Chinese equities: even riskier than you think

During the rout of the past five weeks, the multi-trillion epiphany which struck the rococo temple of modern finance to its very foundations was that a whole stratum of yield-hungry investment monies devoted to what had been marketed as fee-heavy alpha' had, in fact, compressed under its own sheer weight and had undergone a metamorphosis to a dull and highly friable bedrock of disastrously leveraged beta'.

As a result, in general terms, anything which had risen in the heady days to the general peak in late July was left headlong in the dust, while the meek such as that universal whipping boy, the yen may not exactly have inherited the earth, but did at least get a mention in the will.

Thus, the MSCI EM equity index ran up a 27% gain to July 24th, only to drop 8.2% thereafter. Metals, as a group, put on 10.6% to the peak, then shed 8.5% once it arrived. The kiwi dollar soared 14.5% against the greenback, only to plunge 13% from its pinnacle.

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True, agricultural commodities were fairly oblivious to the credit rout as the age-old factors of flood, drought, frost, and disease interacted with the newer era influences of Asian meat and dairy consumption and Western biofuel promotion to keep, in particular, wheat and the European contracts extremely well bid.

Nor did those perennial profiteers of the age of perpetual war (hot, cold, or tepid) the Military-Industrial complex - take much notice, with the AMEX Defense index moving sideways from a 25% pre-crisis game score, but still up 665% in absolute, and 920% in relative, terms since the tech bubble popped in March 2000.

But perhaps the most significant divergence from the wrenching turn in the wheel of fortune was China where the 58% gains, pre-credit crash, were augmented by another impressive 21% climb in its aftermath.

As the world comes to grips with the ramifications of the debt death spiral, China is, of course, the first refuge of the optimist who hopes that, even if America does slide into recession, the Asian colossus can act as a counterweight.

Asked to justify his beliefs, such an individual will chant a litany of positives, citing China's powerful economic momentum; its predominant role in both the consumption of raw materials and the production of semi-processed and finished goods; and its mountain of readily-deployable foreign exchange reserves. Even the supposed advantage conferred upon China by being subject to the diktats of sage and far-sighted central planners, rather than being buffeted by a messy and capricious free market as it shivers from the ague of a screwed-up financial system, is something he will put forward in his defence.

However, the more one looks at China, the less one sees that is different in substance rather than in superficial appearance from any other instance of widespread, credit-led excess, any where else in the world. Thus, a more realistic assessment of China's situation has to be that force-fed (rather than just plain forced) industrialization has led to an Augean stable of malinvestment to stink up the land of Elis, but without any sign of a Heracles to clean it.

Moreover, the speculative frenzy gripping China and pushing the stock-market almost uniquely higher and higher into the stratosphere of over-valuation has seemingly become a pandemic. The newspapers are full of lurid tales of the ordinary man avidly raising the stakes with which he plays the market by colluding with his friendly bank manager to divert what are ostensibly car or property loans to the purpose.

Just as in the last stages of the Western tech boom, anecdotes abound that little real work is being done in the teeming offices and factories of the coastal cities, until the market has closed for the day. If there is any wider truth to such reports, we can well imagine that, having racked up effortless gains in the first few hours, the quality of the contribution thereafter will be correspondingly lessened and this at a time when labour and input costs are rising and when quality control is already becoming a PR disaster for the country (albeit a politically motivated one).

More worryingly, the reckoning has also been made that Chinese corporates are themselves being sucked into this swirl of greed, rather than attending to the business of business. Calculations done by Morgan Stanley recently estimated that whereas 13% of reported profits were of the non-operating variety last year, this has soared to over 30% so far in 2007.

Giving credence to this, the China Securities Regulatory Commission has just issued a warning expressly directed against such practices, even if the impact of the admonition was somewhat spoiled by its spokesman's admission that he would leave this to individual board members to act upon, should they see fit!

This syndrome is again reminiscent of the spiral of boot-strapped profits' reported when our own internet networking giants were booking ever rising sales, even though these were increasingly attributable to the soft, vendor finance extended to ultimately deadbeat start-up companies in whom the big boys also took juicy pre-IPO equity stakes - thus booking two sets of phantom returns along the way.

In the case of China, this latest twist is of even more concern since double counting of profits in addition to the normal macro-economic exaggeration of their nature when a credit-led investment cycle is underway was already seriously overstating the health of the economic juggernaut.

The first distortion arises from the nature of the expansion itself for, from the (admittedly suspect) official figures, we can ascertain that something of the order of 40%-45% of GDP is categorized as investment spending. The significance of this is that at the macro-level investment spending must give rise to larger aggregate profits, simply because the associated outlays appear below the line in the investor's books a truism which means that the revenues for the man filling the investment order are not offset (in any one period) by the entirety of the costs attributable to the man issuing it.

Given that credit raised and spent this way also represents a direct boost to macro measures of profitability (again, newly-created money used to buy investment' goods means summed revenues rise 100%, but costs increase perhaps 10%), the whole superstructure of rapid, hot-housed industrialization cannot fail to look like a riot of prosperous advance to the undiscriminating eye of the top-down analyst or in the mind of the contented little central planner, smugly clutching his copy of Samuelson, back in his stuffy Beijing bureau.

On top of this, as Weijian Shan of Newbridge Capital made clear in his spat with the World Bank last year (fought out in the pages of the Far Eastern Economic Review), the pervasive cross-shareholdings of Chinese corporates mean that the same profit' can be counted multiply in the aggregated score.

Noting further that the tally of profits did not deduct tax from the published numbers, he also drew some scathing inferences about the role played by state-directed lending in subsidising such companies. What he was too polite to mention was that, alongside this particular source of corporate welfare, many factory bosses may well have been effectively gifted the land on which the plant was built, at the expense of the poorly-defined property rights of its former rural homesteaders.

Estimates of the scale of Chinese NPLs to which these practices have given rise vary widely. Moody's has put a figure of $600-odd billion on the size of the hole in bank balance sheets; Ernst & Young had reckoned with over $900 billion (before being browbeaten into an unconvincing, commercially-motivated retraction). Unofficially, there are mutterings of even higher totals, reaching well upwards of 40% of GDP.

To put even the smallest of these estimates in sharper context, not only does Moody's number amount to ALL the reported pre-tax profits earned during the period 1999-2005, it is also equivalent to the whole cumulative trade surplus enjoyed from 1998 onwards! Even more ominously, this sort of calculation suggests that unpaid credits could represent half of all banking assets, however well disguised they are, in an environment of ongoing double-digit loan book growth, by the simple trick of rolling principal and interest forward into new loans the moment they come due on the old.

So, once we become aware that while published real GDP has risen by a factor of 4.4 since 1990s, with nominal GDP growing 11.2 times, M1 has simultaneously reached 18.1 - and M2, 22.6 - times their starting levels, we can see that rampant credit creation has been at the very root of the Chinese experience: a credit creation, moreover, subject to very few of the tenets of best Western practice in its utilization (however shamefaced we must currently be about where we have allowed our own abuses of such norms to lead us, too!).

The irony here is that China has squandered much of its people's savings by throwing them at hopelessly inefficient and corruptly motivated businesses, while allowing goods to be sold abroad at bargain basement prices as a result of the hidden subsidies and the repressed inflation (such as fuel price caps) it practices at home.

At the same time, its Western customers have pretty much given up saving altogether and, hence, have foregone the ability to strengthen their own industrial base. Instead, they have chosen to indulge themselves on the grandest of scales with consumer durables (especially homes) and bling, the mere possession of which will never be able to generate the cash flow required to service the debt load incurred in their purchase.

Much of that debt has, of course, been effectively contracted with China where it comprises the swelling dollar receipts of its over-developed export sector. These dollars, through their role in the central bank's balance sheet, have also formed the backing for much of the reckless expansion of domestic investment credit, so causing further disproportion in the economic mix.

Thus, much of what are known in official parlance as the current global imbalances' is little more than an illusion backed by a conjuring trick by credit-subsidized Chinese producers servicing credit-addled Western consumers, each thinking they are doing well out of the deal.

As we are too well aware, the most over-exposed of those Western consumers have been delivered a final demand in recent weeks and financial markets across the globe have creaked and groaned under the ensuing strain.

Imagine what will happen, however, if a wider, Occidental abstinence from credit-financed over-consumption starts to shrink Chinese export earnings; stretches Chinese company finances; and, perhaps, topples the overheated Chinese stock market, too.

Then, the upward tornado of financial self-reinforcement could easily invert into an all-devouring maelstrom of self-empowering collapse in the same way it did after the Tech bubble. More dramatically, given the underlying weakness of the Chinese banks, direct parallels with 1990s Japan and 1930s Europe would shortly begin to suggest themselves as valuations fell below the event horizon.

With Bloomberg-derived figures for the Shanghai B share index showing that it boasts a lofty P/E of 85.7, despite producing a lowly margin on sales of 2.5% and a paltry ROE of 3.2% (comparable metrics for the S&P are 16.6, 9.4%, and 16.7%, respectively), the Chinese stock market should absolutely not be regarded with a sense of wondrous admiration, much less be taken as a sign of China's ultimate immunity to our current problems (remember the Nikkei also looked invincible in the two years after the Crash of 87).

Rather, Chinese equities should be regarded with a suitably jaundiced eye, for the truth is that they not only represent some of the riskiest of investments to the intoxicated masses caught up in their specious glamour, but also a very real source of danger to the material wellbeing of us all.

Sean Corrigan is Chief Investment Strategist at Diapason Commodities Management, Lausanne & London.