C&B Notes

Boom & Bust for Chinese Assets

A search for higher returns by Chinese investors, fueled and accelerated by multiple forms of credit, has led to speculation in a variety of financial and hard assets. The boom and bust cycles are confounding the communist party’s best efforts to control them.

A succession of asset bubbles has formed in China, caused by a torrent of speculative money sloshing from stocks to bonds to commodities.  The biggest apparent bubble is in housing, but prices have surged for niche assets, too, such as calligraphy, antiques and art.  In May, futures prices for soybean meal, used as pig feed, jumped 40%.  The trading volume of 600 million tons was nine times higher than China’s annual consumption.  The pipe-making material PVC is up 40% so far this year on the Dalian Commodity Exchange.

The world’s second-largest economy is slowing.  Easy credit and successive fiscal stimuli, designed to keep China aloft, mean it is awash in money that is chasing an increasingly small number of investment opportunities.  China’s money supply has quadrupled since 2007, and the new cash is largely trapped inside the country by government capital controls…

“It’s impossible to know when you are in a bubble, but the succession of mini-bubbles is a pretty good sign historically that you are in a bubble,” said Michael Pettis, a finance professor at Peking University.  “There would have to be an improbable number of economic coincidences coming together for all of these mini-bubbles not to be a sign of a bigger economic issue.”  In May, China’s official People’s Daily newspaper published a front-page interview with an unidentified “authoritative person” that was drafted by top economic advisers to President Xi Jinping.  The interview cautioned that without proper management, excessive credit could provoke a systemic financial crisis, recession and the destruction of savings.

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China’s total debt is expected to reach 260% of gross domestic product this year, up from 154% in 2008, according to analysts at Goldman Sachs Group Inc.  That is one of the largest debt increases in modern history.  China’s debt-to-GDP ratio has widened from its long-term trendline about three times as much as the U.S. did before the 2008 financial crisis, according to the Bank for International Settlements, a consortium of central banks based in the Swiss city of Basel.  The debt binge began with a crisis-related stimulus package.  China’s public and corporate debt then grew threefold to about $22 trillion as Communist Party leaders used freer credit to support struggling state-owned firms and meet annual economic-growth targets.

The downside of so much cash washing from one asset type to the next burst into view with a stock-market crash in the summer of 2015 that wiped out $5 trillion, or 43%, of value in Chinese stocks at one point.  The Shanghai market had doubled from June 2014 to June 2015 as investors borrowed 2 trillion yuan ($300 billion) to buy stocks.  To steady the stock market, authorities restricted short selling, and a “national team” of investors relied on by the Chinese government to support its stock market stepped in to purchase beaten-up shares.

Money then flowed into bonds.  Many investors bought them by borrowing money against bonds they already owned, repeating the process over and over again.  Such borrowing grew to 2.5 times the size of the $7 trillion bond market, according to bond-market analysts.  The surge slowed only when yields tightened enough that bonds looked less attractive than other asset types.

In this year’s first quarter, China’s total credit surged by another $690 billion, equivalent to about three times the economy of Ireland.  Then came a bout of commodity speculation, which pushed prices for some products out of sync with economic fundamentals.  Iron-ore futures surged 50% from January to April even though Chinese ports were piled with iron ore.  Prices slumped in May.

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