2015-10-13

Sausage Maker Can't Pay the Bills, But China's Economy Won't Crash

I've seen a lot of crash talk lately, mostly about how China won't crash. Such as this one from Deutsche Bank economists: Here's where you're wrong about China, which includes yuan devaluation as part of the mix. It calls for a turnaround in the next quarter or two and Chinese economists basically agree with that forecast.

I think much of this discussion misses the mark though. The economic contraction in the United States in 2008 was a bad recession, the whole crisis was about a 3% reduction in GDP. Yet it led to a 50% plus drop in the stock market and the failure of major banks. The risk in China isn't an economic crash, it's a financial/debt market panic that spills over into the economy. Given China's penchant for intervention, I suspect the markets would close and limit the downside risk (as long as you're OK with buy and hold). The major losses would be felt overseas in the free markets.

Bloomberg: China Sausage Maker Says May Miss Bond Payment as Defaults Mount

Maybe the ChinNext vs Nasdaq analog will break down, but the amazing similarity to this point tells me this time not only isn't different, history is painting a picture of itself repeating. If the analog holds and multi-month bear market with nearly continuous losses greets the start of 2016, the pain won't be contained to the stock market, nor to China.

From February 2014, China's Volatility Machine
This makes China's economy very fragile. Even without these commodity backed loans, China's economy is at risk from a downturn in commodity prices that weakens demand in emerging economies. With these loans backed by commodities in place, commodity prices are now at risk from Chinese loans souring. If these commodities flow back into the world market, it will be the very trigger event for China's own bust.

On top of all this, much of the shadow banking credit flowed into investments in coal mines and real estate, the former of which is tied to global commodity prices and the latter to China's credit boom.

In conclusion, China has experienced a very long boom phase thanks to reckless lending taking over from 2008-2013, when global growth slowed. Instead of developing an internal market and making counter-cyclical investments, China bet everything and then leveraged up in order to bet on the China/emerging market/commodity cycle.

The one big counter-cyclical asset on China's balance sheet is its vast holdings of U.S. Treasuries. It is one asset that will surge if there is a global emerging markets crisis. Gold will likely be another. Considering the Chinese are likely to devalue the yuan if a deflationary crisis breaks out, those Treasuries and gold holdings will allow China to avoid a complete currency collapse—but it still may devalue the yuan by a significant amount by the end of the bust. That will set the stage for the next great boom......
I see some data points that give me pause, such as the pickup in home sales and land sales, but it's not enough to change my long-term expected outcome for China's credit bubble.

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