China is slowing. That is clear. Meanwhile, its debt is ballooning to prodigious proportions. Talk about a combustible combination for major market dislocations.
The Chinese government is attempting to permanently downshift GDP growth and rebalancing economic drivers. Maintaining financial and economic stability is obviously a paramount concern for the Chinese politburo. This essentially transfers deflation risk from the market in the near term to the real economy over the longer term.
Let’s tackle China’s ever expanding debt balloon first.
“Since 2007, China has added about $24 trillion-worth of debt,” says Hedgeye Financials analyst Josh Steiner.
That’s enormous.
To get a better handle on how big this problem really is, consider this: from 2000 to 2007 (the greatest leverage run-up in global history) the U.S. and Europe each added about $12 trillion in debt, Steiner says:
“So China’s economy is about one-quarter the size of the combined economies of the U.S. and Europe, and they’ve added as much debt in the same amount of time as those two economies did in the lead up to the biggest collapse in global history.”
Moreover, China’s “credit-to-GDP gap,” defined as the difference between the credit-to-GDP ratio and its long-run trend, just hit 30%. As Steiner points out in the video below, historically countries have a protracted credit crunch when this measure breaches 10%.
In other words, “China is extremely vulnerable,” Steiner says. “They’ve got a tremendous amount of debt and the non-performing loans are starting to balloon.”
This boom has been fueled by an unprecedented amount of monetary stimulus. And nowhere is the boom more evident than in China’s bubbly real estate market. After the People’s Bank of China (PBoC) flooded the economy with liquidity in 2016, year-over-year growth in the average house prices in first-tier Chinese cities went from a -5% decline in March 2015 to +30% growth in April 2016.
Over that same period, monetary stimulus stoked investment in Chinese manufacturing and construction. In 2015, heavy industry in China went from 0% year-over-year growth to 5.4%. Meanwhile, growth in industries like retail trade, financial services, farming and forestry have been slowing since 2007.
Since the easy money days of 2016, Chinese central bankers have been pumping the breaks to cool down its overheated property markets. The total monthly sum of net liquidity provided by the PBoC through its open market operations in the month of January amounted to a mere 350 billion CNY. That's a paltry sum compared to last January when the PBoC pumped a whopping 1.235 trillion CNY into the mainland financial system last January.
The -72% year-over-year change in open market operations liquidity provision speaks volumes to the “un-compable” comp that Chinese authorities are facing with respect to fiscal and monetary stimulus in 2017. As policymakers rein in monetary stimulus, the Chinese economy will slow. Already, average home price growth in China’s first-tier cities has declined from peak growth above 30% to 25% today.
What comes next?
The investing implications are fairly straightforward. China is experiencing a financial crisis with communist characteristics. The Chinese politburo is actively trying to manufacture a slowdown to save the economy.
What China is attempting to accomplish has never been done before in modern economic history. It is reasonable to assume the glide path down will be less linear than Beijing hopes. We suggest investors short Chinese large-cap stocks (FXI).
