China’s Empty Homes and Missing Resources

Chinese Businessman holding business card with China Flag
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The World Cup began with remarkable symbolism. After just 11 minutes, hosts Brazil scored…an own goal.

Luckily, many Brazilians were too busy dealing with tear gas and rubber bullets to notice. The idea that living standards are more important than soccer stadiums is not to be tolerated when you’re hosting a World Cup. All protests are to be directed at the referee, not the government.

After Brazil’s embarrassing opening goal, things went back to normal. The home side scored three times…in the right net. The Croats out-fouled the Brazilians more than four to one, and blamed the ref for it.

Bread and circuses are in full swing here in Australia too. State of Origin, the Wallabies, and drug scandals at the Bombers. The number of Australian millionaires surged by 43,000 and protesters took to the street over a budget that doles out marginally less doles.

Action in financial markets is little more than harmless entertainment these days too. The Dow Jones fell 200 points in two days and gold rose. 200 points in the Dow isn’t what it used to be — only just over one percent. And the uptrend in the US index is well intact. Not to mention volatility is at incredible lows.

The Australian dollar is back above 94 US cents and house prices haven’t crashed. Yesterday the unemployment rate in Australia came in close to expected. The 5.8% result was just better than the 5.9% forecast. But part time job losses left the country with 5000 fewer jobs in total.

The world seems to be plodding along. Unless you’re in Eastern Europe or Iraq, of course. In which case boring capital markets are completely irrelevant.

What’s really striking amongst all this financial and economic stability is the lack of optimism. Economies rarely plod along for long. They boom and bust, not trudge. At the moment they’re like a coma patient with the doctor happily proclaiming that ignorance is bliss.

If the patient were to wake up, the brain damage would become obvious. But while the QE and government spending induced coma persists, you have to dig deep or think far ahead to see any hint of trouble. China’s rehypothecation scandal is the leading contender for a crisis trigger. But what is it?

Well, the Chinese have vast stockpiles of resources. They use these resources to back up debt deals. ‘If I default on the loan, you get my warehouse full of copper,’ sort of thing. But, because the resources are used as collateral in financial agreements, and not to actually make something, it can be ‘rehypothecated’. That means the same pile of copper can be used as collateral in many different lending agreements, without anyone being the wiser. Goldman Sachs reckons it can happen up to 30 times over. The only restraint is the time it takes to do the paperwork.

This is sort of like mortgaging your house to 30 different banks and collecting 30 houses worth of loans — don’t get any ideas…

To those of you who read about the history of money, this will all be very familiar. It’s the same story as the gradual move from precious metal coins to fiat money over thousands of years.

First people dealt in the physical metal as money. Then they deposited the physical at a warehouse in exchange for a warehouse receipt. A transaction involved giving someone the warehouse receipt, meaning they can pick up the gold or silver. That way you don’t have to lug around heavy precious metals. Eventually people just dealt in warehouse receipts because nobody bothered to pick up the physical.

Once warehouse owners realised this, they began to issue more warehouse receipts than there was gold or silver. Eventually the metal just wasn’t even relevant anymore. The Pound Sterling became a pound of sterling silver in name only.

Of course, it’s not all smooth sailing. There have been plenty of runs on banking systems in their long, nefarious history. When depositors turned up en masse to demand their gold and silver, and the bank couldn’t pay, it often caused a serious financial crisis.

The same might happen in China’s resources rehypothecation system. At some point, someone will figure out that there aren’t enough resources to back up all the borrowing and collateral pledging that’s been going on. A lot of people have a lot of claims on not enough iron, copper and other resources. If borrowers were to default, there would be a run on the collateral system. And only a few lenders would be able to recover what was promised.

But are defaults likely? Well, it turns out China has about 52 million vacant properties, not to mention many underwater borrowers. Even a surge in the urbanisation rate would struggle to fill enough empty homes to prevent prices falling further, according to China’s Southwestern University of Finance and Economics.With China’s property looking shaky, lenders are getting nervous.

Now the game is like a Mexican standoff. If you try and make use of ‘first mover advantage’ and get your hands on the resource collateral, it could cause a system wide breakdown. You have to sneak out of the theatre, which is difficult once everyone smells the smoke.

So far, companies have made moves in China’s second and third largest ports, where the hypothecated resources are kept. Inspectors can’t find the resources, state owned companies are demanding delivery of them from warehouses, and the banks are denying everything in an attempt to avoid a full scale run.

The Chinese courts are involved now too. And they are likely to put the common good, not to be confused with common sense, before contracts and reality.

Is all this bullish or bearish for resources? If there are far fewer tonnes of iron ore, copper and aluminium in Chinese warehouses than anyone thought, and the banking system and construction industry implodes because of it, what happens to the diggers and drillers in the lucky country?

Well, gold offers the hedge for both scenarios. The Chinese want the metals as they get richer, and it is caught up in the rehypothecation mess too. Either way, it should perform well based on China.

Speaking of gold, the World Cup continues tomorrow. It will be a big day. Australia will take on Chile.

The lucky country’s team could not have gotten a less lucky draw. Literally, it’s statistically impossible. If they’re left standing in a few weeks time, it will be a victory.

Last and least, this may be our last reckoning from Albert Park. No doubt you’ll notice us write more slowly from Queensland in weeks to come.

Regards,
Nick Hubble
for The Daily Reckoning

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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can 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.
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2 Comments on "China’s Empty Homes and Missing Resources"

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Jason
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This is the kind of news you would never see in any of the Fairfax or Murdoch press, who along with our government have an official policy of Lick China’s Ass-what could be called the ‘Australian Pekingnese Lapdog Policy.’ China has a few ‘problems’ 1) World’s third lowest fertility rate. 2) An oil importer 3) A rapidly aging population (a real aging population problem not whinging about it) 4) International distrust-many people around the world view China as a threat, as racist and arrogant and untrustworthy. It will take change and time for China to shed this image. Homes will… Read more »
Toenee
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Looks like war then… There’ll be war within and war with out. It always has been this way. Economies and different countries with different ideologies and cultures and axes to grind and other agendas etc. always seem to get into biffo sooner or later when the crap hits the fan and turn upside down. Just ’cause we’re in the tech era/revolution means naught. Just ’cause the world younger folk are more connected (even in countries such as China, Iran etc.)won’t stop the elite from causing some sort of distraction like conflict. Only thing is for connectivity between the world’s folk… Read more »
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