Why China could be heading for an epic banking crisis

published 5 June 2013

13-06-05-peoples-bank — China: debt is snowballing

We've been rather bearish on China for a while now.

And that's been the right call. Chinese stocks have been among the worst performers in the world, even all through the post-2009 rally.

Meanwhile, commodities the most China-dependent asset class in the world have a had a rough time too.

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Yet things could get a lot worse. China could be heading for its very own banking crisis, according to a report from Socit Gnrale

Is China heading for a Minsky moment?

It's fair to say that Socit Gnrale strategist Albert Edwards is nearly always bearish.

But in his latest piece, he leaves the bearishness to someone else the firm's China economist, Wei Yao.

She reckons that China could be heading for a Minsky' moment. This is an event named after economist Hyman Minsky. In short, it's what happens when a credit bubble bursts and the prices of assets that have been supported by that bubble collapse.

Why does this happen? It's as a result of ill-considered, non-productive lending. Boom times lead to people taking punts on continued growth using borrowed money. Assets become hugely overvalued compared to the income they generate. Eventually, this income is no longer sufficient to pay the interest on the debt taken on to fund these purchases.

As a result, lenders panic, and ask for their money back. Asset values collapse as investors are forced to sell everything even their less dodgy investments to raise funds. This is very unpleasant for all concerned of course.

Of course, we saw all this happen very recently. The goldfish-like memory of the market already sees 2007/08 as dim and distant history, but it was a Minsky moment the panic over sub-prime that kicked off the great financial crisis.

And now it looks like China could face something similar.

So what's the problem?

The basic issue is that credit in China is growing more rapidly than the economy. That's been the case for the past five quarters. "As a result," says Wei, "the debt snowball is getting bigger and bigger, without contributing to real activity."

There's a fairly straightforward equation at work here: if you take on more debt, but your economy doesn't grow enough to keep up, then pretty soon you're going to be overwhelmed by the cost of servicing said debt.

Moreover, a lot of this debt is being funded outside of the banking sector in the shadow' banking sector. This "has clearly increased the vulnerability of China's already burdened financial system."

Already, Wei reckons that China's corporate debt-servicing costs amount to nearly a third of China's GDP. The Bank for International Settlements estimates "a number of economies had similar or moderately lower debt-service ratios when they were headed towards serious financial and economic crises. Examples include Finland (early 1990s), Korea (1997), the UK (2009) and the US (2009)."

Wei's not the only one concerned. Edwards also cites Charlene Chu of credit ratings agency Fitch. She recently noted that "companies' ability to pay back what they owe is wearing away, as China gets less economic growth for every yuan of lending."

What does all this add up to?

Basically there are a whole load of companies and local governments that have taken on too much debt and won't be able to pay it back. That means that both the banking system and the shadow banking system are riddled with holes and just waiting for the right trigger to spark a panic.

The general view when it comes to China is that because the financial system is so dominated by the government, they won't let anything too awful happen. But then, people felt the same way about the Federal Reserve (and bizarrely still do) before the sub-prime collapse came about.

Protecting yourself and profiting from a China crash

We've already seen both commodities and the Australian dollar suffer on fears of a slowdown in China. A full-blown implosion would hit them even harder. We'd certainly keep avoiding the industrial mining stocks.

If you like trading currencies, and you've got a bit of experience behind you, then you might want to look at shorting the Aussie dollar versus the Canadian dollar. Both nations are hugely over-leveraged, and both are dependent to a great extent on commodity exports.

But the difference lies in their primary market. Australia depends on Chinese economic growth, while Canada depends to a great extent on US economic growth. So it's essentially a bet on the US outperforming China. It's a trade that has already done well, but it could go a lot further. For more on currency trading and spread betting in general, you should sign up for my colleague John Burford's free MoneyWeek Trader email.

If you're not so keen on the idea of taking high-risk punts on currencies, then on the defensive side, it is probably a good idea to make sure you have some gold as insurance (about 5-10%) in your portfolio. If the Chinese worry about the integrity of their financial system, it is likely to boost demand for the yellow metal.

But also, have some exposure to the US dollar. If China crashes, then people will run for safety. And they still see the dollar the global reserve currency as a safe harbour.

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

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.