The blog’s new Research Note in the ‘Your Compass on China’ series highlights the way that China’s commodity imports have been used to finance its housing bubble. This is clearly a shock for investors, who have till now believed the imports were a sign of its superior economic policies and long-term growth prospects.
The Qingdao probe could thus become the straw that breaks the camel’s back for world markets. There are two reasons to believe this is a serious threat:
- Investors have assumed that China’s vast share of global commodity demand was due to its economic growth. Now they will slowly wake up to find it was more about supporting a housing bubble
- Similarly, they have assumed that China had become ‘middle class’ with Western living standards and incomes. Now they will be forced to realise that consumer spending has been driven by the ‘wealth effect’
The worry is that the global financial system is currently priced for perfection. and may not be resilient enough to cope with this shock. Investors, companies and individuals have been lulled into believing that central banks’ experience with the Lehman Bros collapse means they will never let markets suffer a major downturn:
- Borrowing to buy stocks in New York is at record levels
- Investors Intelligence US sentiment index at 62.2% is at danger level, above August 1987 and October 2007
- American investors so-called ‘fear index’, the VIX, is at its lowest level since 2007
The best view is always from the top of the mountain, and thus it is no surprise to see Goldman Sachs still bullish:
“If nothing unexpected upsets the stock market’s delicate balance at these lofty heights, VIX could fall to record lows.”
The Qingdao probe is exactly the type of ”unexpected” event to reveal this as simply wishful thinking. The key issue is that a large part (we don’t yet know how much), of China’s vast purchases of commodities since 2009 has not been used to build the economy. Instead, it has been used as collateral to finance a huge property bubble.
China’s new leadership clearly understand this. As the blog discussed in its February Research Note, they are now implementing a series of well-designed policies with the help of the World Bank to limit the damage from the bubble’s collapse. We can only hope they are successful.
Now, however, the rest of the world is about to discover what they already know. The blog’s fear is that this discovery will prove extremely painful, because of being so “unexpected”.
A core reason for concern is the total size of China’s corporate debt. It overtook the US in 2013 at $14.2tn, according to ratings agency S&P:
“China’s corporate issuers account for about 30% of global corporate debt, with one-quarter to one-third of it sourced from China’s shadow banking sector. That means as much as 10% of global corporate debt, about $4tn to $5tn, is exposed to the risk of a contraction in China’s informal banking sector.”
China’s ‘collateral trade’ is at the heart of the issue. This is why the Qingdao probe is potentially so earth-shaking:
- Already some lenders are withdrawing from commodity financing in China as the risks rise
- Global market prices for copper and iron ore are declining, as informed players exit the market while they can
- The Economist notes that China’s banks are starting to become more reluctant to grant letters of credit
An investigation by the Wall Street Journal (WSJ) makes the link between the ‘collateral trade’ and housing very clear,. It appears the owner of the company at the centre of the Qingdao probe was heavily involved in real estate development:.
“In 2008, China’s government unleashed a $4 trillion stimulus package aimed at helping the economy withstand the global financial crisis. The stimulus drove a wave of credit through China’s financial system that launched a building boom in cities like Qingdao.
A real-estate company controlled by Mr. Chen currently is developing at least four projects in Qingdao, including a residential project called “Brocade City” and a large mixed-use development in the city center, according to the firm’s website.”
The WSJ adds that Mr Chen was not unique:
“Just about every trader who does collateral financing is also likely to have a real-estate development on the side, because the property sector gives higher returns,” said Jerry Chen, a metals trader at Shanghai-based Star Futures.”
It is already clear that China’s property market is entering a major slowdown, with Beijing sales down 35% so far this year. This will itself prove an enormous shock as property has been a money-making machine till now, with prices doubling every 2 to 3 years since urban property was privatised in 1998.
As property prices now fall, the ‘collateral trade’ will come to an end. In turn, investors will slowly realise that China’s economic growth has indeed been tied to a property bubble which is now beginning to burst.
There is thus a serious risk that today’s warning tremors in Qingdao will become a serious earthquake, and open fault-lines across the global financial system. Investors may now find out the hard way that central banks have instead created a debt-fuelled ‘ring of fire’, with China’s property bubble at its epicentre.
Today, the blog launches a major new Research Note in the ‘Your Compass on China’ series, produced in association with leading Hong Kong-based financial advisory firm Polarwide.
Titled ‘Here today and gone tomorrow – a simple guide to China’s world of trade finance’, it is probably the single most important paper it will publish all year – please click here to download a free copy.
The bottom line – China’s vast imports of commodities such as iron and copper have, in reality, often been used to finance today’s property bubble. This is how it worked:
Sardine tins were scarce during World War 2 in the UK, and often became tradable items in their own right. Then one day, a company decided to open some for a celebratory lunch, only to find that the sardines had decayed, and were uneatable. On complaining to their supplier they were told – “That’s not our fault. Those sardines were for buying and selling, not for eating.”
This is perhaps the best analogy to explain what has been happening in China with its so-called ‘collateral trade’ since 2009. The world wanted to believe that China’s rise to consume two-thirds of the world’s iron ore, and 40% of its copper, was due to its superior economic policies and long-term growth prospects. But the truth is somewhat different. A major part of these imports have instead been used as collateral for loans to support its housing bubble.
News agency Reuters has suggested, for example, that 100 million tonnes of iron ore are currently tied up in such financing deals. This would be enough to build 1200 buildings the size of New York’s Empire State building. A wide range of other commodities have also become involved more recently, including polymers such as polyethylene and polypropylene. As the Wall Street Journal reports:
“In mid-2013, authorities limited how much traders could borrow against commodities like iron ore and copper. But that only pushed investors to start using a wider range of collateral, including soybeans and palm oil”.
The concept behind the ‘collateral trade’ was simple, though its various mechanisms are complex. Its aim was to finance speculation in China’s property sector as it reached bubble-like proportions, with central Beijing apartments selling for 34 times average earnings. This is four times the ratio seen at the height of the US sub-prime boom.
Property developers have been offering sky-high returns for short-term loans. And one easy way to participate has been to use imported commodities as collateral for letters of credit issued offshore – often in Hong Kong. Investment bank Goldman Sachs estimate that up to $160bn may have been involved in such schemes.
Now, however, China’s new leadership has begun to steer a new course with the economy. The $10tn lending programme developed since the Crisis began in 2009 is being wound down. Property development, currently almost a quarter of the economy, is being drastically scaled back. As state-owned China Daily has highlighted:
“If the country is to eliminate up to half of its industrial base to make way for business based on the mobile Internet, it will have to keep the credit line really tight for local development projects.”
Thus the ‘collateral trade’ is fighting for survival as China’s government and central bank clamp down. China’s 3rd largest port, Qingdao, was closed in early June, with news reports suggesting that up to $1.6bn of allegedly fraudulent deals were under investigation. Qingdao had already started to see property price declines of 20%-30%, as the government’s new policies hit home. Now, as The Diplomat notes:
Qingdao’s commodity and asset market troubles offer an example of how the decline in the shadow banking and real estate markets is playing out in China. It reveals that interconnected degradation is eminently possible and potentially circular, as one shock reinforces another in turn. It is likely that we will see other similar situations emerge in the near future. Qingdao also shows that after-the-fact policies such as loosening mortgage lending are too small to combat full-on market retrenchment. It is hoped that larger reform policies will stimulate economic growth where defensive economic policies cannot. Much is likely to play out through the end of this year.
Investors and companies are now discovering, the hard way, that a large part of China’s commodity imports have not been used for their proper purpose. Instead, like wartime sardines, they have simply been collateral for buying and selling – this time, in support of a gigantic property bubble.
China seems to be trying to tell the outside world something quite important about the impact of its economic policy changes. But to judge by most expert commentary, the outside world is convinced they are bluffing. Thus JP Morgan issued a Buy recommendation yesterday on the Shanghai market:
“Chinese stocks will probably rally as much as 20% as gauges of economic growth stabilize and valuations rise from historic lows. We recommend a trading buy of China equities, based on seasonality and all-time low valuations. We expect a 15-20% market rebound in the coming weeks, once growth stabilizes due to seasonality and the market’s focus switches to structural reforms.”
But state-owned China Daily gave a different view from the prestigious Academy of Social Sciences the same day:
“Surging borrowing costs are threatening China’s economic growth this year. With growth momentum already slowing, Chinese enterprises will find their earnings increasingly insufficient to cover the cost of debt, with loan rates now exceeding 9%. The situation inevitably raises the question of how the credit-dependent economy can keep expanding at the current pace. There’s a dilemma facing the central bank.
“If the People’s Bank of China maintains a tight monetary stance and loan rates stay high, economic growth will be constrained. Cash-starved companies will result in a contraction in business activity, with the Purchasing Managers’ Index for manufacturing likely to slide below 50 in the second quarter. If the PBOC loosens monetary policy to push down borrowing rates, it will have to achieve total social financing – a broad measure of liquidity – of more than Rmb 19tn ($3.14tn) to support GDP growth of 7.5%.
“But that amount of total social financing would represent 12% year-on-year expansion, much faster than last year’s gain of 9%. An increase of that scale will cause massive macroeconomic risk, because non-performing loans will pile up faster and the goal of reducing the economy’s reliance on credit-fueled expansion will recede even further into the distance. To have more sustained and quality growth, we’ve got to let the growth rate go down.
“Yet another risk is the massive debt of local governments that rely on land as collateral. If there’s a setback in the property market and land values decline, it’s unclear how local governments can repay their debt, analysts said. As of June 30 last year, that debt stood at an estimated Rmb 17.9tn.
“People always say China’s economic growth model is export- and investment-driven. But if you look at the data for the past two or three years, it is becoming solely investment-driven. Exports in 2012 made a negative contribution to GDP growth, and if you deduct speculative funds disguised as trade payments, you’ll find that exports were a drag on growth again in 2013. As the economy increasingly relies almost solely on investment, any slowdown in investment could curtail growth.”
And then, as if it wanted to ensure we got the message, it used the chart above in reporting on the coal market :
“China’s drive to transform its economy, which includes reducing the role of energy-intensive industries and paring steel capacity, is driving up coal inventories at key ports as demand across a variety of sectors weakens. Inventories at Qinhuangdao in Hebei province, the largest coal port in China, exceeded what’s widely viewed as the warning line of 8 million metric tons on Feb 6, which was a 10-month high, according to the China Coal Transportation and Distribution Association.
“The rising stockpiles indicate that downstream users at steel mills, cement factories and coal-fired power plants are reluctant to purchase fuel because of weak market conditions.
“Inventories at Qinhuangdao usually hover around 6MT, but the figure has been rising in the past few months. In the past three weeks, the figure soared almost 2MT, reaching 8.28MT on Sunday. Inventories are also rising at the other three major coal ports in North China – Caofeidian and Jingtang (both in Hebei province) and the municipality of Tianjin. Inventories at the four major ports in North China totaled 22MT by the end of last week.
“Given that coal fuels so many industries, weak demand for the fuel also portends a slowing economy.”
“Massive economic risk”, or “trading buy”? Opinions really couldn’t be more opposite.
Time will tell if the outsiders know best – but the blog doesn’t believe that China’s new leadership are bluffing.