CHINA’S ZOM­BIE ECON­OMY: AN EM­PIRE STUM­BLES

CAN THE SURGE IN COM­MOD­ITY PRICES LAST?

Finweek English Edition - - FRONT PAGE - By Petri Redelinghuys

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,

Sal­danha Bay

An­glo Amer­i­can Head­quar­ters in Jo­han­nes­burg

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