July 3, 2017    16 minute read

China’s House of Cards Is Also Subject to the Laws of Gravity

Smoke and Mirrors    July 3, 2017    16 minute read

China’s House of Cards Is Also Subject to the Laws of Gravity

How many news headlines have you seen over the last decade – as a result of a superb marketing PR campaign orchestrated by Beijing, and for which Western media played an all too willing “master’s voice”? Headlines claimed that the Chinese economy would transform smoothly from one that was investment led to one that was consumption-driven.

Equally stunning, every time a national congress of the Communist Party of China is being organised (remember the 18th back in 2012, and now the 19th coming up in the autumn of 2017), Western media is listening to its findings as if it had discovered a new soothing melody.

Over the last ten years, many articles have also been posted regarding the potential problems affecting China, both economically as well as socio-politically speaking. On the eve of the 19th National Congress (autumn 2017), it would seem a relatively good time to take a hard look at some of the fundamentals of the Chinese economy.

Look to the East

Also, while many feel that the next banking crisis could erupt in Europe, another daunting area on the radar map are the emerging markets. And specifically China, that seems to be running the same storyboard as Western countries did back a decade ago, and hence are at risk of a major financial and economic crisis.

Many know that China is exhibiting a couple of red flags such as a large number of loss-making SOE’s (state-owned enterprises), endemic corruption, weak global demand, bearish real estate conditions in some regional markets, etc.), but concomitantly feel that the Middle Kingdom is trying hard to adjust itself from an export-led economy evolving into a consumer-led economy.

In other words, the question being is whether the China effect is merely ‘transient contagion’ as some would have us believe and those red flags will disappear as soon as the economy has been transformed?

Should we, therefore, buy the argument that the Chinese stock market is unrepresentative of the real state of the country’s economy (that would be detached and the plaything of ill-informed, mischievous speculators)? The answer is simple. Most likely!

Today’s Shanghai SSE Composite Index is at 3,191 points up from 1,820 as of end December 2008, or nearly 60% higher. But, does this increase indeed mirror a structural improvement in the economic fundamentals of China that would have taken place during those last ten years? As they say, the answer lies in the question.

The Macroeconomic Data and Its Accuracy

Here again, this is a suggestive remark. To speak bluntly, China being an authoritarian regime built around a one-party (the Chinese Communist Party), its government authorities are not subject to any form of independent scrutiny that would look at the veracity and accuracy of the data reports produced by the authorities. In other words, on top of dark doubts over the accuracy of China’s economic data, it is a public secret that the Chinese economy’s trajectory has been experiencing a downfall since at least 2010.

This downfall is already acknowledged by the official annual GDP growth rated the have been under the magic 7% ever since that date. Yes, officially speaking China grew 6.9% growth in Q1 2017, but growth was more likely at around 4% given that central and local Chinese authorities are known to fake their revenue and investment figures merely for the sake of propaganda – ultimately to protect the legitimacy of the Communist Chinese Party.

The ultimate horror for the Chinese government is that an increasing unemployment rate would eventually lead to massive popular discontent potentially jeopardising the legitimacy of the one-party (CCP – Communist Chinese Party) authoritarian state.

Or, in one word, Beijing is afraid of a revolution (like the one that put Mao in power in 1949 and the failed one that took place on the Tiananmen Square in the Summer of 1989). Indeed, in the event of massive layoffs that unique social bargain (i.e., economic growth in exchange for political rights) between the CCP and its citizens – that maintained a manufactured social-political stability in China – would be breached.

That’s why for Beijing the ‘magic’ GDP growth number is 7% – everything below that number triggers heart palpitations within the CCP leadership… And guess what: the official annual GDP growth is at 6.9% (just barely below 7.0%) – so you can imagine how fast Beijing’s heart must be beating right now … And by 2018, Chinese officials claim that GDP growth will be even lower – at around 6.5%, while unofficial growth will most likely fall to around 3% (call CPR as Beijing will have a stroke for sure in 2018).

The Second Piece of the Puzzle

A couple of staggering numbers: China’s debt has quadrupled since 2007. Fueled by real estate and shadow banking, China’s total debt has nearly quadrupled, rising to $28trn as of end 2015, from $7trn in 2007. At 282% of GDP, China’s debt as a percentage of GDP (total debt and not just government (public) debt – i.e. total debt being equal to government debt, financial and non-financial debt as well as household debt) is greater than that of the United States (269%) or Germany (258%).

And, remember the US and German economies are more developed and mature than the Chinese one. Additionally, three other features unique to China are equally worrying: (i) over 50% of the loan books of Chinese banks are related to a bearish real estate market; (ii) a shadow banking industry that has spurred close to 50% of all new loans; and (iii) the debt of many local governments is probably unsustainable given their weak public finances.

In practice, with Beijing contemplating massive layoffs as economic growth is faltering below the magic 7% the Beijing authorities are going for an apparently more direct and straightforward resuscitation – they have created one of the worst investment and credit booms.

Whenever you watch programs about China, you can see the noticeable results: onerous construction projects illustrated by hundreds of ghost cities not to mention useless bridges and roads.

What’s more, there are those infamous state-owned enterprises (SOE) dating back from the Mao era whose financings have been extended yielding on the short-term run an expansion of employment, but also a long-term cost of bringing down their cash flow generating capacity due to excessive overcapacity that the markets can no longer absorb. All of which has been a bit shortsighted, especially for a government famed for its 10-year plans. But the biggest danger stems from how all this investment and expansion has been financed.

State Banks

The government ordered the large state banks to go deep into their wallets; and the banks are obliging. And after Beijing has become anxious that the growth in direct bank lending has been perhaps more rapid than is consistent with the maintenance of proper credit standards, the banks have been showing the kind of creativity that would have made any investment banker proud. The consequence is that the loan books of the Chinese banks (not to mention of also the shadow banks) have been swelling by more than 10% on an annual basis since 2008.

This aggressive credit boom, in turn, caused total debts in China to be now nearly three times GDP as of end 2015 – funded by an increase in bank liabilities of nearly $15trn over that same period. Or, in other words, the delta of the balance sheets of Chinese banks for the period 2008 – 2015 is equivalent to the consolidated size of US commercial banks, but whose balance sheets took over a hundred years to grow to that aggregated size.

But, officially, Beijing leaders (and their acolytes in the capital markets) continue to brainwash the world with the rhetoric that the Chinese economy shifts from one led by exports and industry to a greater dependence on consumption and services, and that is the reason why the Chinese economy is painfully adjusting through massive indebtedness.

However, China’s poorer economic performance in the last decade is more likely due to mismanagement by the leaders of China, weak financial planning, and (a public secret:) the fear of losing the reigns of power. This frenzy has been pushing these same Chinese authorities in kicking the can down the road through massive money creation and continued excessive bank lending.

But, as one knows finance rarely offers a free lunch, as it will most likely come back to bite you. Be it a socio-economic crisis, a financial crisis, or even a political crisis, sadly and tragically enough Western leaders remain stubbornly convinced that this is a mere blip on the radar, and thus not the coming of a perfect storm. Why?

Simply, hundreds of billions of dollars in trade volumes annually are involved, and thus the vested interests are way too high – hence the ostrich policy (keep your head buried in the sand). But, it is there for all to see who are willing to open their eyes: the debt mountain has only gotten bigger – not just in emerging markets and China but also in the so-called developed world.

Over-Leveraged Institutions

Indeed, according to a McKinsey report dating back from 2015, nearly a decade after the debacle caused by the Global Financial Crisis (GFC) where extreme over-leveraging pushed several major financial institutions into the abyss, the indebtedness addiction seems to have gotten worse – crazy, right? Indeed, in the period 2008 – 2016 global debt grew by a staggering $57trn, totalling $215trn, causing the debt to GDP ratio to total 325% at the end of 2015. That poses new risks to financial stability and may undermine global economic growth.

Whichever way you look at the China question, no one can deny that the commodity price collapse compounded by a steady increase in US interest rates risks driving emerging market economies into dangerous waters as a rise in US interest rates will slowly erode the attractiveness of emerging market yields.

Over the last decade, total leverage in emerging markets has continued its upward trend, surpassing $55trn, or 215% of the emerging-market gross domestic product by end 2015, according to the Institute of International Finance (IIF). As local currencies weaken against the dollar (or the US dollar strengthens against these EM), the foreign burden escalates, which is why everyone is so concerned about the impact of a Chinese devaluation.

This debt has until now been supported primarily by the proceeds from exports (being commodities or finished goods), and given the current slump/ weak recovery, that is a problem. Where foreign debts and earnings line up there is little reason to worry; however, the worry for commodity-driven economies is that falling commodity prices (be it energy or mining) mean their firms will now have lower dollar revenues than projected when they took on additional leverage.

Further, the piece that is truly alarming is the $20trn of corporate debt that emerging-markets took on and that is mostly labelled in US dollars according to the Global Financial Stability Report, and to a lesser extent, in euros. So why should international markets worry? Well, once the Federal Reserve Bank raises its rates, the dollar cost of debt rises, and for emerging market companies that do not produce dollar revenues, (and have weak currencies), rising debt costs could get very challenging.

Contagious to the Rest of the World

From a contagion perspective, the largest financiers to these emerging markets are European banks (with over $4trn in debt exposure to these regions), and in particular, for instance, Santander (Brazil), BBVA (Turkey and Mexico), BNP Paribas (Eastern Europe and CIS), SocGen (Eastern Europe and Russia), HSBC (India, Indonesia, and China), Erste (Eastern Europe), Barclays (South Africa), Unicredit (Turkey, Russia, and Eastern Europe), and Standard Chartered (India and China).

They all have significant exposures to countries informally known as the “Fragile 8” (namely, ABCIIRST countries: Argentina, Brazil, Chile, India, Indonesia, Russia, South Africa, and Turkey) that could bite off a large chunk of the equity base of these banks. But US banks too, in particular Citi (Latin America), as well as JPMorgan (via the FX markets) and Bank of America (via the FX markets) are entirely exposed to the emerging markets.

And as the burden escalates and the risk of corporate defaults in these emerging markets start to loom, badly needed capital exits these same emerging countries at a time when these foreign capital expenditures are badly needed. And even if those emerging market companies were to opt for local debt, the accessibility to it would likewise become a problem as regional economic growth weakens and local banks are running out of refinancing options to roll over loans. And going back to the China menu, when Beijing catches a cold, commodity-driven emerging market economies that are already fragile (and in some cases in political crisis) risk catching pneumonia.

In this globalized and interconnected world, if emerging markets do catch pneumonia, then Europe and the US risk catching (again) flu at the very least. But, can the United States get through a contagion unharmed?

Most likely not, unless the Federal Reserve Bank can engineer a significant drop in the dollar (which it cannot as the US economy is now back in the black). Additionally, a possible drop in the USD risks would result in deflation reappearing on the radar, while the Federal Reserve Bank has been making every effort to stir up inflation.

Given the troubling signs from various market indicators – notwithstanding encouraging economic figures in Western countries, on the long run the rationale that “this time will be different” is most likely untrue. The problem is that the global economy has become increasingly reliant not only on higher levels of debt (to generate a glimpse of economic growth) but also on the back of very low-interest rates.

Many politicians (be it in the West – former President Obama or PM Trudeau – or in the East with China under the auspices of Xi Jinping) think that can grow out of a crisis by merely using an ATM to print money. Think about it: under President Obama, US government debt doubled from $10trn to $20trn, while the economy recovered very slowly.

Under Justin Trudeau, deficits are once again deepening with a projected shortfall of $23bn for 2016-17 (up from a deficit of only $1bn in 2015) and no timeline to balance the books While in a recent report Standard and Poor’s said that the health of heavily leveraged companies globally had expanded negatively, despite an increase in defaults, credit quality and rating stability measures remained in line with historical averages.

Also, the US economy for the Q1 2017 was doing better than in Q1 2016 with gross domestic product (GDP) at 2.0% end March 2017 compared to 1.6% end March 2016 according to Trading Economics – one can hope that corporate defaults in the US will lessen. At the moment, problem borrowers in the US remain concentrated in oil, gas, metals, and mining (given an overcapacity and weak pricing in these sectors).

Back to China

Some Chinese corporates took on excessive debt during the boom years, and now that the downturn in China seems to be in for the long run, they seem to be caught off guard. Therefore, there is a reasonably high likelihood of seeing the financial performance of companies operating in severe sectors such as metals and mining, real estate and capital goods deteriorating further by end 2017.

The credit quality of many corporates has weakened to a critical level as underlying cash flows are no longer able provide for a proper debt service. And tragically it is not feasible for the government to save all of them. As such, for an economy to be swayed off that degree of addiction to debt-fuelled growth, there is a need for some shock to the economic system, right?

In an ideal world, you would want the growth rate of credit and investment not to exceed the annual GDP growth of a country failing which the debt volume and the write-offs of useless investments become unaffordable. In other words, the longer that China faces an aggressive credit and investment growth, the greater the likelihood that a crash will eventually bring the country to its knees, subsequently spilling over to connected international financial institutions and global economies.

Lessons from History

If history can provide any comfort regarding takeaway lessons, developing countries which previously expanded credit as rapidly as China suffered significant economic slowdowns afterwards (take for instance Turkey in 2015, Russia in 2013, Korea in 1998, Thailand in 1997, Mexico 1994, etc.).

As a result, one should worry about China. Additionally, the fact that Beijing is not making much effort to be transparent, causing huge suspicions about China manufacturing numbers (aka window dressing), and thus hiding the reality of its economy may lead investors to start thinking that it maybe all a Ponzi scheme. Indeed, an increase from 71% of GDP in 2009 and taking total debt to close to 300%of GDP is stunning, and a credit boom of this scale is not likely to end well.

Granted, for many western leaders, the bright object in the room is the vast amount of foreign exchange (FX) reserves that China is boasting ($3trn) even though the trend has been negative. For 2016 as a whole, China’s reserves shrunk by nearly $320bn to $3trn, on the back of an already record drop of $513bn in 2015.

If Being authorities were to continue to burn through these FX reserves at a fast rate, Xi Jinping may have little choice but to devalue once more the yuan (as he did in 2015). This devaluation would likely irritate global financial markets, and stoke tensions with the new US Trump administration (remember that D. Trump accused China of being a currency manipulator).


Up until the occurrence of the Global Financial Crisis in 2007-2008 the Middle Kingdom had for 30 years defied sceptics, maintaining a 10% growth rate that had not fallen below 7% since 1990. But today, the official annual growth rate is below that magic 7% (and is projected to fall by around 6.5% in the coming year). However, unofficially, the GDP rate will more likely be around 2-3%, inevitably resulting in higher unemployment numbers, and thus massive dissent, ultimately bringing into jeopardy the legitimacy of the one-party CCP regime.

It is important to emphasise that the key to foretelling credit trouble is not necessarily the size but rather the pace of growth in debt, because during rapid credit booms, more and more loans go to wasteful investment projects, bringing asset-quality matters to the forefront. Those who continue to trust (blindly) in China’s exceptionalism say it has special defences. It has a war chest of foreign exchange reserves and a current account surplus, reducing its dependence on foreign capital flows.

Furthermore, its (state) banks are supported by large domestic savings and enjoy low loan-to-deposit ratios. Again, history – a valuable ally in times of trouble – shows that although these factors can help fend off some kinds of trouble – a currency or balance-of-payments crisis – they offer no guarantee against a national systemic credit crunch. Chinese leaders are acutely aware of how their economy has been built like a house of cards, and that it is potentially about to fall.

However, it is (wrongly) believed that some truths are better not being told, particularly to those that you are governing (Chinese citizens) and those that are buying your products (Western countries). But, ultimately, even China will be subject to the laws of gravity.

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