Perfect Storm Gathering in China?

The slowing of the world's second-largest economy is sending shock waves around the globe, writes MoneyShow's Jim Jubak, also of Jubak's Picks, and here's what investors should watch for as they try to stay out of the storm's path.

I can see a potential perfect storm brewing in China that could—please note that "could"—send chaos sweeping over global financial markets and economies.

I can see the conditions for the storm in place—just as during hurricane season we can see a tropical depression building in the warm waters between Africa and South America. The question now, as it is with any hurricane, is whether that depression will build into a weak storm—a Category 1 that lashes countries in its path with rain but doesn't result in much damage—or turn into a Category 4 or 5 that leaves a wide swath of destruction in its path.

And, of course, there's the important question of which countries lie in the storm's most likely path.

At this point I'd say the storm brewing in China is likely to rise to a Category 2 and cause damage to China's economy and stock market, as well as to stock markets and economies dependent on China's economy for growth: including commodity economies such as Australia, Brazil and Canada; Asian trading partners such as Korea, Malaysia, and Indonesia; and global export economies such as Germany.

Beyond that? Well, the timing of this storm adds to the possibility of it rising well above a Category 2, and the vulnerabilities of China's banking system, say a Category 3, is well within the odds. For the storm to climb beyond that to the perfect storm level isn't impossible, but given the still rudimentary connections between China's banking system and global financial markets, the global economy would have to be very unlucky for this storm to inflict significant damage on markets and economies outside of my list.

Watching the Weather Map
At this point I'd say cut back on exposure to those markets and economies that are most likely to take a hit from even a Category 2 storm. And watch the weather map carefully to see how the global financial weather develops over the rest of the summer.

The starting point for watching the buildup of China's potential perfect storm is the country's July 15 report that second-quarter GDP came in at 7.5%. First-quarter growth had come in at an annualized 7.7% rate, above, barely, the official government target for the year of 7.5%.

As I've written, the readings pointed to rough weather ahead. In June, to take one instance, China's exports fell by 3.1% year over year. That was the first drop in exports since the beginning of 2012 and the biggest monthly drop since October 2009.

There are good reasons to believe the data pointing to a slowdown in growth. For example, the European Union, China's biggest trading partner, is in recession. And, most importantly for storm watchers, the People's Bank of China engineered a cash squeeze in China's banking system designed to get credit growth under control.

In the week that ended June 21, the People's Bank produced a liquidity crunch by refusing to inject significant cash into the banking system, sending interbank lending rates (the interest rate that banks charge each other on short-term loans) to double digits. (The overnight rate climbed to 28% intraday on June 20.) When the bank did start to inject cash into the system, the overnight repurchase rate fell to 5.83% by June 26. But that still left the interbank rate about twice as high as normal. And when the People's Bank did inject cash, it didn't treat all banks equally. Most of the liquidity went to the country's five biggest state-owned banks. Mid-sized banks still reported a cash crunch.

Attempting a Soft Landing
This engineered cash crunch is a key source of energy for a developing storm in China.

First, the move makes capital scarcer and more expensive, and that's likely to lower growth in the economy.

Second, while the People's Bank did move to expand liquidity again, it didn't completely reverse its policy. Big banks got cash and other parts of the financial system were left in a crunch. Since the big state-owned banks lend primarily to big state-owned enterprises, this has left small and mid-sized companies, those that depend on the shadow-banking system for capital—facing an extreme cash crunch.

And third, the policy suggested that the government in Beijing might be willing to accept lower growth—even growth below the target growth rate—in order to get China's shadow banking sector under control. Fitch Rating's analyst Charlene Chu estimates that a third of all outstanding credit in China is held in channels outside of loans from regulated banks.

The calendar also contributes significantly to the energy driving the development of a storm in China. The second-quarter numbers released July 15, showing that growth had slowed to 7.5%, don't include the entire effect of the ongoing credit crunch. Much of the effect of the People's Bank's June move is still working its way through the economy, so we still don't know how hard the People's Bank actually stepped on the brake.

For example, we do know that second-tier Chinese banks have faced higher borrowing costs and, as the cost of buying credit default swaps to insure against the chance that loans would go bad climbed, second-tier Chinese banks have had trouble borrowing funds from Asian banks outside China.

In other words, second-quarter numbers on growth are only the beginning of the story and not the end. Investors, traders, and speculators looking at the second-quarter data can't be sure how low growth will go in the next quarter or for the rest of 2013.

Keep an Eye on China's Biggest Companies
That doubt has been exacerbated recently by confusing statements by officials ranging from Finance Minister Lou Jiwei to Premier Li Keqiang that mentioned 7% growth as if it might be a new target. Officially the government's economic growth target for 2013 remains at 7.5% and China's official Xinhua News Agency corrected Finance Minister Lou's quotation mentioning 7% growth in a July 12 story. But the "accidents" have made markets wonder if the Chinese government is setting up expectations for lower than 7.5% growth—without a big government effort to stimulate the economy to get growth above target again.

Investors, traders, and speculators will be able to get a better read on the dimensions of a China story over the next few months by watching what happens to big Chinese companies that run into trouble.

China faces massive overcapacity in key industrial sectors (China's steel industry is running at just 80% of capacity, for example) that makes it impossible for companies in such sectors as steel, solar, ship building, aluminum, and automobiles to make a profit. China Confidential estimates that 75% of the companies in Chinese heavy industries faced overcapacity in their sectors. Companies in these sectors survive only because local government officials need the jobs that these state-owned enterprises produce and because they have access to capital from state-owned banks. If state-owned banks stop providing unlimited loans, some companies in these sectors will go belly up. (Whatever that means in China since the country does not have a working system for handling formal bankruptcies.)

China Rongsheng Heavy Industries, among China's biggest ship builders, is a highly visible test case. Rongsheng is among the roughly one-third of China's 1,600 shipyards with no new orders. The company has 15 billion yuan in loans that come due this year. Net debt is now 168 times shareholder capital. Overdue receivables have climbed by 68 times since 2011. Not surprisingly the company has applied for government help. The company is theoretically private but Jiangsu province owns a 48% interest. Will Beijing and the province let Rongsheng and its 6,500 jobs go under?

What We Now Know
It's not clear whether letting companies like Rongsheng fail or bailing them out would have a bigger effect on the power of China's gathering storm. The local governments that might bail out these companies for the sake of their jobs are just about out of cash. Anything but the largest banks don't have the liquidity. So any bailout would have to come from the national government and the state-owned banks.

At some point everyone would have to admit what everyone now knows but doesn't say: local governments and Chinese banks aren't going to get their money back. And that would increase the liquidity pressure on all Chinese banks except the biggest; it would raise the cost of money for all Chinese companies except the biggest state-owned enterprises; and it would close more doors to Chinese banks (all but the biggest, anyway) in overseas financial markets.

Fail or bail, the cost of capital will go up and the Chinese economy will slow.

You don't go from a local Category 2 storm to a global Category 3 or higher without some kind of transmission mechanism. It took the interlocking obligations in investment portfolios and in the derivatives market to turn the US mortgage disaster into a global financial crisis, for example.

So what potential systemic feedback loops could increase the power of this storm?

A slowing Chinese economy would hit commodity producers and commodity producing economies hard. The global mining industry, which has already slashed capital spending, would slash spending again. A drop below 7% growth for China's economy would be enough to take down growth another notch in Australia, Canada and Brazil, for example, and to reduce sales even further at commodity producers and equipment makers. The good news is that most of the commodity economies are in good financial shape, with reasonable balance sheets and reserves. We aren't looking at a replay of the Asian currency crisis, with Canada and Australia playing the role of Thailand and Korea. The industry itself is dominated by huge companies with solid balance sheets and easy access to global capital markets. The bad news is that I can think of a few commodity economies that aren't on very solid financial footing—Russia is the primary worry, I think—and a slowdown in commodity demand is likely to force a few commodity players to reorganize or sell. Watch out for dividend cuts in the sector and for big write-downs. Absent a breakdown in Russia or some other significant commodity economy, though, I don't see this as enough to turn a China storm into a global storm.

A slowing Chinese economy will put downward pressure on financial markets in commodity economies as big institutional investors sell these economies short as a hedge on China. If you want to hedge against the risk of a meltdown in China, the easiest way is to short Australia or Canada or Brazil or Indonesia. With financial assets in these markets already under pressure from falling currencies against the dollar, the downward pressure on prices will be considerable. That's certainly a problem for these markets and for companies in these markets that borrowed in dollars without hedging the risk that their local currency would fall against the dollar, but the limited size of these markets makes it unlikely that a bet that went wrong would be large enough to sink a financial institutional that is systemically important. The one place I'd watch carefully is South Korea—not because the Korean government is as exposed to this slowdown as it was in the Asian currency crisis (it's not) but because many investors seem to be selling the liquid Korean market as a way to reduce exposure to Asia. However, absent a big derivatives mistake by a big bank, I don't see this as turning a China storm into a global storm.

A slowing Chinese economy will put huge pressure on Chinese manufacturers to sell at just about any price. And that will put pressure on non-Chinese competitors to cut prices or lose market share. Here's where I worry most about contagion, with Europe as the transmission mechanism. To escape its recession, the Eurozone needs exports and it won't get the export growth it needs if the global economy is slowing, driven by a slowdown in China's growth rate. In the last couple of weeks we've seen signs that the plans that patched up this debt crisis in Greece, Portugal, and Ireland have started to come undone. Italy, Spain, and France are all showing continued economic slowing. The governments that have pushed through the austerity programs that have been the backbone of the Eurozone approach to this crisis are facing serious challenges to their continued grip on power in Athens, Lisbon, and Rome. The Hollande government in France is exploring new lows in political popularity. And the Eurozone has done nothing to produce a new banking regulatory regime to deal with a return to the bad old days when banks that had invested in the sovereign bonds of their home governments threatened to collapse, taking the price of these sovereign bonds with them. (The Portuguese 10-year government bond closed at 7.27% on July 12.)

Add in the bad news from the calendar—that nothing will get done until after the German elections in September and that anything left undone by the time of the spring elections to the European parliament will stay undone until summer 2014—and you've got the real possibility that a scare from China that was enough to send global bond prices down and global interest rates up could set off a new round of the euro debt crisis just as financial markets were feeling spooked by a slowdown in China.

I think getting China's storm to escalate to a global storm of Category 3 or more would require a BIG drop in growth (to 6%?) in China's GDP and the collapse of a significant European government (Italy is my pick for "significant" and "possible.") Even in this worst-case scenario I don't think we get a replay of Lehman and the global financial crisis. The storm produced in this scenario might not be perfect but it would be scary enough.

Keep your barometer handy this summer.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund did not own shares of any stock mentioned in this post as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund's portfolio here.