What Is Happening in China?

March 21 2014

Chinese banks extended over US$ 15 trillion in loans (140% of Chinese GDP) over the past five years. Yet credit in itself is not an evil; when it’s backed by savings it only represents a certain amount of unclaimed resources, which can now be used in production. Our societies thrive on credit. It is indispensable in almost every walk of life and it was perhaps even the catalyst that freed th

What Is Happening in China?

Chinese banks extended over US$ 15 trillion in loans (140% of Chinese GDP) over the past five years. Yet credit in itself is not an evil; when it’s backed by savings it only represents a certain amount of unclaimed resources, which can now be used in production. Our societies thrive on credit. It is indispensable in almost every walk of life and it was perhaps even the catalyst that freed the human race from the harsh reality of our natural state of poverty.

But did China extend more credit than warranted by high Chinese savings? What about the shadow banking system in China? What happened in China the past five years and where will it go now?

We’ve Heard This Before

The subprime-crisis in the US was a cobweb of (re-)hypothecation and asset packaging. Yet in China something similar happened. As the People’s Bank of China expanded its balance sheet ruthlessly in an effort to maintain the peg of the yuan to the dollar, it bought US-dollar denominated assets while expanding its liabilities, which amounts to a monetary injection. This in turn led to a credit bubble in real estate and infrastructure.

So what did Chinese banks do? Chinese banks engaged in similar activities as US banks before the subprime-apocalypse. Chinese banks repackaged their loans and sold them to trust companies en masse. Then the banks would buy the trust product and sell it to their customers. It was an excellent way for Chinese banks to offload credit risk to others. After a while, trust companies got an even smarter idea: to do it all by themselves. They extended credit directly to real estate developers and then sold the credit as a trust product to investors.

The latter means the unwinding of China’s credit bubble will not be shouldered by just the banks, as happened in the US. Real estate speculators and trust companies will share the burden.

Default Avalanche Starting

We’re starting to catch the first glimpses of a major wave of Chinese defaults. For instance, Chinese steel company Highsee Group defaulted on a 3 billion yuan debt last week. Likewise, Liansheng Resources Group (a Chinese coal miner) defaulted on its debt too. Curiously, Liansheng’s debt was — as many others — repackaged and sold as a wealth management product. Now it appears that the PBOC considers bailing out the holders of the repackaged debt, but not the miner itself.

It's not just steel and coal, however. The Chinese brokerage South China Futures terminated its business on "major operation risks." South China Futures is one of the first dominoes that has tumbled in China, and more is yet to come.

Slowdown in Chinese GDP Growth Inevitable

Almost 50% of Chinese GDP growth originated the past few years from the real estate market. A slowdown in Chinese GDP is therefore inevitable. Some investors still count on 8% growth annually the coming years, but knowing what we know now, that scenario seems highly unlikely. A better estimate would be roughly the half, or perhaps, for some time at least, even less.

Declining GDP growth could hit China rather sooner than later, as growth in investment, retail sales and factory output all fell to multi-year lows. Investors are and have been hyper-focused on Chinese GDP numbers, yet the 8% GDP growth of past years were driven in part by its credit bubble and excessive real estate speculation. It is, as Ludwig von Mises would call it, “malinvestment” and will go bad in the future although we now count it as “economic growth”. The 8% of the past was partially illusory.

What Will a Chinese Slowdown Mean for Gold?

In my last article on China, I argued that real interest rates on savings deposits are, for the first time since very long time, positive. This statement still holds and therefore I foresee some weakness in gold prices down the line. China seems to be aware of the risk of creating legions of “zombie banks”, insisting that banks take substantial hits, but at the same time seem to be willing to bail-out Chinese depositors.

All other things equal (Crimea, tapering), the unravelling of China’s credit bubble might have some negative short-term effect on gold prices. All said, I’m still bullish on gold and China in the long run, and I might even be picking up some Chinese stock in the future, as Chinese stocks will continue their fall.

As long as China doesn’t lower its benchmark interest rate and vows to bail-out depositors from the ruins of bank credit, Chinese investors will not necessarily flee to gold, contrary to what Alasdair Macleod argues. Be aware of China, dear gold investors.

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