In China, there is a steel company called Wuhan that has been diversifying into wine production and pig farming. There is also a shipbuilder, Yangzijiang, which is using the cash it gets as down payments on its ships to run a lending business on the side.
These might sound like amusing anecdotes of a faraway land. But they are more than that. Between them, they tell the story of the greatest credit bubble yet. Both the shipbuilder and the steel company alert us to two things.
First, China’s fantastic housing bubble. China has long been printing money to buy dollars and keep its exchange rate pegged. In a normal environment, this would have led to inflation. But, as Eclectica’s Hugh Hendry points out, that’s not what happened.
Why? Because, at the same time, the authorities set the interest rate on deposit accounts at 0.72% and left it there. By 2008, inflation was 7.9%. So the real rate of return on a deposit was -7.2% – which helped to dampen consumption to a record low for any country: 34% of GDP.
This must have seemed pretty smart to the authorities when they first thought of it. But there is no such thing as an economic policy that doesn’t fall foul of the law of unintended consequences.
Instead of accepting this massive dose of financial repression, the Chinese became a nation of property speculators and shadow bankers. They borrowed money from unofficial lenders – perhaps via the likes of Yangzijiang – to get their hands on deposits, and bought flats all over China’s major cities.
Before the repression of deposit rates, investment in residential housing as percentage of GDP was under 3%. In the first quarter of last year, it was around 10%. Even official estimates say that, by mid-2010, 18% of all households in Beijing owned two or more properties. Prices are wobbling now, but it remains a bubble that Hendry says is “without precedent in emerging markets”.
China has also hit what Hendry calls the’ last stage of mercantilism’. That’s when you have expanded so much that capacity exceeds demand by too much for your prices to hold – and you have to diversify into pigs to make a return.
Back in 2009, China appears to have made a policy decision to save the world by building a credit bridge from disaster to recovery. While the rest of us dragged ourselves out of recession, China stabilised the global economy with the mother of all spending sprees.
It worked at first. Investment shot up, with the rail network seeing spending rise by 67%, and 50% of all lending directed towards infrastructure projects.
However, the policy now looks less like a bridge to recovery than a bridge to nowhere. China has spent a fortune keeping things going but the West still hasn’t recovered enough to take back the baton. That leaves it with an economy that is not just very reliant on exports for growth, but also prone to financial crisis if it doesn’t get growth. With its biggest market – Europe – in recession, that’s dangerous.
It is also why you don’t want to hold shares in a company “building new ships at a price barely above that of second-hand ships and lending hand over fist during an unprecedented credit boom using a plethora of financial techniques from rural micro finance to venture capital”. That’s Yangzijiang again.
My point is that we are all so interested in Europe that we might be missing the next part of our rolling financial crisis. It started in the US; it moved to Europe; it’s heading for China – and that’s where our next shock is likely to come from. So what do you do?
Some will say that you should still buy, regardless of the bubble. After all, the only thing one can say about a credit bubble is that it exists – and in existing it guarantees its own bust. It is impossible to tell when that bust will be. It is also true that equity performance is not particularly related to economic growth – if it were, the Chinese market wouldn’t have fallen 43% between 2010 and 2011.
You could also argue that China is cheap – although this might simply represent the fact that the indices are largely composed of quasi-state companies.
Then there is the chance that, as the housing bubble in China deflates, investors desperate for yield will force up stocks instead.
Finally, HSBC’s Charlie Morris points out that China is loosening monetary policy and that investors have historically “been well rewarded for buying Chinese equities in these expansionary periods”. Morris is buying shares in the HSBC China ETF. If you have money you don’t mind losing, you might follow him.
I’m not. I‘m avoiding Chinese stocks. I’m avoiding industrial commodities and commodity stocks. And I’m avoiding luxury goods companies. When the Chinese credit bubble bursts, who will be left to buy all those overpriced watches and handbags? It’s too risky.
• This article was first published in the Financial Times