The Great Unwinding of Chinas Credit Bubble

March 14 2014

China is heading for short-term disaster. For years it embarked upon a tremendous credit expansion which led to a miscoordination of scarce resources, especially in housing. Now the Chinese credit bubble is quickly unravelling, exactly as the Austrian business cycle would indicate. I warned that a Chinese readjustment would have “a rippling effect on gold, as well as other commodities tha

The Great Unwinding of Chinas Credit Bubble

China is heading for short-term disaster. For years it embarked upon a tremendous credit expansion which led to a miscoordination of scarce resources, especially in housing. Now the Chinese credit bubble is quickly unravelling, exactly as the Austrian business cycle would indicate.

I warned that a Chinese readjustment would have “a rippling effect on gold, as well as other commodities that were bid up to new record highs during the Chinese credit bubble.” The first signs of the great unwinding are now here: copper, iron ore and coal prices have collapsed and are trading significantly lower. Copper prices were hammered last week, dropping more than 10%, while iron ore suffered its biggest one-day loss in more than four years.

Gold prices, however, have moved upwards arguably due to the unrest in Ukraine and better investor sentiment in the western world. But what will happen next?

A Novelty: Positive, Real Interest Rates in China

Important to note is the fact that falling consumer prices in China have led to positive real interest rates on savings accounts. The interest rate now equals around 3% on a 1-year time deposit, while Chinese (official) inflation has dropped to 2% and might fall further. Of course, the yuan did came under pressure the past weeks, but most still expect the yuan to go higher in the longer run.

Remarkable was last week’s plunge of $104.5 billion in treasury securities held in custody for foreign accounts, a wide deviation from what’s usual and by far the biggest drop on record. No one knows for sure, but this sudden decline might be an indication of China’s willingness to support the yuan to keep it from falling or even to let it appreciate against other currencies.

As a result, a temporary divergence can be expected from the almost 100% correlation between the gold price and Chinese household savings; gold might drop as Chinese deposit more at their banks. This divergence from “the normal” of the past 10 years might result in some pent-up demand down the line, as Chinese investors temporarily favor cash over gold. The “new normal” might well mean lower gold prices for a while.

What’s Next in China

The great unwinding of China’s credit bubble will cause discomfort for some: real estate speculators will go bankrupt, highly leveraged nonfinancial companies will default, Chinese stock prices will fall further, and producers of commodities bid up during the bubble will bear impaired earnings.

Yes, nonperforming loans are also rising, but for now such increases seem nothing out of the ordinary. Bad banks loans in Spain are over 10% of total, but in China they’re at a mere 1%, the Spanish average during the “good times.” Nonperforming loans will increase to 1.2% this year, analysts expect. To put these figures into perspective, US nonperforming loans currently equal 1.7% of total. The number of bad Chinese loans remains pale in comparison to the rest of the world. As such, analysts focusing on these non-performing loans figures risk missing the bigger picture in China.

Will the Gold Rally Continue?

The gold price moved higher in 2014 mostly due to the political unrest in Ukraine. But as soon as the threat of a renewed cold war weakens, the current gold rally may end prematurely. Gold investors might then shift their attention to the developments in China for further guidance.

It is up to the diligent investor to make a judgment to whether the Chinese are more likely to go through a painful process of deleveraging and letting the market reallocate resources or whether the Chinese are more likely to resort to bail-outs, lower interest rates, and relieving banks of bad loans. The turmoil in China is just starting, and Chinese equity investors are advised to wait and see how things will unfold.

My best guess is that China will leave the market readjust itself in some way or another, while backing the yuan. With interest rates as they are, Chinese might move (some of) their savings into bank accounts, while reducing their lust for gold somewhat. The current rally might thus not sustain itself, and gold will eventually close near or below its bottom.

Gold was poised to rally after the widespread negativity at the end of 2013 and might cross the US$1400-mark, but that doesn’t mean the correction in gold prices is a thing of the past. Of course, this is just one of many scenarios; I could be wrong with gold heading higher and higher without setbacks any time soon.

Does It Really Matter?

Does it really matter whether gold prices fall back to below US$1,200 per troy ounce? Gold still trades at a significant discount to its former record height and debt levels are still rising worldwide. The western world is on an unsustainable trajectory and decision makers won’t stop unless halted by the market, and gold will — eventually — outperform traditional asset classes.

Does it really matter whether gold demand of Chinese origin temporarily regresses to the mean, or is uncompensated for by a parallel rise of gold hoarding by the People’s Bank of China? Not really; it merely postpones Chinese gold demand to the future. The trajectory of the western world hasn’t changed and gold will be again a winner sooner or later.

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