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You may or may not have noticed, but quite a few Chinese companies have gone bust this year.
As Bloomberg notes: “China is zooming to a record year of corporate-bond defaults, with the 2018 total already more than three-quarters of the previous high” (in 2016).
By the start of this month, Chinese companies had defaulted on about $2.5bn of public debt.
This is no bad thing. It’s good that China is allowing companies to go bust. That’s how markets and capitalism are meant to work.
But that all looks like it’s about to come to a halt.
China doesn’t want to fight a war on two fronts
People have been worrying about China’s huge debt burden for years now. You’ll have lost track of the number of times you’ve heard about how China is a giant Ponzi scheme, or about all the Chinese ghost cities.
The thing is, these arguments aren’t wrong. China has built up a lot of debt. And it has misallocated an awful lot of capital. In order to keep economic growth going and employment high, money has been pumped into construction projects and industries that will never ever generate enough money to become self-funding and to repay the original debt.
It’s hard to be overly critical of China for doing this because in our low, low interest rate world, pretty much every country in the world has effectively abolished bankruptcy and ended up pumping money into companies and projects that wouldn’t survive or even get off the drawing board at higher rates.
But the sheer scale of Chinese malinvestment has been extraordinary. From 2008 to 2018, China’s gross debt rose from 171% of GDP to 299%.
“China’s credit boom is one of the largest and longest in history. Historical precedents of ’safe’ credit booms of such magnitude and speed are few and far from comforting”, note Sally Chen and Joong Shik Kang from the International Monetary Fund.
And even the Chinese central bank warned publicly late last year that a “Minsky moment” (which is basically when everyone wakes up and realises that no one can repay their debts) was a real risk for the Chinese banking system.
So for the last wee while, the Chinese government has been trying to have a bit of a clean up. It’s made it harder for companies to borrow money. It has allowed some corporate defaults, to make it clear that you can’t just lend money willy-nilly and expect it to be repaid.
Hence the rising profile of Chinese corporate defaults.
Why now? Well, as Jonathan Allum of SMBC Nikko points out, the Communist party had been hoping that strong global growth (which would boost export demand) would give it the opportunity to rein in financial risk. They could run the risk of tightening financial policy internally as long as the rest of the world was compensating.
Trouble is, they reckoned without Donald Trump.
As trade tension has ramped up with the US, this benign backdrop has changed dramatically. And now, the Chinese government is backing away from cleaning up its own backyard in order to focus on its external problems.
Monetary policy is already being loosened. Indeed, according to Andy Mukherjee on Bloomberg, “President Xi Jinping’s deleveraging campaign is clearly over. Or at the very least, it’s going into the freezer for as long as there’s no letup in trade tensions with the US.”
A final blast of euphoria for global stockmarkets
Why does this matter to you?
Because, as John Authers pointed out earlier this month in the FT, a lot of the jitters that beset global markets earlier this year have arguably been down to China tightening monetary policy.
That has a knock-on effect on global growth and speculative activity – as you can see through the prices of assets such as copper (and I also increasingly suspect, bitcoin).
So if China starts to ease up on monetary policy – just as the world has been worrying about a slowdown, trade wars, inverted yield curves and the like – then we could be about to see a rebound in sentiment.
I’m not saying that this is a sure thing. But it’s a scenario to watch out for. Let’s say China had decided that it can’t fight an economic war on two fronts, and eases monetary policy again at home, to get the growth/credit engine humming again.
And let’s say that, with the mid-term elections directly ahead, Trump is keen to demonstrate some victories, but he certainly doesn’t want to rattle the stockmarket. So he and China spar a bit, but meanwhile he continues the pressure on the Federal Reserve to be careful of tightening too much and also keeps talking down the dollar.
Investors decide that despite all the first-half jitters, there’s not a cloud in the sky. We finally get our blow-off top, the one that GMO’s Jeremy Grantham hinted at at the start of this year. If you want to use a historical analogy, that would suggest we’re in 1998 / early 1999 territory.
As I said, it’s a scenario. It might not happen. But it’s certainly one way that the bull market might end.
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