FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
June 27, 2006
IN THIS ISSUE:
1. China’s Economy Is Out Of Control
2. China: Crisis & Implications
3. What, You Haven’t Heard This?
4. Bad News On China Hasn’t Soaked In Yet
5. BCA’s Latest Caution To China Investors
6. Time To Take Profits In China
China’s economy is booming – everyone knows that. But “booming” is an understatement. Most analysts believe China’s GDP is running at a 9-10% annual rate or higher. Industrial output in China surged 17.9% in the 12 months ended May. China’s exports mushroomed by 25.1% in the 12 months ended May. Domestic retail sales soared 14.2% in the last year. Meanwhile, China’s M-2 money supply exploded by 19.1% over the same period. In short, China’s economy is out of control!
The authorities in China know they have major problems on their hands. With growth of this magnitude – both economic and monetary – China is facing an inflationary spiral at some point. Yet China’s enormous manufacturing industry is slashing the prices of goods produced in an effort to increase export sales, which is significantly decreasing profit margins.
Yet an out of control economy, the threat of an inflationary spiral and plunging profit margins are only part of the problem in China. Perhaps worse, China is facing the threat of an enormous banking crisis. As the economy has exploded, Chinese banks have made mountains of loans to borrowers of all shapes and sizes, and today many of those loans are non-performing and will have to be written off at some point.
In short, China may be an economic and financial disaster waiting to happen. This explains why the Chinese stock markets have started to fall this year. As usual, millions of investors have flocked to China’s equity markets over the last several of years. And it’s not just investors; virtually all of the major banks around the world are heavily invested in China and have non-performing loans on their books as well.
In my July 19, 2005 E-Letter, I warned about the potential dangers of investing in China. I specifically warned my readers about the possibility of a banking crisis in China. Many of my concerns about investing in China have come from research done by our good friends at Stratfor.com, the global intelligence network founded by Dr. George Friedman and headquartered here in Austin.
China: Crisis & Implications
This week, I will quote liberally from Stratfor’s recent in-depth analysis of the troubling situation in China. Where you see bold type, that is my emphasis, not Stratfor’s. Let’s get started.
“China announced Wednesday [June 14] that industrial production increased in May more rapidly than at any time in the past two years. Output rose 17.9 percent compared to May 2005. The numbers exceeded expectations. Exports in May rose by 25.1 percent while domestic retail sales grew by 14.2 percent. In other words, the Chinese government's campaign to slow China's overheating economy is not working. On the contrary, the economy is accelerating.
That is why the People's Bank of China (PBC), China's central bank, issued a statement Wednesday saying that banks should be concerned about the potential risks associated with the rapid increase in lending, following a meeting between PBC officials and representatives of China's banks. China's M2 -- the broad measure of China's money supply -- grew at 19.1 percent year-on-year, outstripping government targets. More important is the fact that Chinese banks, which are provided annual targets for the amount they should make in loans, have already loaned over two-thirds of that amount -- with more than half a year to go -- and it appears that the rate of lending is accelerating.
Put very simply, the Chinese economy is out of control. One would think that the faster the growth, the better the economy; but at a certain point -- and in this case -- that is not so, which is why the PBC is trying to get control of the situation. The problem is the massive overhang of debt, and in particular, troubled loans. Looked at from the standpoint of Chinese corporations, servicing this debt is a tremendous burden. Looked at from the standpoint of Chinese banks, the loans threaten the banks' viability if they become nonperforming.
The solution of Chinese companies is to sell more products to generate cash to pay off the loans. It is difficult to sell into the Chinese economy because of high savings rates, driven by government policies and economic insecurity. The Chinese government needs a high savings rate to help stabilize the banks; dramatically increasing domestic consumption would undermine the savings rate, threatening the banking system just as surely as defaulting loans would. The solution for these companies, therefore, is to increase exports. In a world already saturated with Chinese exports, the only way to increase cash flow is to cut already low prices. That increases cash flow but does nothing for profitability. In other words, companies already saddled by debt burdens cut into (or below) profit margins to service the debt.
The banks, meantime, do not want to write off nonperforming loans. The trick is to keep them performing -- at least to some extent -- since the definition of a ‘troubled’ loan is both more elastic and less devastating to a bank's balance sheet. To do this, the banks arrange to lend more money to troubled enterprises. This allows some repayment of old debts, but simply puts off the day of reckoning on all sides (and increases the magnitude of reckoning when it arrives). Thus, bank lending accelerates at a breakneck pace -- not going into market-driven opportunities, but maintaining essentially failed enterprises for a while longer. Production surges at lower prices and the entire process moves faster and faster.
The problem is that any slowdown in economic growth decreases cash flow from imports, cuts into debt payments, and increases nonperforming loans until the entire edifice starts to collapse on itself. This is what happened to Japan in slow motion in the 1990s, and to Southeast Asia with dizzying speed in 1997.
The Chinese government knows it needs to slow down growth to avoid hitting a brick wall. It also knows that slowing down the economy can threaten the entire banking system. It is therefore engaged in setting restrained economic targets and expansionary economic policies simultaneously. It is caught between a rock and a hard place. At a certain point, Chinese companies will no longer be able to grow their exports rapidly. In the case of China, it is the speed bump that is the brick wall. Slowing down is dangerous and speeding up disastrous.
At this moment, therefore, the Chinese economy, incredibly, is speeding up. Virtually every economic indicator we see -- with allowances given for uncertainties in Chinese statistical methodology, to put it politely -- is surging out of control. It has been clear to the Chinese government for a while that this is coming, and it is now clear to the Western media that China is in trouble. Business Week, which has normally written breathlessly enthusiastic articles on the Chinese miracle, ran one this week entitled ‘China: Big Economy, Bigger Peril?’
Indeed.” END QUOTE
What, You Haven’t Heard This In The Media?
Most Americans have no idea that China is in such bad shape financially. Most people have no idea that China is facing a potential inflationary spiral and at the same time a serious banking crisis. If you have money invested in China, either through direct stocks or mutual funds that invest in China directly, or exclusively, I would seriously recommend you consider getting your money out now.
Yes, there is certainly the chance that China will get through this serious economic and financial dilemma without a major meltdown and a stock market crash, but the odds are not good. And we do not have to rely on Stratfor alone to document how bad China’s problems are. Recently, such heavyweights as Ernst & Young, Price Waterhouse Coopers, McKinsey Global Institute and Fitch Ratings have all issued reports warning about China’s non-performing loans.
Fitch Ratings (www.fitchratings.com) is the international ratings agency with offices in over 75 countries and provides issuer and bond ratings, research and surveillance on banks around the world. Now let’s return to Stratfor as Dr. Friedman gives us an idea of the magnitude of the Chinese bad loan dilemma:
“Fitch is estimating China's bad-loan situation (our term, lumping all these categories together) at [US]$673 billion, but it warns that -- given Chinese accounting and reporting, and the fact that what reporting exists is not credible -- $673 billion is a low number. That's important. If $673 billion was the final number, then measures that are put in place could limit the ultimate losses to a level below that figure. If, however, the total number of bad loans is substantially higher than $673 billion -- which is our view of the situation -- then the system would be lucky to have to write off only this amount.
There are numerous ways to measure the magnitude of the problem, but one of the simplest is this. China is said to hold nearly $819 billion in foreign reserves. Fitch's conservative estimate of the bad loan situation comes close to matching that number, and a more liberal calculation would swallow those reserves up and then some. Put very simply, the Chinese banking system is in deep trouble -- and with it, so is the Chinese economy.
It has become an article of faith that China's economy is booming. The economy certainly is growing rapidly. But growth and size alone don't tell you how healthy an economic entity is. During the Great Depression, the U.S. economy was enormous, but it was crippled. Japan's economy was growing at a phenomenal rate in the 1980s, all the while heading for its disaster. Size and growth are but two measures of an economy -- or of a business. They do not tell you how well it is doing.
The basic problem of the Chinese economy, as in many Asian nations, is that the banks have not made loans with business considerations in mind. They made loans for political reasons and to maintain social stability. In many cases, loans were seen as being more like grants. As a result, they were invested in enterprises that did not make enough money to repay (or even attempt to repay) the loans. Frequently, rather than bankrupting the business or writing off the loan, the banks lent more money to the business -- so that it could repay old debts, and there was an appearance that the loans were viable. Loans went into land speculation or to investments in areas that were already overbuilt. (And this does not attempt to take into account ancillary problems, such as corruption and embezzlement, which also have been significant issues for the Chinese government.)
In the first part of 2006, there has been a huge surge in lending in China. With the economy already growing at rates of more than 9 percent, it would seem structurally impossible to grow it any faster. Shortages in skilled workers, management, buildings -- all these limit the rate of growth. The truth is that a substantial portion of the loans that went out were issued to keep bad loans floating, like using one credit card to pay the monthly payment on another. You can do that for a while, but you can't do it forever.
What keeps the Chinese system alive is not domestic consumption, which is not rising in tandem with overall growth. What keeps China afloat is exports -- exports in ever greater numbers, and with ever-smaller profit margins.Surging exports are critical to China, as they were to Japan before it. They generate the cash that allows the financial system to continue operating.
This is also the Achilles' heel of the Chinese economy, as Fitch points out.” END QUOTE
Bad News On China Hasn’t Soaked In Yet
If you are reading this troubling news on China for the first time, don’t be surprised. The financial media has, by and large, ignored the big-name studies released just recently on China’s huge bad loan problem. While the recent studies on China’s bad loans turned the most of the market indexes lower, most of the indexes are still substantially higher than they were in 2004 and 2005. Investors who bought China stocks or funds should still have decent to substantial profits. I recommend you consider reducing your exposure to China now.
There are plenty of analysts who believe China will work its way through the bad loan dilemma without a crash, and maybe they will be correct. If so, then maybe Chinese stocks will move higher over the next couple of years. However, the risks of a financial meltdown in China are just too great now in my opinion. Dr. Friedman obviously agrees:
“Here is the problem. The official policy of the Chinese government is to cool off the economy. In fact, the Chinese are attempting to cool growth only in certain sectors, where they perceive particularly dangerous bubbles starting to form. For the most part, however, they are doing everything they can to keep the economy hot, in order to try to manage the financial problem. Now, Fitch argues in its report that the Chinese banks are better equipped than in the past to deal with their problems. We agree with that assessment; they were completely unprepared in the past and now are abysmally prepared. You cannot prepare to deal with a loan situation as bad as that in China. You simply keep cycling as fast as possible and hope that something turns up.
In our view, this [recent] spate of reports on China's financial situation marks a turning point.
One of the things that has kept the Chinese economy booming was cheap exports. But another was the perception in the West that, underneath it all, China was sound. This perception induced foreign banks to invest in Chinese banks. . . However, when ‘irrational exuberance’ (to quote Alan Greenspan) is at its peak, it is hard to break through the noise. Markets continue to rise, even as bad news comes out. Last week, for example, we saw the Bank of China make its initial public offering and shares soar, just as these financial reports were emerging. That doesn't mean these reports are wrong or that the Chinese have things under control. It simply means the market is ignoring news and rising on its own giddiness.
Nevertheless, a turning point has been reached that will be difficult to ignore. Reports from Stratfor are, of course, one thing. Reports from a single credit agency are another. But when a series of reports from highly respected, mainstream analysts all come out within a few days of each other -- with each, in their own way, telling the same basic story, it becomes hard for the system to dismiss that. Western companies moving into China have CEOs and CFOs who must exercise due diligence. There are now too many reports out there to be simply ignored. All of them are caveated. None of them write China off. But a critical mass is forming that will cut through the froth in due course.
Obviously, this does not mean that China will implode, disappear or anything like that. It will remain an enormous economy and an important one. But this does mean that the dynamics of the Chinese economy are shifting. The debt issue represents a deep structural problem that China will either deal with -- as South Korea did -- or not, as Japan did not. (Japan reaped more than a decade of economic stagnation as a consequence. It is significant that China lacks the degree of insulation that Japan built up; the economy has more external exposures and would not weather a similar crisis as well.) The point is that, ultimately, the books have to balance everywhere. That means that the huge structural imbalance of China, which these debts represent, must be rectified. And that process, as in all such matters, will be painful.
It is not clear how much pain Chinese society can withstand before it fractures. This is clearly a concern for Beijing as it tries, simultaneously, to reform the economy and to crack down on dissent. The Chinese, like anyone in this fix, try to put the best possible face on the situation. Which is why they exploded at Ernst & Young [for their recent financial report]. But even the government in Beijing couldn't shout down the ensuing tidal wave of financial reports; instead, they grumbled and pointed to the passages that said it could all be managed.
Perhaps it can. But if it can, it won't be easy -- and we doubt that it is possible. We have been writing about this problem for several years now, and people keep asking when the crisis will come. Our answer is simple: If this isn't a crisis, what would a crisis look like? The Chinese financial system is sinking under nonperforming and underperforming loans. . . At some point, the weight of evidence will shift the behavior of the Western financial community, and that will be that.” END QUOTE
Clearly, Stratfor believes that it is only a matter of time before the love affair with China will be over. If true, that should mean there is much more on the downside for China’s stock markets.
BCA’s Latest Caution To China Investors
The Bank Credit Analyst has been bullish on China for the last several years, and they have been correct in their advice to invest in so-called “A,” “B,” and “H” shares on the Chinese stock exchanges. Incidentally, in addition to offering economic advice in their various publications, BCA also manages money for investors through one of their related affiliates. On June 8, BCA notified clients and subscribers that they were stopped out of all their long positions in Chinese equity shares, and they recommended staying out of China shares for the time being.
In BCA’s June 8 issue of “China Investment Strategy,” the editors opined that the Chinese economy is due to slow down later this year. As such, they suggested there will be a better opportunity to repurchase A, B and H shares at some point in the future, which indicates that they are still positive on China over the long-term.
However, it seems clear to me that in early June the editors at BCA did not have the benefit of the latest studies from Ernst & Young, Price Waterhouse Coopers, McKinsey Global Institute and Fitch Ratings, which all issued warnings about China’s non-performing loans. It will be interesting to see if BCA remains long-term positive on China in light of those reports.
The bottom line is, BCA is out of the market in China and that is what I recommend to you.
As I see it, and Dr. Friedman sees it, there are no good options for China over the next several years. With their economy surging at 9-10% or higher per annum, China risks an inflationary spiral, and as we all know, that will not end pretty. On the other hand, if the Chinese authorities raise rates enough to slow down their red-hot economy, they could well face a banking and financial crisis. Either way, China faces a tough situation over the next few years!
While the Chinese authorities have taken baby steps toward slowing the economy slightly, such as the recent increase in the bank reserve requirement, it would appear that the authorities are not willing to slow the economy significantly to reduce the threat of inflation. With the political threat of a recession, and a possible banking crisis, the authorities appear willing to let the red-hot economy continue. This means the bad loan problem will only get worse.
What Stratfor does not address in the analysis quoted above is what effects will a major problem in China have in the US and the West in general. I would argue that a major problem in China – whether it be soaring inflation or a banking crisis – will be very bad news for the US and the West.
As noted above, most of the major Western banks and financial institutions have large investments in China, some or many of which may be in non-performing or under-performing loans of various types. It remains to be seen how they will deal with the valuations of such loans in light of the recent reports from Ernst & Young, Price Waterhouse Coopers, McKinsey Global Institute and Fitch Ratings.
The bottom line is, the risks of investing in China now are very high in my opinion and that of Stratfor. Even BCA, which tends to be more optimistic, has closed out all of its clients’ positions in the Chinese equity markets. If you are invested in China, I would recommend you consider doing the same. If you have invested in China, or funds that invest primarily or exclusively in China, over the last few years, you should have very nice profits, even with the recent decline in the markets.
Finally, as you have read above, there is certainly the possibility that the wheels could fall off of the “Chinese miracle.” If that happens, the Chinese stock markets could go into a multi-year nosedive, much like we saw in Japan in the 1990s, or even worse. I recommend that you consider taking profits now. You don’t want to be long Chinese shares or funds when the herd of investors that have rushed into China in the last few years decides to bail!
I also believe a meltdown in China could send the US and Western equity markets into a bear market as well. This is just another reason why I have virtually all of my investment portfolio managed by professional money managers who use “active management” strategies that can move to the safety of cash or “hedge” long positions should we get into a bear market or an extended downward correction in equities.
Maybe it’s time you looked at these risk-averse programs as well.
Wishing you profits,
Gary D. Halbert
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