CHINA’S ZOMBIE ECONOMY: AN EMPIRE STUMBLES
CAN THE SURGE IN COMMODITY PRICES LAST?
all cower and tremble before the terrible and slowing economy of China!
It sounds so totally and completely ridiculous when said like that, although in truth, that is probably the most accurate way in which investors’ reactions to the onslaught of confusing and contradicting information coming out of China can be described. Markets are confused and a little more cautious than usual, and there is certainly no shortage of opposing views on what the future holds for China, and the rest of the world economy, to help spur on the current risk-off attitude in markets.
So in an attempt to understand what is actually happening, let’s explore some of the facts that we have at our disposal and what their potential impact could be on our, and world markets.
The fact is that the Chinese economy is slowing down. Now, there are some discrepancies between official government GDP data and that of independent economists and analysts, although the overall trend is similar.
The official data released by the Chinese government states that the 2015 GDP growth rate was 6.9%, below the magical 7% mark that the market has come to accept as the absolute minimum rate of growth for the Chinese economy in order for global markets to not to be too adversely affected. What is perhaps more concerning is that independent global advisory firm Oxford Economics estimates that the actual 2015 Chinese GDP growth rate was 6.3%. It cites differences in how the GDP input data is measured and states that the data being used by the Chinese government is “too smooth” to be trusted.
Many developments are standing empty – ghost cities are commonplace in China – and property prices have been steadily declining from late 2014 to date.
Digging into the various figures
This does not mean that the Chinese government is lying to the whole world about what is happening in its economy, it simply means that there are institutions out there that believe that there are more accurate ways in which to calculate the statistics on which the world markets have come to rely on so heavily.
Other notable independent institutions that analyse economic data are of course the ratings agencies. Recently Moody’s downgraded its outlook on China from Moderate+ to Moderate with a negative outlook.
Admittedly these ratings scales and methodologies can be rather confusing, but in essence they measure the risk associated with owning debt by either a company or a country.
Moody’s downgraded China’s sovereign debt rating citing the weaker yuan, very high levels of property-based debt, lower levels of imported goods, lower prices of commodities in general and less room for monetary policy to successfully steer China clear of the momentous economic headwinds that the country is facing. It is currently forecasting Chinese GDP to come in at 6.3% for 2016 and to shrink further to 6.1% in 2017, with the slowdown mostly concentrated within the heavy industry, or manufacturing, and importing sectors.
[Moody’s] is currently forecasting Chinese 6.3%GDP to come in at for 2016 and to shrink further to 6.1% in 2017, with the slowdown mostly concentrated within the heavy industry, or manufacturing, and importing sectors.
This is bad news and – if accurate – will no doubt lead to even lower commodities prices and further pressure on economies such as ours in South Africa.
Zombie firms and debt levels
It is also worth mentioning that Moody’s subsequently downgraded 25 non-insurance financial institutions in order to bring their ratings in line with China’s sovereign rating. On the surface this looks rather run-of-the-mill, although a number of these banks have been on negative watch for a while, so it would not be all that surprising if we see more downgrades in the near future in this particular sector.
Even though monetary policy is accommodative, credit conditions are tight and with the sheer number of manufacturing firms only managing to survive on lines of cheap credit from the banks – also known as zombie firms – to provide them with cash flow as they essentially run at losses, it raises concerns around the stability of the banking sector during times when their customers are not earning any money and getting themselves into an everdeepening pit of debt.
Currently China’s debt levels are around 250% of GDP and with GDP slowing and levels of credit growing, this does not bode too well for long-term sustainability. A monster has already been created and is now being fed more and more as Chinese authorities desperately try to stimulate economic expansion. It appears to be a vicious cycle that has only one outcome… disaster.
Ghost cities and a shadow banking system
Let’s look at this debt problem a little more closely in order to try and understand exactly what is causing it, and what the potential outcome could be. Research has shown that asset bubbles that are fuelled mainly by equities are usually not that destructive when they inevitably burst, although if bubbles are fuelled mainly by debt, the damage is far greater and longer lasting, often leading to major recessions.
China has experienced a decade-long boom in property prices, more than likely fuelled in its later stages by speculators trying to ride the momentum of ever-increasing property valuations. Many of these properties were financed by a variety of rather creative debt instruments sold to individuals by Chinese banks. What they would do is essentially create a trust company that borrows money from individual Chinese investors by selling them what are basically just high-yield junk bonds. The monies raised by these activities would then be invested into real estate or in companies related to realestate development – a fantastic way to get an economy to grow above 10% for a decade on the back of construction.
The problem is though that many developments are standing empty – ghost cities are commonplace in China – and property prices have been steadily declining from late 2014 to date. This shadow banking system that helped fuel the debt-based property boom could well be the very thing that brings down the banking system in a USA 2008-style subprime mortgage crisis as property valuations tumble.
Combine this with the aforementioned zombie firms and we have the makings of a potentially bigger crisis just waiting to unfold.
Now, you would think that in order to stop this problem in its tracks, or at least try to resolve it in some way, that you would have to reduce the amount of loans you grant. Instead China is easing monetary policy by lowering benchmark interest rates and also, interestingly, lowering the required bad debt coverage ratio that banks are required to have. Historically this bad debt coverage ratio was 200%, although recently this has been reduced to 150%, which of course leads to banks lending more money.
Sure, perhaps the percentage of bad loans in comparison to total economic activity is rather small at 1.7-odd percent of GDP, but this is easily kept down by simply granting more loans. When we look
Currently China’s debt levels are around 250% of GDP and with GDP slowing and levels of credit growing, this does not bode too well for long-term sustainability.
at the absolute value of outstanding bad loans it paints a completely different picture.
The chart to on p.29 shows us how the total outstanding value of soured loans has soared over the last three years. And these are just the current bad loans. When you include loans that show signs of future repayment risk, the total amount of credit at risk of default is closer to CN¥4.2tr (yuan) – about $645m. Keep in mind that it only took $600m to bring about the 2008 financial crisis. It would appear that China is doing everything it can to simply delay the inevitable, and when considering this, that Moody’s downgrade is starting to make sense now.
What happens when the yuan weakens?
Turning our attention to the weakening yuan, there are a number of things to consider. The first of which is the impact that a weaker yuan would have on the Chinese economy as well as the economies of countries that regularly trade with China, such as South Africa. A weakening Chinese currency would mean increased price competitiveness for Chinese companies, but as we’ve seen, also leads to massive outflows of investment as investors move money out of China in fear of a further weakening currency. Which of course leads to an even weaker currency.
It necessarily follows that companies that sell to China would see their profits dwindle somewhat as the currency they are being paid in becomes less valuable. Not so good for a relatively small emergingmarket economy that exports mostly resources and mainly sells to China.
To counteract this, China has been using its vast foreign exchange reserves to defend the yuan by buying its own currency back with the foreign exchange reserves that it has. Which brings us to the second consideration: the rapid pace at which these foreign exchange reserves are dwindling.
Trillions in foreign reserves. Or not?
Last year China’s foreign exchange reserves fell by an annual record of $513bn, bringing reserves to the lowest level since 2011.
To highlight the severity of the capital flight from China, the chart above shows the incredible increase in outflows over the past few years. This is an alarming trend and one that does not look like it will be broken easily.
Furthermore, doubt has been cast on the accuracy of the official reported amount of Chinese foreign exchange reserves. To be more specific, the doubt comes from the amount of liquid reserves China has. Some speculate that much of the foreign exchange reserves are held in illiquid assets such as private equity investments and offshore property, which cannot be easily sold off and used in time of need due to their grossly illiquid nature. Kyle Bass, a US hedge fund manager who has wagered billions on the fall of the yuan, believes that China’s actual reserves are more than $1tr below the Chinese government’s official reported number of $3.2tr in February. This is concerning.
If the yuan devalues considerably, this would mean that all other products – such as foodstuffs and wine – that we export to China will fetch lower rand profits.
Another source of concern is the amount of foreign exchange reserves that were used in order to prop up the stock market during the tumultuous times of mid-2015 to early 2016, during which the Shanghai Composite fell by 40-odd percent.
Sure, the Shanghai Composite had run incredibly hard before that and even though it fell 40% it still ended last year in the green, but in the process China threw hundreds of billions of dollars at the problem, not to mention injected $93bn into two banks, bringing the total amount spent in defence of the Chinese economy to around $800bn. $800bn spent out of the total $4tr in reserves China had just over a year-and-a-half ago means that it has spent 20% of its foreign exchange reserves in a very short period of time. Money that could have been spent on foreign direct investment into developingand emerging-market economies, as well as be used as a windfall should any unexpected shocks hit the Chinese economy.
Defending the yuan
Not only has China directly bought back its own currency in the open market in order to prevent its devaluation, but it has been silently defending it in other ways as well. The Chinese government has taken steps to limit outflows from its country by arresting leaders of underground banks who were converting billions of yuan into dollars and euros, made it more difficult for
individuals to purchase insurance policies in US dollar, halted sales within China of investment funds and wealth management products that are denominated in dollars and, most recently, started charging taxes on currency transactions. These are all calculated steps taken in an attempt to prevent money from leaving the country.
The questions now are: how much more can the Chinese policymakers do, and how much further will they allow their foreign exchange reserves to dwindle before they implement blatant capital controls? Some speculate that with strict capital controls, China could allow their foreign exchange reserves to go as low as $1.5tr, while without capital controls only as low as $2.7tr. At which point the Chinese government will be helpless in the defence of the devaluation of their currency and we are facing a situation where countries that export to China will suffer severely.
US bond market fears
Another interesting consideration is the possible effect that the fall of China could have on the US bond market. China is the single largest investor in US government bonds and should it need to tap into those investments in a continued effort to save its slowing economy, the selling pressure could crush the US bond market and possibly trigger an entirely different type of financial crisis.
What does this mean for SA?
So what does all of this mean for the South African economy? First we need to ignore all of South Africa’s own political and economic risks in order to isolate exactly what the ‘China effect’ on our economy will be. In this sense we are only really concerned about two things: commodity prices in dollar terms and the strength of the yuan versus the rand.
If China slows down more and has a hard landing – which some argue is actually busy happening right now – we can expect commodity prices to continue sliding on the back of lower demand. China is the world’s biggest importer of raw materials and if it no longer has such great need for them, prices will have to revert to their long-term means which, believe it or not, are considerably lower than they are now. This could lead to massive job cuts in the mining sector as mining companies that are already struggling to stay afloat will run at severe losses.
Some companies might fail while many might merge and sell assets to one another in an attempt to survive the storm. Take Kumba Iron Ore as an example: China vowed to cut local production of iron ore, which led to a short-lived but severe rally in iron ore prices. This might have boosted Kumba in the short term, but iron ore prices are on the way back down again and so is the Kumba share price.
Anglo American has decided to sell its stake in Kumba and African Rainbow Minerals has stepped up to the plate, saying that it is considering buying the stake. This is sectoral restructuring on a grand scale and, as we’ve seen with Anglo American, more than likely just the start of mining companies’ vast asset sales that are on the horizon. Yes, this will mean that large amounts of capital will be lost as share prices tumble, but it will also mean that we will end up with more efficient mining companies in the years to come.
In the long term value will be created, but at a great cost to investors and everyday mineworkers, and thus, SA’s tax revenues and ultimately, our economy. If the yuan devalues considerably, this would mean that all other products – such as foodstuffs and wine – that we export to China will fetch lower rand profits, which will again lead to the same problems as before, namely job cuts and lower tax revenues. If China has the muchfeared hard landing that now appears almost inevitable, SA will pay very dearly for it and more than likely not be able to avoid a deep recession.
This does not mean that investors should run for the hills though. The fat lady has not yet started singing and there is much more that will no doubt unfold in the weeks and months to come. Besides, there are great investments to be made during difficult times and we know that even if you stay invested during recessions and crashes, the market recovers and asset prices rise again. It is just a matter of patience and discipline to stay the course during the difficult times and to try to find the phoenix that will rise from the ashes of the world’s once-fastest-growing economy.
If the yuan devalues considerably, this would mean that all other products – such as foodstuffs and wine – that we export to China will fetch lower rand profits. China could allow their foreign exchange reserves to go as low as $1.5tr while without capital controls only $2.7tr.as low as
Yunnan Province of China. Chenggong is a satellite city located just south of Kunming. As of 2012, much of the newly constructed housing in Chenggong is still unoccupied, and it is reportedly one of the largest ghost towns in Asia.
Kumba Iron Ore Iron ore export terminal,
Anglo American Headquarters in Johannesburg