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Easy Money Inflates a New China Bubble
07/30/2009 4:03 pm EST
Even the go-for-broke gamblers on the Shanghai stock exchange are getting worried. On July 29th, rumors that the Chinese central bank was going to step on the brakes sent that market tumbling 5%.
The next day, stocks made up part of the loss by tacking on 1.7% as the People’s Bank of China said it would keep the cash taps open. The Shanghai Composite index is now up 82% for the year.
Traders and speculators in Shanghai are right to be worried. Efforts by Beijing to get the Chinese economy growing again have more than done their job—the economy grew by nearly 8% in the second quarter of 2009, according to the government—but they’ve also created another asset bubble in China.
China is back to the go-go days of 2007. Chinese investors opened 565,000 new brokerage accounts last week, the biggest increase since January 2008. China State Construction, China’s biggest homebuilder, raised $7 billion in its July 29th initial public offering (IPO). Shares jumped 56% the first day of trading. It was the biggest offering in China since the October 2007 Shanghai IPO of Petrochina (NYSE: PTR), which marked the top for Chinese stocks. (For more, see my blog Jubak Picks at jubakpicks.com)
This isn’t sustainable, folks. The bubble will keep inflating for a while (my guess is into 2010), but these soaring stock and real estate prices and the Chinese economic recovery are built on a flood of bank loans, many—probably most—of which will never be repaid. This wave of cash has further warped an already dangerously unbalanced Chinese economy by encouraging a wave of investment in the export sector when the world isn’t exactly rushing to buy.
Who will lose when the bubble bursts?
Chinese investors who poured their life savings—or borrowed money—into Chinese stocks, of course. Certainly, Chinese banks, which will, as in 1997, wind up with a mountain of bad debt.
But the biggest losers are likely to be global companies that bet China would pull the world out of recession and invested in new capacity or borrowed money to expand production.
What got this started? A stimulus package that went further than anyone imagined.
China initially announced its four-trillion-yuan ($586-billion) stimulus package to a chorus of skepticism. Doubters questioned how effective it would be and how much of it was actually new money.
What no one realized last November was how massively the Chinese financial and political system would leverage any spending by the central government.
So, China’s state-run banks have made $1.08 trillion in new loans in the first half of 2009. That’s three times the new loans banks made in the first half of 2008 and 50% more than they loaned out all last year.
Local governments rushed to submit stimulus projects even before the ink on the package had dried. That added more money to the total, since in the Chinese system, projects approved by the central government are often only partially funded by the national treasury, while local government units kick in the rest. But local governments in China aren’t any more flush with cash than their US counterparts are, so they borrowed much of their contribution to the stimulus.
Drenching the economy with cash worked to get GDP numbers up again. In the second quarter, China’s economy, by the official numbers, grew by 6.9%. That reversed an ominous decline to 6.8% in the fourth quarter of 2008 and 6.1% in the first quarter of 2009. Those numbers worried Beijing, where it’s accepted wisdom that the country needs growth of better than 7% to create enough new jobs to keep the domestic peace (and keep the Communist Party in power).
So, China’s money supply, as measured by M2, shot up a huge 28.5% in June. But lending standards went out the window, and much of this money went to the least efficient part of the economy, the state-owned businesses.
According to McKinsey & Company, large, usually state-owned companies get 84% of all bank loans, but account for only 45% of GDP. Meanwhile, small and medium-sized companies are often shut out of the lending market (they got just 5% of all direct lending in the first quarter) or have to pay ten times the official interest rate to get an underground loan.|pagebreak|
Much of the stimulus went to investment in fixed assets such as railways (up 127% from 2008) and roads, irrigation, and public works projects (up 55%). The surge of new money into these sectors increases the imbalance in the Chinese economy between investments in fixed assets and consumer spending. These fixed-asset investments will pay off for China only if the world is ready to recreate the “China makes and the world takes” pre-recession model.
If you add state to corporate investment, there’s a lot of money betting that Chinese companies will be able to export even more to the world in the future.
Many of these loans will never be repaid, putting the banking sector in danger again. Let’s not pretend that China’s banks managed to lend out three times the 2008 money and keep anything resembling loan quality standards in place.
So, we’re looking at a replay of the bad-loan debacle of the late 1990s. Accounting tricks and massive state subsidies helped China restructure more than $300 billion in bad loans from 1999 to 2004—equal to about $1.2 trillion in the larger US economy. That got those loans off the books at state-owned banks (it helps if you own the banks and make the accounting rules), but the bad debt is still floating around somewhere. And China’s banks look as if they’re about to add to the bill.
Finally, a lot of this cash looks like it has gone into China’s asset markets. Loans to the tune of $170 billion went into stocks in the first five months of the year, for example, according to the Development and Research Center of China’s State Council.
We all know what happens eventually to stock markets where rising prices are built on borrowed money, right?
“Eventually,” though, is the key word. So far, Beijing has shown very limited interest in taking away the punch bowl in either the financial markets or the real economy.
Oh, there have been some steps to raise reserves and a bit of rhetoric, but nothing that’s done more than give pause to a few revelers. My guess is that loose money will stay loose in China until growth climbs back into double digits. I think Chinese officials hope that by that time, the world economy will have kicked in and be ready to buy enough stuff to get China’s export machine running on its own.
What we’re witnessing, then, is a race to see whether the bubble will burst before the global economy can pick up enough so Beijing can step on the brakes.
Of course, every day the Chinese government lets the money supply grow at 25% or better makes the bubble bigger, creates more export capacity for the world to absorb, and raises the risk that the drivers in Beijing will overreact when they do put on the brakes.
I don’t see this ending tomorrow, but I don’t see this ending well.
And that’s one reason I’d rather put my money into a more balanced economy such as Brazil than into China itself. Yes, Brazil is linked to China’s growth, but Brazil’s domestic consumer economy isn’t completely overshadowed by its export sector. For two Brazilian stocks to watch, see my recent Jubak’s Pick.
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