The blog’s new Research Note in the ‘Your Compass on China’ series highlights the way that China’s commodity imports have been used to finance its housing bubble. This is clearly a shock for investors, who have till now believed the imports were a sign of its superior economic policies and long-term growth prospects.
The Qingdao probe could thus become the straw that breaks the camel’s back for world markets. There are two reasons to believe this is a serious threat:
- Investors have assumed that China’s vast share of global commodity demand was due to its economic growth. Now they will slowly wake up to find it was more about supporting a housing bubble
- Similarly, they have assumed that China had become ‘middle class’ with Western living standards and incomes. Now they will be forced to realise that consumer spending has been driven by the ‘wealth effect’
The worry is that the global financial system is currently priced for perfection. and may not be resilient enough to cope with this shock. Investors, companies and individuals have been lulled into believing that central banks’ experience with the Lehman Bros collapse means they will never let markets suffer a major downturn:
- Borrowing to buy stocks in New York is at record levels
- Investors Intelligence US sentiment index at 62.2% is at danger level, above August 1987 and October 2007
- American investors so-called ‘fear index’, the VIX, is at its lowest level since 2007
The best view is always from the top of the mountain, and thus it is no surprise to see Goldman Sachs still bullish:
“If nothing unexpected upsets the stock market’s delicate balance at these lofty heights, VIX could fall to record lows.”
The Qingdao probe is exactly the type of “unexpected” event to reveal this as simply wishful thinking. The key issue is that a large part (we don’t yet know how much), of China’s vast purchases of commodities since 2009 has not been used to build the economy. Instead, it has been used as collateral to finance a huge property bubble.
China’s new leadership clearly understand this. As the blog discussed in its February Research Note, they are now implementing a series of well-designed policies with the help of the World Bank to limit the damage from the bubble’s collapse. We can only hope they are successful.
Now, however, the rest of the world is about to discover what they already know. The blog’s fear is that this discovery will prove extremely painful, because of being so “unexpected”.
A core reason for concern is the total size of China’s corporate debt. It overtook the US in 2013 at $14.2tn, according to ratings agency S&P:
“China’s corporate issuers account for about 30% of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector. That means as much as 10% of global corporate debt, about $4tn to $5tn, is exposed to the risk of a contraction in China’s informal banking sector.”
China’s ‘collateral trade’ is at the heart of the issue. This is why the Qingdao probe is potentially so earth-shaking:
- Already some lenders are withdrawing from commodity financing in China as the risks rise
- Global market prices for copper and iron ore are declining, as informed players exit the market while they can
- The Economist notes that China’s banks are starting to become more reluctant to grant letters of credit
An investigation by the Wall Street Journal (WSJ) makes the link between the ‘collateral trade’ and housing very clear,. It appears the owner of the company at the centre of the Qingdao probe was heavily involved in real estate development:.
“In 2008, China’s government unleashed a $4 trillion stimulus package aimed at helping the economy withstand the global financial crisis. The stimulus drove a wave of credit through China’s financial system that launched a building boom in cities like Qingdao.
A real-estate company controlled by Mr. Chen currently is developing at least four projects in Qingdao, including a residential project called “Brocade City” and a large mixed-use development in the city center, according to the firm’s website.”
The WSJ adds that Mr Chen was not unique:
“Just about every trader who does collateral financing is also likely to have a real-estate development on the side, because the property sector gives higher returns,” said Jerry Chen, a metals trader at Shanghai-based Star Futures.”
It is already clear that China’s property market is entering a major slowdown, with Beijing sales down 35% so far this year. This will itself prove an enormous shock as property has been a money-making machine till now, with prices doubling every 2 to 3 years since urban property was privatised in 1998.
As property prices now fall, the ‘collateral trade’ will come to an end. In turn, investors will slowly realise that China’s economic growth has indeed been tied to a property bubble which is now beginning to burst.
There is thus a serious risk that today’s warning tremors in Qingdao will become a serious earthquake, and open fault-lines across the global financial system. Investors may now find out the hard way that central banks have instead created a debt-fuelled ‘ring of fire’, with China’s property bubble at its epicentre.