China To Take A Big Stick To Financial Crisis

HDPEmargins.pngBy John Richardson

CHINA is facing a financial crisis that could put US sub-prime into the shade.

“Between 2007 and 2012, the ratio of credit to GDP climbed to more than 190%, an increase of 60 percentage points,” said US funds manager, GMO, in a report.

“China’s recent expansion of credit relative to GDP is considerably larger than the credit booms experienced by either Japan in the late 1980s or the US in the years before the Lehman bust.”

Current property valuations are totally unsustainable. For example, as Reuters has pointed out, “China’s average annual urban disposable income in 2012 was 24,565 yuan. Home prices meanwhile averaged 20,700 yuan per square metre in Beijing last year “.

The problem is that when the government introduces measures to deal with the property bubble, people will search for loopholes, including even divorce, to bypass restrictions.

“Property is seen as safe haven against inflation, against all sorts of changes in the economic cycle,” Pauline Loong, managing director of Asia-Analytica Research in Hong Kong, told Bloomberg.

“So you have a curb, so the money stops for a while; the minute they see a loophole, the minute they see something, the money goes back in, so the demand is there.”

Hence, despite the introduction of the 20% capital gains tax at a nationwide level and restrictions introduced by 17 different cities, house prices in March rose by their greatest amount in more than two years.

Property is not only seen as a hedge against inflation, but as a much better way of making money than the paltry deposit rates available from the state-owned banks.

The same applies to wealth management products, which are being peddled by the big banks and which are classified as off-balance-sheet financing. 

Here we come in full circle as another form off-balance-sheet lending - trust funds – have found their way into the property sector. Property developers are desperate to keep the bubble inflated as they know that once the air starts to escape, they will go bust.

“China’s shadow banking system {the same as off-balance-sheet financing] has much in common with the American version, which thrived before Lehman’s collapse,” continued GMO, in the same report.

“Trust funds that finance cash-strapped property developers have a whiff of the sub-prime about them.

“Wealth management products that bundle together a miscellany of loans, enabling the banks to generate fees while keeping loans off balance sheet, bear a passing resemblance to the structured investment vehicles and collateralised debt obligations of yesteryear, while thinly capitalised providers of credit guarantees are reminiscent of past sellers of credit default insurance.”

It has also become apparent that last year’s “recovery” was funded largely by local governments borrowing money for infrastructure spending via the shadow-banking system.

Dong Tao, Credit Suisse China economist, makes the very interesting point that “never in the history of modern China” has so much monetary easing {i.e. last year’s infrastructure spending) failed to jump-start what he calls “the real economy”.

Chemicals and polymer markets continue to illustrate the weakness in the real economy. For example, polyethylene (PE) markets remained lacklustre last week as traders and end-users kept purchases at a minimum, while reports circulated of plans to cut cracker operating rates, according to ICIS pricing.

And, as the slide above illustrates, Northeast and Southeast Asia remain the worst-performing regions for high-density PE (HDPE) integrated margins.

The reason the real economy is struggling is that private businesses are being squeezed by higher inflation, a result of last year’s stimulus binge.

Rising labour costs, due to a long-term shift in labour availability, have placed further pressure on private companies.

And at the back of everyone businessman’s mind must surely be that China’s new leaders are showing every indication that they will take a big stick to the impending financial crisis. This will go well beyond the odd piecemeal, and so far ineffective, measure to control property prices.

“More signs are emerging that major economic reform is underway,” wrote fellow blogger Paul Hodges, in this post last week.

“Hence 1993′s leadership transition may well provide a useful parallel for today’s policy changes.

“Then president Jiang Zemin (kingmaker in the recent politburo appointments) and economics minister Zhu Rhonji initiated a major credit crackdown to curb speculation in the property market. Property prices dropped 40% in the major cities, and private sector GDP growth was just 3%.”

Very significant could be the fact that the new finance minister is Zhu Rongji protégé, Lou Jiwei.

China might wield a big stick by, very simply, starving the financial system of credit.

This appears to be already happening. For instance, on 28 March Bloomberg reported: “Investments in ‘non-standard’ credit assets, used by some banks to bypass loan restrictions and credit risks, can’t exceed 35 % all funds raised from the sale of wealth management products, or 4% of the lender’s total assets at the end of the previous year, the China Banking Regulatory Commission said yesterday.

“The latest rule may reduce total financing in China’s economy by 1 trillion yuan, Citic Securities Co estimated in a note today.”

And, as we reported yesterday, project financing, including for coal-to-chemicals, is becoming much harder to come by.

The blog is struggling to find a reason why business sentiment will improve in China during the rest of 2013.

It could well become a great deal worse as the painful adjustment process takes place.

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