China is a dream world that’s symbolic of current investor psychology. Because real economic growth was so hard to achieve in the U.S. as consumers became overly indebted late in the 20th century, Wall Street and the powers-that-be looked to China as the next engine of global economic activity. For many years companies here have benefited enormously from trade with that nation. Nonetheless, we suspect China’s growth story over the last decade will go down as the biggest financial fantasy of all time in the sense that so little of it was truly organic or based on competitive markets. It was mostly the result of central government planning and reckless infrastructure spending.
Massive debt growth fueled their bubble just like it did about everywhere else on the planet. In fact, according to a recent Wall Street Journal article, “analysts at Standard Chartered PLC estimate that Chinese corporate debt was equivalent to 128% of gross domestic product by the end of 2012, up from 101% at the end of 2009.” That absolute level of debt is a major red flag and their growth rate is another. The article goes on to say that “according to a 2011 report by the Unirule Institute of Economics, an independent think tank in Beijing, once government support such as cheap loans, rent-free land and direct subsidies—cash injections—are stripped away, China’s industrial state-owned enterprises were unprofitable between 2001 and 2009.” We simply continue to wonder how much longer this can continue if this is even close to the truth.
The Wall Street Journal also recently contained a piece on China by a Morgan Stanley analyst who wrote that “since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the ‘shadow banking system,’ private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans. Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.”
The Chinese central bank (PBOC) has been tightening monetary policy, though few have mentioned it. This occurred even though copper inventories in China remain very elevated versus this time last year and economic growth seems spotty. It also appears that the leadership there wants to contain housing growth with renewed vigor. They are raising down payment requirements and limiting purchases. Given the historic growth-at-all-costs mentality, one would expect pro-growth policies. We have to wonder why they are pursuing a renewed effort to contain economic activity. We also wonder why tremendous credit growth is having so little incremental impact on GDP, which is growing closer to 3-4%, not the “official” 7-8%, according to outside observers. We suspect that troubles with bad loans are finally starting to weigh on policymakers desires to continue to do business as usual.
Chinese banks are very tight-lipped about losses, of course. However a recent article from Quartz reported that: “Shang Fulin, the chairman of the Chinese Banking Regulatory Commission, raised concerns at a mid-January meeting that over half of the 67 trillion Yuan of loans held by Chinese financing institutions have been made to risky borrowers such as local government financing vehicles, property developers and industries with overcapacity. Shang added that such loans need to be ‘heavily fortified’ and require ‘classified policies.’” Who knows how long it might last, but it looks like China may for now be more interested in dealing with past problems loans as opposed to continuing to create them. In essence, it looks like maybe bad loans have reached a level that clogs the financial system to such a degree that rapid growth might compound the problem. Call us crazy, but maybe China’s leaders are losing control of that economy.
The Chinese example shows that central planning has both unintended consequences and limitations. We may be dealing with the same realization in the U.S. Financial fantasy is not a healthy underpinning for any sound investment philosophy.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.