How to profit from China’s hidden debt crisis

Developed governments from the UK to Japan are wrestling with massive debt burdens.

They're all trying different ways of shedding this debt from austerity, to money-printing, to financial repression. It's not clear how successful they'll be, but it is clear that these debts will weigh on growth in the developed world for some time.

That's why so many investors have pinned their hopes on growth in emerging markets, and China in particular, to pick up the slack from the developed economies.

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Trouble is, China's problems could be even bigger than everyone else's.

Here's why, and what it means for your money

China's financial system is already creaking under the weight of bad debt

Over the last decade, the Chinese state has invested huge amounts in roads, houses and other infrastructure. The trouble is, a lot of this investment was wasted. Worse, during the financial crisis, banks were forced to make even more bad loans in order to offset the slowdown in global trade.

The upshot is that large parts of the Chinese banking system and local government are bankrupt. Indeed, reports the FT, things are so bad, that Zhang Ke, a senior Chinese auditor, has warned that "local government debt is out of control' and could spark a bigger financial crisis than the US housing market."

His accounting firm has "all but stopped signing off on bond sales by local governments." And last week, credit rating agency Fitch cut China's sovereign credit rating.

So what's the problem? At first sight, China's debts don't look bad at all. The country's official debt-to-GDP ratio is just 25%, well below the equivalent figure in America, Britain or Germany.

Trouble is, this doesn't take account of all that dodgy local and regional government debt. While these are technically separate from the central government, there's no way the cities and regions would be allowed to go bust. So their debt is effectively the government's debt.

Conservative estimates put total debt by this measure as low as 65% of GDP. But if you include dodgy financing products the same trick Greece used to fiddle its way into the euro some estimates put the figure above 100%.

While an outright default is unlikely the central government would step in to bail out' troubled banks or local governments - a loss in confidence in the banking system would cut off credit to the more productive private sector.

That's a problem, because it hampers growth. As Jamil Anderlini points out in the FT, in the late 1990s, China's financial system was similarly burdened with debt. As banks kept rolling over, forgiving, or concealing bad loans, China was left with "a clutch of zombie banks that kept on lending but created progressively less real economic activity".

China's disastrous demographics

The bad news is that the growth outlook for China is also threatened by a much bigger, longer-term problem: demographics.

In 1978, the Chinese government established a policy limiting each family to one child. Reducing the population's growth rate was supposed to lower the risk of famine and prevent China from becoming overpopulated'. However, if it wasn't clear from the outset, it's becoming very plain now that the policy was an economic disaster waiting to happen.

As the population has aged, China has managed to artificially create a situation where there will be too few young people and workers to support the old people and non-workers. The Brookings Institute notes that this will "test the government's ability to meet rising demands for benefits and services".

The problem of one couple being left to care for four sets of grandparents already has a name 'four-two-one'. And now, for the first time in its history, China's working age population has started to fall. There are a third fewer primary school children than there were in 1995.

One solution is to relax the rules, and in some cases that has happened. However, it's likely to be some time before the policy is entirely abandoned. There are also signs that the policy is so ingrained that it will be hard to raise fertility rates - many couples that are already allowed to have two children don't do so.

The fall in the pool of available workers is also eroding China's cost advantage. Professor Kate Phylaktis of Cass Business school notes that this will slow down China's growth too.

In her view, the only way China can keep growing is by increasing the quality of its goods. But to do so, China will have to allocate capital more efficiently. In other words, it can't rely on getting state-backed banks to lend money for state-backed investments that may or may not produce a return. It needs more discriminating lending, to private sector companies, that either produce results or go bust.

And of course, you can't do that if your banking system is effectively bust and being forced to keep zombie' infrastructure projects alive, rather than lending to productive businesses.

In short, hopes that China will be the engine that drives the global economy could well fall short of the mark. Both Michael Riddell of M&G Investments and George Magnus of UBS agree that the "middle-income" trap is a real threat to China. According to the World Bank, nine out of ten countries that had middle-income status in the 1960s are still in the same place today.

How to play China's slowing growth

So, how should investors deal with a Chinese slowdown?

Firstly, a Chinese slowdown is likely to hit copper, one of the key industrial metals. Indeed, there are already concerns that Chinese stock levels (the amount of the metal kept in warehouses), is getting too high. This is one reason that we've been avoiding base metal miners for a long time.

But if you'd like to get more adventurous, then you could take a look at a short copper' fund. ETFS Short Copper (LSE: SCOP) rises when the copper price falls. Do bear in mind that betting on commodity prices is speculative it's not a long-term investment and you should monitor the price closely.

Secondly, we remain very bearish on Australia, which relies on exporting raw materials to China. Again, if you're willing to take a bit of risk, we'd suggest ETFS Short AUD Long USD (LSE: SAUP), which is a bet on the US dollar going up against the Aussie.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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