Since the 2008 global financial crisis, China’s economy has been moving in a different direction to the rest of the world. Across most advanced economies, companies and households have been busy trying to pay off their debts. Meanwhile, in China a massive government stimulus package has sustained a healthy pace of economic growth in the face of falling demand from the West.
Shadow banks
Yet this expansion of credit has resulted in some worrying side effects, which we believe threaten the stability of China’s financial system, and probably represents the greatest imbalance in markets today.
One of the greatest concerns is the shadow banking sector, which comprises a range of activities outside the official and regulated areas. Government loans have flowed through state-owned enterprises to small and medium-sized businesses starved of cash as well as investors looking for additional yield. But the system is beginning to show signs of stress, which was demonstrated in June when the inter-bank market seized up.
As part of its commitment to maintaining economic growth above 7% a year, China’s government has been adding to the alarming debt pile this year. Our analysis suggests this situation is unsustainable and leaves the economy vulnerable to a credit crunch. The risk of contagion from bad debts is high and there are doubts about the government’s ability to fund a banking bailout.
We are very concerned about the situation in China and believe the credit bubble is likely to burst at some point. In November there was an important meeting for the Central Committee of the Communist Party of China, the highest political authority.
During the Third Plenum, President Xi rolled out his blueprint for the central government reforms. The 46-page document released after the plenum included everything from weakening the role of state-owned enterprises to liberalisation of interest rates and capital markets as well as a relaxation of the one-child policy.
The indicated reforms are a step in the right direction but are not a panacea to the country’s credit problems and slowing growth. The timing and the implementation of the reforms will be crucial. As the system is in a fragile imbalance, too fast or overambitious measures may cause an accident in the Chinese financial markets. The government leaders will meet again in December to decide on a detailed economic strategy for the coming years.
Credit squeezes, bubble bursts
Improved data in August and September indicates the government is able to revitalise economic activity, but only by providing further credit growth. It must strike the right balance between maintaining stability in the financial system without hurting the economy. Yet any serious reforms could cause the bubble to burst as credit tightens, causing growth to slow. We do not know how a banking crisis in China could develop.
However, when the credit bubble does burst, it will undoubtedly send ripples across global financial markets. Investors should be aware and prepared for the fallout.
We do not believe that China’s credit bubble is about to burst imminently. But we believe the risks in the banking system are significant and that investors should protect portfolios by reducing direct and indirect exposure to China. This includes Chinese domestic stocks, especially financials, highly capital-intensive industries that rely on credit, and SOEs. It also includes firms with strong revenues from China, such as luxury goods and car manufacturers, as well as industrial commodity-related sectors that export to China.
Although equity valuations appear cheap, we advise avoiding the temptation of looking for short-term, tactical investment opportunities. The market could fall rapidly at the first signs of any problems. Instead, investors should ensure their portfolios are well diversified by incorporating uncorrelated instruments and assets could help to cushion the impact of the credit bubble bursting as well as other associated risks.
Look carefully at the numbers
They include specialist macro-hedge funds that follow the situation in China closely and have the ability to gain exposure in ways that could deliver attractive returns if the worst-case scenario plays out. These investments should offer diversification when China’s financial system begins to show increasing signs of stress.
Where can we look for signs that the credit bubble is about to burst? The obvious places are measures of the health of the financial system and wider economy, such as Shibor and purchasing manager surveys. However, we believe these figures are unreliable. The Chinese government knows the market is following these indices closely and is likely to be massaging them in order to maintain positive sentiment.
To get a more realistic picture about what is happening in the real economy, we are speaking regularly to people on the ground in China with first-hand knowledge of events as they develop.
