Early last year, the idea that China’s miracle economy might finally have sprung a leak started to gain some acceptance by even the biggest China bulls.
After all, it was pretty hard to keep arguing that growth could never fall below the magic 8% level when even the Chinese government said it come in at around 7%.
Yet the sight of a few bits of perkier economic data now have everyone declaring a ‘soft’ landing. The stock market is ticking higher, and the China bulls are back in force.
I still wouldn’t touch it with a ten-foot bargepole…
The one sure predictor of a mega-bust – a mega-boom
As Edward Chancellor points out in an excellent column for the FT’s funds supplement this morning, there is one predictor of financial crisis that is unmatched: “reckless credit expansion”.
Chancellor quotes from a paper by Claudio Borio at the Bank for International Settlements. Borio tries to highlight the importance of the credit cycle (in other words, how tight or loose lending is) to understanding macro-economics. He observed that “economic hard landings often followed periods of strong credit growth and house price inflation”.
This shouldn’t be a controversial topic, but it is. Maddeningly, the people in charge still argue that the financial crisis came out of nowhere. You can see why: it gets them off the hook. But it’s entirely wrong. “We have forgotten the basic law that every credit boom… contains the seeds of its own demise.”
Borio’s point is that the credit boom years are an aberration: “Reckless credit expansion spurs unsustainable growth and results in the misallocation of capital.” In other words, money gets thrown at projects and investments that can’t ever pay for themselves.
When the bust comes, the best thing to do is let the bad investments unwind and go bust. If you instead try to get back to the boom years by using ultra-loose monetary policy, all you do is “delay the resolution of economic imbalances and even generate new asset price bubbles”. That’s what Alan Greenspan did after the tech bubble burst, and it’s what Ben Bernanke is trying to do now.
By this measure, which country currently looks most vulnerable to a hard landing? China, of course. As Chancellor reminds us, China’s ratio of debt to GDP rose by 60 percentage points in the five years to 2012.
By itself, that probably doesn’t mean much to you. So to put it in perspective, that’s “a much larger increase than that experienced by either the US prior to 2008 or by Japan in the second half of the 1980s”.
In other words, China has ‘geared up’ more dramatically than either the US or the Japan did right before two of the most devastating economic collapses in living memory. And despite government attempts to cool the property bubble, credit has gone on expanding. “Last year, China’s non-financial credit expanded by a staggering 33%.”
As for ‘malinvestment’, Michael Pettis, a professor at Peking University, flags up an International Monetary Fund paper which investigates just how mad China has gone with its infrastructure investment.
In short, China has used its citizens’ savings to subsidise huge levels of investment in infrastructure. This can’t carry on. If it does, says Pettis, “overinvestment will contribute to further financial fragility leading, ultimately, to the point where credit cannot expand quickly enough and investment will collapse anyway”. But China’s growth meanwhile has become so dependent on this level of investment, that any slowdown or adjustment will hit growth hard.
So either way the country is in trouble. While I’m bearish on China, I wouldn’t be at all surprised to see a strong market bounce from here if investors decide they are back in ‘risk-on’ mode. But I won’t be buying in. As Chancellor points out, “nobody can tell when China’s financial cycle will peak. We can say the longer this boom lasts, the harder the landing will be”.
Another risky country that might be a better bet than China
And if you’re tempted to invest in China because the stock market looks cheap, I’d suggest that you consider Russia instead. The country is still too dependent on energy prices, but it certainly hasn’t experienced a credit bubble.
Now, the truth is, I’m not keen to invest in either country. I am not an especially risk-averse investor (the amount of my own pension invested in Japan is a testament to that). But there is simply too much political risk in both China and Russia for my liking.
What concerns me most is the apparent attitude that private ownership of an asset is a right granted to you by the government, and which can be rescinded at any time the state wants the asset back. Forget understanding company fundamentals – being a successful investor in that environment depends mainly on knowing which backs to scratch, and that’s not something you can divine from even the most transparent balance sheet.
So why am I even bringing it up? Well, our regular contributor Tim Price did flag up one particularly tempting way to play Russia in our New Year roundtable which had me thinking that I should maybe give the country another look. (If you’re not already a subscriber, get your first three issues free here.)
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