"China's Bubble" Warning By Doomsayers

You gotta love it how more and more people just seem to join the chorus once somebody with some credibility says something interesting. China is in the midst of "the greatest bubble in history," said James Rickards, former general counsel of hedge fund Long- Term Capital Management LP. Who is Rickards??? Why is he saying things at all? He's just the counsel at what was the biggest collapse in the 90s.... aahhh. The Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan, said Rickards, now the senior managing director for market intelligence at McLean, Virginia-based consulting firm Omnis Inc. Rickards joins hedge fund manager Jim Chanos, Marc Faber and professor Kenneth Rogoff in warning of an overheating and potential crash in China's economy following a rally in stock and property prices. Now even the World Bank has chimed in to say the same thing.

Are we heading down the road as opined by those above. Beijing has already raised lenders' requirements twice this year. Let's look at some problem areas.



If China’s credit growth were to slow sharply, non-performing loans (NPLs) would spike by the end of the year. Although the problem would not be as large as in the late 1990s, another recapitalization would be difficult without tapping government coffers. The asset management companies set up to recapitalize the banks in 1999 have yet to repay their loans, and nobody is willing to buy their assets at prices anywhere near what would be needed to cover their costs.

The problem seems to be with the politically-connected municipal investment and development companies (MIDCs), which would likely be able to maintain their credit lines. The MDICs are at the center of a risky shell game with local banks, in which land and credit lines are swapped to maximize the companies’ access to financing. However, most infrastructure projects financed by these companies remain a long way from profitability, and land prices used for collateral were seriously inflated last year. If they no longer had access to credit, many MDICs would default, which would spark a tough fight over who is responsible for the redemption of the loans. The China Banking Regulatory Commission (CBRC) estimated that 8,000 MDICs accounted for 14% of new lending in 2009, though other estimates put the figure much higher.

In the Chinese bond market their presence was even larger—they issued RMB250 billion in bonds last year, up from RMB30 billion the year before, accounting for the bulk of the 88% jump in corporate bond issuance through Q3 2009. The State Council recently said it is seeking to regulate these companies, calling their financing a “latent systemic risk in the financial sector.”Chinese regulators have told commercial lenders to restrict new lending to municipal development companies, the official Shanghai Securities News reported on February 24, 2010. Banks were told to stop lending to any projects backed solely by a local government guarantee and reject any projects that lacked adequate capital.

Victor Shih, a professor at Northwestern, estimates that their total borrowing between 2004 and 2009 was US$1.6 trillion (RMB10.9 trillion), or about 33% of GDP and 70% of its foreign exchange reserves. Banks have already pledged additional credit to the companies. "If the central government does not restrict bank lending to them, these entities will go deeper into debt, thus either requiring the sale of much more land or the creation of a pile of nonperforming loans."

Shih estimates that government debt, including the hidden liabilities, could reach RMB39.8 trillion (US$5.8 trillion) or 96% of GDP in 2011. This includes non-performing loans held by state-owned banks, liabilities of the development banks, and the debts of the asset management companies set up to recapitalize the banking sector. "The worst case is a pretty large-scale financial crisis around 2012". "The slowdown would last at least two years and maybe longer."In 2009, the Ministry of Land and Resources reported that government land sales netted RMB1.6 trillion (US$234 billion), most of which went to local government coffers. The government sold 319,000 hectares of land in 2009, up 44% from 2008, the revenues from which increased 63% y/y. Land sold for "real-estate use" accounted for 84% of this. At the height of the previous property bubble in 2007, the government raised RMB1.3 trillion from land sales. If China's property bubble were to burst in 2010 the revenue from land sales could dry up, which would weigh heavily on local governments' abilities to continue financing the stimulus.

Official debt-to-GDP ratio was 17.7% at end of 2008, but this may be closer to 60% once local government debt, backstopped bank loans and bad assets are included. This is still below the U.S. level and not explosive, but stimulus spending by local governments and loans from state-owned banks may push the 2009 fiscal deficit up to 10% of GDP.

Hot money poses another problem for RMB appreciation. If the RMB looks like a one-way bet, which a modest and steady appreciation path would indicate, then international funds will find their way into property and other assets in Beijing, Shanghai and the other major cities. RGE estimates that China experienced about US$40-50 billion in “hot money” inflows in Q4 2009. This could worsen the asset price bubbles regulators have been trying to ease since late last year. (Housing affordability is among Chinese consumers’ top complaints.)

There are problem spots in China, and its mainly in property. The MDICs are too reliant on land sales and have borrowed excessively. Its about to implode anytime, just another couple of rate hikes and another round of curbs on lending should do that.

While that may also deflate China stock markets, I do think the ill effects on stocks will be very temporary. Just have a look at the two charts below:

While the US is gaining share, China is losing share. Aside from an uptick in the summer months of 2009, China's stock market cap as a % of world market cap has been trending downward throughout the entire rebound.

One of the easy ways to see how a country is performing relative to other countries is to look at its market cap as a percentage of world market cap. In the early stages of the global rebound off of the March lows, the US rose significantly, but other countries were gaining even more. In recent months, however, the tide has turned, and the US is now outperforming the rest of the world. As shown below, US stock market cap as a percentage of world market cap has been steadily rising since last November. During the 2003-2007 bull market, emerging markets and other countries really outperformed the US. If this bull market continues and the US continues to gain share, it will represent a very big trend change that will make a huge impact on portfolio performance depending on an investor's domestic versus international equity allocation.

The charts also reveal that the bulk of the liquidity has gone into property and not stocks. Hence it will have a muted effect when property side busts.

Moody's upgraded China's ratings outlook to positive from stable on November 9, 2009, keeping the rating at A1, on expectations that the country's economic recovery is taking stronger hold with only modest effects on the government's finances. The agency cited possible asset price bubbles and the long-term effects of China's stimulus program as risks to its outlook. It also upgraded the ratings for seven Chinese banks, a sector that some analysts worry may be hit with a surge in non-performing loans following this year's sharp credit growth. Moody's said that the banks could withstand such "stress scenarios" given their strong capital positions and earnings.

There are those who would defend the property boom in China. JPMorgan's Jing Ulrich argues in the FT that Chinese real estate is not overvalued and the fallout of a price contraction would not be severe because there is less leverage involved. "Chinese household debt amounts to approximately 17% of GDP, compared to roughly 96% in the US and 62% in the eurozone. ... Over the past 5 years, urban household incomes grew at a 13.2% compound annual growth rate, compared to an 11.9% CAGR in home prices."

While that may be the case, the problem with China property is with the MDICs and not the end buyers per se. So, JP Morgan can still be wrong.

May main reason for saying China is not headed for a big implosion is that the Chinese economy is still relatively a relatively closed economy. The liquidity swishing around is still controlled by Beijing, with the exception of some hot money into property. We cannot regard China like normal more open economies - e.g. Malaysia or Indonesia, where we can be on the receiving end of a lot of hot money, and will feel the gravity of it when these funds exit. You do not have such a keen issue in China.

Beijing knows the unbalanced lending to state firms and municipal councils, and is trying to redress the problem, albeit a tad late. Really should get out of China property for the next 12 months.



p/s photos: Wang Yi Bing

The Real Picture Behind 'China Crisis'

There are basically two groups of investors in their opinion of China's economy. In one camp are those who are optimistic on the economy’s strength and its ability to thrive in an otherwise bleak global environment.

The most recent economic data release showed a sharp rebound in the Chinese export sector has further enhanced the positive sentiment

In the other camp are an increasing number who believe that China’s economic
miracle is nothing but a mirage and that 2010 will be a year of painful reckoning. Some analysts are claiming that China’s growth model is fundamentally flawed and the massive stimulus measures adopted since late 2008 have only intensified the economy’s structural imbalances, which will make the inevitable downside adjustment even bigger. The usual worrying features of the economy such as asset bubbles, “mis-investment”, an inefficient banking system, growing social unrest and corrupt governance - some are predicting an imminent economic crash and even social chaos. Some prominent hedge fund managers have reportedly even begun shorting the “China story” in recent months. Well, for every buyer, there has to be a seller... so the story goes.

Is the economy headed toward a sudden collapse, as expected by the “house of cards” camp? The answers to these questions obviously weigh heavy in investors’ decision making. There has never been a lack of skepticism toward the Chinese economy. Even 5, 10, 15 years back, there were the usual China-bashers and permanent-bears who have been proven wrong over and over again by the country’s enormous economic success and social progress over the past three decades. However, the question marks about the country’s fundamental growth model deserve careful assessment. The core argument of this bearish camp is that the Chinese economy is mainly driven by capital spending and exports, both of which have exhausted their potential. The economy is bound to slow sharply due to a lack of new sources of growth. Or is that the full picture?



While there is always a chance of a major collapse in any economy, I think China is going to chug along just fine. I do not think that China’s capital spending is excessive. China’s capital spending boom has mainly been driven by profit incentives rather than government direction. Those who think that China’s capital spending is terribly inefficient and will face an imminent crash will be proven wrong. If you take the data and extrapolate on internal capital returns on the country's projects - China's figure is very much in line with other developing countries.

Second, one may argue that the U.S. consumer sector has entered into a prolonged period of deleveraging, and that its demand for Chinese products will never recover to pre-crisis levels. However, an important fact is that China’s export market has become increasingly diversified. If you refer to the chart, even though the U.S. remains the largest market for Chinese overseas sales, its market share has shrunk from a peak of 22% in the late 1990s to 17% today. In fact, Chinese sales in some of the nontraditional export markets such as Australia, Latin America, Africa and the Middle East have experienced much faster growth in recent years than sales to other developed markets.

Meanwhile, China continues to reduce trade barriers with emerging Asian countries. At the beginning of this year, China and the 10-country Association of South-East Asian Nations (ASEAN) formally established one of the largest regional free-trade zones in the world.

Over the years, the Chinese authorities have worked to boost domestic consumption in an attempt to reduce the economy’s dependence on exports and capital spending. In this sense, slowing capex and exports should be taken as a positive sign, as it means that policy makers’ consumption-boosting initiatives have finally begun to bear fruit.



The Chinese authorities still have a lot of room to boost growth. Infrastructure in the country’s rural regions is still grossly insufficient and needs tremendous government input. Massive domestic savings and the very low public sector debt burden means there is a lot of financial resources the government can utilize to buy a lot of growth, similar to what they have done over the past year. This kind of growth-boosting campaign is of course unsustainable over a prolonged period of time, but China is among the few countries in the world that are most capable of dealing with a crisis scenario with extraordinary policies – and have a significant war chest to do it with.

Hence we should not see a crash or a major crisis of any sorts in 2010. Yes, the markets will have to experience some bumps here and there, in particular when Beijing tries to tighten the screws on lending and rein in liquidity a bit every now and then - but its for the betterment of the economy, not a noose around the economy's neck.

Currently, the authorities are beginning to tighten policies again. The risk factor is the country’s bubble-prone asset markets and potential damage to its banking system. Specifically, as a result of China’s massive household sector savings and highly pro-cyclical global capital inflows, Chinese asset prices are prone to boom-bust cycles. So far the extreme volatility in asset prices, such as the 70% crash in the domestic A-share market and housing price declines in some major metropolitan areas between 2007 and 2008, has inflicted little damage on banks’ overall asset quality, as the above chart would indicate clearly. This is because policymakers have maintained a significant buffer between asset markets and the banking system - banks’ mortgage lending practices have been very conservative, with a mandatory down payment ratio of 20-40% for real estate purchases. Banks’ direct exposure to the stock market is also negligible, as leveraged investments are not allowed.

Recently, the authorities announced that index futures, margin trading and short-selling in the A-share market have been officially approved. Even though it may take months for these instruments to be developed and deployed, and they are undoubtedly positive in terms of improving the efficiency of the domestic capital market.

Structurally, China’s economic performance will most likely continue to outpace that of the rest of the world. This warrants a more positive stance on Chinese assets over global benchmarks, especially as current valuations of Chinese assets are comparable to global and emerging market averages. Have a look at the chart above on China's valuations - its very reasonable still. From a cyclical point of view, it’s important to recognize that there is a disconnect between a country’s economic performance and its stock market. One does not need to be super-bullish on an economy’s immediate growth outlook to be positive on its financial asset prices.

Stock markets are highly sensitive to policy shifts, which is a lagging response to economic performance. Weak growth leads to policy easing, which is stimulative for the stock market. Similarly, strong growth normally leads to tightening policy, which bodes ill for equity prices. In some cases, good economic news turns out to be a headwind for stocks. Currently, China’s strong growth recovery is pushing policymakers to tighten, a critical juncture that is typically associated with heightened volatility in equity prices. While the Chinese A-share market will continue to struggle in the coming months, investors should not take this as a sign of pending economic troubles. These tightening measures are good problems to have.


p/s photos: Gu Chen

China Banks' Risk Profile

The bulk of market capitalisation in Asian equity is in bank stocks. China has been leading the way, and the banks' health should be monitored closely. We know of the rampant bank lending that has been on going for the past 12 months. Now we need to know the extent of the potential bad debts and how that would play out in 2010. We already know that bad debts for credit cards have already doubled year on year and that is an ominous sign.

China's banks posted strong profit growth in Q3 2009 as new lending continued to surge. The jump in new lending meant that non-performing loans decreased as a percentage of assets. Regulators started to tighten lending standards in Q3, which along with the need to meet new capital adequacy requirements, could eat into profits. However, a shift toward longer-term loans and of savers into demand deposits may increase the net-interest margin for banks, which fell through Q3 2009 due to lower interest rates.

Capital Adequacy Ratios

Fitch warned that due to "major ongoing weaknesses in loan classification and disclosure of off-balance-sheet exposures" China's banks' capital positions are probably worse than they appear. The banks have used an increasing amount of off-balance-sheet transactions to bundle loans and sell them to investors, which represents a "growing pool of hidden credit risk." These transactions free up space on the banks' balance sheets so that they can increase their lending without lowering their capital adequacy ratios.

China’s Banking Regulatory Commission denied reports that it would raise the minimum capital ratios to 13% in 2010 from 10-11% now, but it said that banks would need to develop “medium-to-long-term plans” to replenish capital after the lending binge of 2009. As of September, all of the largest banks except the Bank of China had capital ratios over 12%. The shift toward longer-term loans from Q2 2009 has boosted the net interest margins of China’s banks, but the loans also come with higher risk weightings, pushing down their capital ratios. In order to maintain their 12% capital adequacy ratios, China’s 11 largest listed banks would need to raise an additional RMB368 billion (US$43 billion) in capital, according to calculations by BNP. Core capital adequacy ratios at the banks fell to 8.9% at the end of September 2009, from over 10% at the end of 2008.

In August 2009, the WSJ reported that the China Banking Regulatory Commission was considering a ruling that subordinated debt held by other banks would no longer count as supplementary capital. Estimates suggested that as much as 51% of subordinated debt issued by banks (RMB210.0 billion in H1 2009, three times the total amount for 2008) was held by other banks. In October, regulators issued a ruling that was significantly easier for banks to meet: Only subordinated debt acquired after July 1, 2009 would need to be deducted from Tier-2 capital. This will make it more difficult to replenish capital by issuing subordinated debt but does not require significant changes as a result of the ruling.

When the government recapitalized the banks in the late 1990s, it formed asset management companies (AMCs) to purchase non-performing loans from the banks, which were funded through bonds held by the banks. The AMCs have had very low recovery rates on the NPLs, and their bonds may have to be rolled over or written off. The government opted to allow at least one of the recapitalization bonds that allowed China's banks to become commercial enterprises to be rolled over for another decade. A US$36.2 billion bond held by Cinda Asset Management was to come due at the end of September, but was rolled over for another ten years. Writing off the principle due would have cost CCB more than half of its net assets, and the remaining bonds, which come due in 2009/10, are expected to be rolled over as well.

From October 2009, insurance companies will be allowed to invest in the property market. This will allow state-owned banks to transfer underperforming commercial property holdings to insurers at book value, and insurance companies will not have to write down the property values because they will be booked as long-term assets. This lets insurance companies diversify their assets to better match the duration of their liabilities but also protects banks' balance sheets.

Central Huijin, a division of China's sovereign wealth fund, said that it would continue to buy shares in China's three largest banks to reassure investors and stabilize their share prices.

How Much Will Non-Performing Loans Increase?

The increase in NPLs may come in mid to late 2010 given that they tend to peak 12-18 months after a credit boom. However, the revival in property markets and increase in mid- to longer-term loans may limit the deterioration of assets.

The surge in NPLs would be limited to RMB400 billion (US$58.5 billion) in 2010, but another RMB250 billion (US$36.6 billion) in NPLs could emerge in 2011. If credit is tightened more in 2010, NPLs would jump higher.

The Banking Regulatory Committee is raising minimum capital adequacy requirements from 8% in 2008 to 11% by 2010, but the PBoC controls the reserve requirements, blunting the regulators’ ability to control loan growth.

FT Dragon Beat: If 1/6 of the RMB20 trillion in bank lending to be issued from 2008 to 2010 goes sour, then the government's liability would be RMB3.3 trillion, which is about the same as all the nonperforming loans recognized so far.


p/s photo: Freida Pinto

China Is Really Aware That It Has a Bubble Situation

Unpaid credit card debt in China has risen by a horrifying 126.5% from a year ago. Beijing should have known this very well as it was central government which instructed the banks to lend like crazy 12 months ago. As at the end of September 2009, there was 7.43bn yuan of credit card debt that was at least 6 months overdue. Mainland Chinese banks pushed those credit cards aggressively when Beijing "encouraged" the banks to be "easier with loans and credit disbursements". Beijing had encouraged banks to expand that line of business thinking that it would boost retail sales. Well, it may have had that effect, but they now also have a credit binge problem. The overdue amount represented 3.4% of total credit card debt.

The problem can get a lot worse because as it stands, the penetration rate in China for credit cards is only 0.13 cards per person now. Compare that to the US, a place where like New Zealand for sheep, there are 1.5bn cards for its 300m population - unbelievable, 5 cards for each person, including kids.


p/s photos: Marie Ann Umali

China Is Aware That There Is A Bubble

As China is facing the prospect of large capital inflows from investors betting on RMB appreciation in 2010, policymakers have made it easier for mainland Chinese to invest abroad. This may be adding to the massive fund inflows other regional markets have experienced in 2009, especially China’s SARs. China’s rapid credit growth and loose monetary policies are also encouraging the trend.

• WSJ: A bubbly property market in Hong Kong and record gambling revenues in Macau are partially a result of capital leaking out of China through “under-the-table transfers.” GaveKal Dragonomics says that the scale of the “shady money” coming from China’s loose credit and stimulus measures “is becoming slightly embarrassing for Beijing.” Capital controls are supposed to regulate the amount of money flowing to the SARs, but offshore bank accounts and other channels allow money to flow relatively freely. (11/23/09)
• Michael Casey, WSJ: “[A] booming China is importing easy money from the Fed at a time when it least needs it, and is then exporting the same to its similarly undeserving neighbors.” (11/18/09)

Measures Taken to Increase Capital Outflows

• On November 11, the State Administration of Foreign Exchange (SAFE) said it would expand a program that allows individuals to exchange up US$5,000 per-day to non-financial institutions. This helped to spark a rally in China’s B-shares, which are mainland shares denominated in foreign currencies. (Bloomberg, 11/13/09)
• In October SAFE announced US$1.5 billion in new quotas under the qualified domestic institutional investors (QDII) program, which allows mainland funds to be invested in overseas assets. These were the first new quotas granted in 17 months.
• In July 2009, SAFE eased rules on the use of foreign exchange by Chinese firms, which will allow companies to borrow in foreign currencies on the mainland, invest with their foreign exchange revenues, and seek new funding sources.
• China's outbound direct investment reached US$55.6 billion in 2008, nearly double the amount in 2007, but much lower than the US$92.4 billion of inbound direct investment. In 2009, the gap looks may narrow. Through Q3 2009, the Ministry of Finance reported US$32.8 billion in non-financial outbound FDI, up slightly from the same period last year. Meanwhile, FDI to China decreased 14% y/y over the same period.
• Mainland Chinese are limited to converting US$50,000 per-year into foreign currency, but investors often pool the quotas of family and friends to get around the limits.

p/s photo: Maggie Wu