye on it.

Meanwhile, the US economy is a picture of (relative) strength. In the three months to September 30 (news from a month ago, keep in mind), the US economy grew 3.5% annualised. That follows 4.6% annualised growth in the second quarter and -2.1% in the first quarter (because it was so cold, remember?)

That averages out to a 2% real growth rate for the year so far. Nothing to get carried away with, wouldn’t you agree? Well, the market doesn’t see it that way. The last two quarters have been very robust and today’s news was enough to bring in new buyers and scare the short-sellers.

But let’s break the latest quarter’s result down. The biggest contribution to growth (accounting for 1.32 percentage points, or nearly 40% of total growth) came from ‘net exports’, which means the US increased exports and decreased imports.

This relates to the US shale oil revolution, which reduces the need for the US to import large quantities of oil. In 2011, 2012 and 2013, net exports made a positive contribution to economic growth, but nowhere near as high as 40%. So the recent quarter’s contribution was a bit of an anomaly.

The other major contributor was ‘personal consumption expenditure’, at 1.22 percentage points or 35% of the total. A strong 4.2% increase in ‘final sales’ drove this result. But disposable personal income growth was only 2.7%, so consumer income growth remains lacklustre.

Elsewhere, government spending made a decent contribution (accounting for nearly a quarter of total growth) while private investment continued to disappoint.

All up, while the headline number looked good, the components were less so. Expect the market to move on from this quickly…although the meme of ‘strong US growth’ will probably continue for a while longer.

Meantime, QE is over, yet confidence remains. I said yesterday that liquidity creates confidence…which creates more liquidity and more confidence. With liquidity going, going, gone…why still the confidence.

QE is a game of hot potato. Each player passes the potato (zero yielding cash) onto someone else, swapping it for a different financial asset and paying just a little more for it than the previous person. As the game of hot potato continues, asset prices rise and yields fall as hot hands keep swapping cash for other financial assets.

No one wants to hold cash.

But now, QE is over. The hot potato is cooling down. Maybe people are happy to hold cash for a little longer, just to see what happens in a no QE environment. As liquidity dries up, they lose a little confidence.

It makes me think the market is pretty close to this point:

Source: Warner Brothers
What will be particularly interesting for the Australian economy is the effect of the end of QE on our biggest trading partner, China. Don’t forget, China partly shares US monetary policy via its loose currency peg to the US dollar. No QE means tighter monetary policy in China too.

How that affects the Middle Kingdom and its attempts to gently deflate its credit bubble remains to be seen. The Australian reports today that bad debts at China’s major banks are up 22% this year. That’s only off a low base though, and probably vastly under represents the actual amount of bad loans in the system. Anyway, they’ll increase a lot more in the years ahead.

I’ll show you what I mean. Last month, the International Centre for Monetary and Banking Studies released their 16th Geneva report on the world economy with the title Deleveraging, What Deleveraging?.

Here’s a chart that should have any iron ore miner shaking in their red dust covered boots. I call it China’s death cross. It shows debt as a percentage of GDP soaring (blue line) while nominal growth slows sharply. That tells you the increase in debt is unproductive, and a further slowdown in nominal growth will uncover a whole host of bad debts.

Source: Geneva Report

Here’s what the report had to say.

Since 2008, Chinese total debt (ex-financials) has increased by a stunning 72% of GDP, or 14% per year, a shift almost double that experienced by the US and UK in the six years that preceded the beginning of their financial crisis in 2008.

This brisk acceleration has brought the overall leverage of the Chinese economy to almost 220% of GDP, almost double the average of other emerging markets

The stunning increase in leverage since 2008 arguably came at the cost of an inefficient use of resources, as is often the case when leverage increases at a quick pace. Moreover, the increase coincided with the shift from export orientated growth to domestically orientated growth. This possibly exacerbated the overinvestment problem in China and created conditions of overcapacity in a number of sectors.

Indeed, while investment in previous years was mostly concentrated in manufacturing and in sectors affected by the additional demand created by the export boom following the WTO accession, the credit boom in 2008 and thereafter spurred huge investments in housing and infrastructure. These sectors, although effective in supporting the economy in the short term, failed to boost potential output and actually created excess capacity in related sectors, like steel.

In turn, overcapacity in a number of key sectors led to downward pressure on production prices. Since 2008, the slowdown in measures of growth to about 7% has been accompanied by a fall in underlying domestic price pressures and slower growth in nominal GDP.

As a consequence, China is facing a poisonous combination of high, fast growing leverage and slowing nominal GDP. This, in turn, suggests growing difficulties in servicing and repaying debt in a number of sectors in the future are likely. These difficulties might be exacerbated by the fact that market rates are likely to increase as a consequence of ongoing financial reforms.

In addition to these patterns, the debt situation in China is made even more fragile by two further considerations. First, the recent increase in debt was raised especially by relatively weak borrowers, such as local governments with fragile income streams and, in particular, companies active in construction and other sectors (e.g. the steel producing industry) plagued by overcapacity. Second, credit was granted by relatively weak lenders, as shown by the sharp increase of the weight of shadow banking (trust funds, etc.) within total lending.

While that may sound pretty bad for China’s economy, given that it represents 40% of our export market, it’s bad for Australia too. Unfortunately, there’s not much we can do about it. We just have to hope that China can pull off the almost impossible.

That is, we must hope that it can create a boom without experiencing a bust.

I’m betting it can’t…

Have a good weekend, and happy punting for Derby Day and the Melbourne Cup if you’re so inclined. Next week you’ll be in the capable hands of Vern Gowdie. I’m off for a week of daddy duties — pushing swings and meeting many and various demands throughout the day (and night) — while my wife enjoys a few days of child-free relaxation.

Greg Canavan+
For The Daily Reckoning Australia

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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