Last week, the Australian newspaper published the below chart showing Australia is in the midst of the biggest mining investment boom in its history that is forecast to reach a whopping 7% of GDP (hat tip Tom Conley).
It’s a view shared by the Australian Treasury who, in the recent Federal Budget, forecast that “the terms-of-trade, and so mining activity are expected to remain at historically high levels for an extended period”. The Treasury also forecast that China would account for just under a quarter of the world’s GDP by 2030, up from around 13% currently, with Australia being a key beneficiary of this growth.
The party poopers:
While the Australian Treasury is viewing China through rose-coloured glasses, other experts believe that China’s economy is on the brink of a sharp slowdown that could send commodity prices into a tailspin, and send the Australian economy into a recession.
The most famous of China bears, Jim Chanos of investment firm Kynikos Associates, provided another interesting counter-perspective on China in an interview last week on CNBC (video below).
Mr Chanos, whose investment team has recently returned from a tour to China, makes a number of shrewd observations including:
- China’s economy is showing real signs of weakening, particularly in real estate. “The cracks are spreading in the facade… You’re seeing real estate firms shutter, sales offices closed down. Some of the engine behind the boom is at least beginning to sputter.”
- Chinese developers are now turning to Hong Kong to raise capital through junk bonds as China’s banks wind back lending.
- 60% of China’s economy is driven by construction (mostly real estate) – twice the proportion of the 1997 Asian tigers before the Asia financial crisis. By comparison, only around 10 to 15 per cent of developed economies are driven by construction.
- A sharp slowdown in construction could plunge China into recession quickly. “A lot of people are willing to say China will slow down… The really scary thing is if you do the numbers and they cut back on construction it’s not a slowdown, and they go negative real fast… The fact of the matter is if they hit the brakes really hard, the economy goes into reverse. It doesn’t slow… Nobody will say that publicly because it’s unbelievable. But it happens to be the way the numbers work”.
- A Chinese economic slowdown or recession would have strong knock-on effects for commodity producers like Australia via a terms of trade shock that would cut per capita income, and send share and housing prices sharply lower. “It’s interesting that the only other countries that are experiencing a property boom besides China are Brazil, Australia and Canada” [all commodity producing countries tied to the China growth story].
Richard Koo, Chief Economist of Nomura Research Institute has also provided an interesting interview below (hat tip Zarathustra).
According to Mr Koo:
- In the wake of the 2008 Lehman Brothers collapse, the Chinese government implemented a massive fiscal stimulus package and told the banks to lend as much as they could to regional governments in order to generate growth. The regional governments spent this money on construction projects, which then led to massive inflows of funds into the private sector.
- China has a massive housing bubble at the moment. It has built a large number of high-rise condominiums that cost almost $US1 million each when the bulk of the population are earning only modest sums. The Government is very concerned that Chinese citizens may revolt against the high prices. Accordingly, Mr Koo believes that the clamp-down on the housing market is real and “we could see some blood in that industry or sector going forward”.
- The Chinese Government has the ability to offset the growth negatives arising from the slowing housing market with massive government stimulus so that the total GDP is maintained. However, we could see some non-performing loans eminating out of the real estate sector.
Zarathustra has provided a nice critique of Mr Koo’s contention that China would once again employ massive amounts of stimulus in the face of a real estate market collapse. According to Zarathustra, any monetary or fiscal policy response would delay the Chinese Government’s efforts to rebalance its economy away from its current unsustainable investment-led model towards a consumption-based economy. While further stimulating growth via increased investment could work for a while, the problem of sustaining the unsustainable fixed-asset investment would remain, only bigger.
That brings us to Michael Pettis and some exclusive material from his newsletter this week in which he describes problematic debt structures for China, but we can also recognise Australia:
Very briefly, there are four things that increase credit risk by increasing the probability of a mismatch between revenues and debt servicing costs:
The total amount of debt relative to assets (or perhaps GDP, in the case of a country) is important. The more debt a borrower has, the more likely that his debt servicing costs will at some point exceed revenues. It is important that we calculate correctly the value of assets and GDP for this to be a meaningful exercise. If, for example, I am right in claiming that for several years China’s reported GDP growth may have exceeded real GDP growth because the value of misallocated investment was systematically overestimated and the cost of environmental degradation underestimated, then we would have to make sure we adjust the debt to GDP ratio to reflect this.
The structure of the debt matters. In my book (The Volatility Machine) I distinguished between invertedand correlated debt structures. Inverted debt is debt whose servicing costs decline when underlying economic conditions improve and rise when underlying conditions deteriorate. An obvious example is the dollar debt incurred by South Korea in the 1990s. As long as economic conditions in South Korea improved, the ability of Koreans to repay the debt improved even more dramatically. Assets prices rose and the dollar depreciated in real terms, making the cost of the debt decline. Of course during the crisis the exact reverse occurred, and as Korean ability to service debt plummeted, the cost of the debt rose. This kind of debt structure automatically increases volatility – both on the upside and, more worryingly, on the downside.
Inverted debt structures occur also when there is a possibility of surge in contingent liabilities in the banking system. This usually happens either when borrowers during an economic downturn are not able to generate sufficient cash flows to repay debt, or because the debt is collateralized by assets, whose values are themselves sensitive to credit conditions (as they often are). This, of course, is the reason why I spend so much time trying to understand the debt levels and structures in China. For anyone who wants to read more on the subject of liability structure, I discussed it more extensively in a July, 2010, blog entry.
Feedback loops matter. This might be implicit from the previous point, but one of the real sources of credit risk is in the existence of agents whose behavior reinforces underlying conditions in a positive feedback loop. Collateralized lenders who force asset sales as credit conditions deteriorate are such agents. External currency borrowers who have urgently to cover their short positions when the currency unexpectedly depreciates must do so by selling their currency and forcing it even further down also create positive feedback loops.
The point is that good markets cause these agents to act in ways that further improve the markets, while bad markets force them to do the reverse. This automatically adds volatility by creating an inverse relationship (i.e. negatively correlated) between revenues and debt servicing costs, and of course the more negatively correlated, the greater the probability of a mismatch between the two.
There are, of course, negative feedback agents, and these automatically reduce volatility. The most important is probably the central government or the central bank, whose behavior can counteract adverse changes in debt conditions as long as their behavior and ability are credible. This is why it is extremely important, in my opinion, always to protect the sovereign credit by limiting its borrowing, its implicit or explicit guarantees, and its market signaling. When sovereign debt is itself the problem, it is hard for any credible agent to create negative feedback.
Underlying volatility matters. Companies whose expected earnings are very volatile, or countries whose economic growth is very volatile, are unable safely to carry as much debt as less volatile counterparts. Volatility in earnings (or growth) itself increases the probability of a mismatch between revenues and debt servicing costs
Debt and transparency
We need to keep this framework in mind when we examine debt structures in China. It is not just a matter of comparing total debt with total assets. We have to be sensitive to how changes in values between debt and assets are correlated, how agents are likely to behave in bad times, where we might see surges in contingent liabilities during those bad times, and how debt concerns are likely to be transmitted.
This last point is worth elucidating. One of the sillier comments I often hear from China analysts is that because of lack of transparency in the banking system no one will ever know how bad the national balance sheet is and so we will never need to worry about the problem of too much debt.
This claim (and I swear I have heard it many times) is nonsensical for at least two reasons. First, although lack of transparency may be benign or even positive in a feverish up-marked driven by liquidity growth (after all if you desperately want to buy sup-prime mortgages, its better not to know about too much about how the mortgages are generated), it is always a serious problem once market conditions change.
When investors become nervous, the fact that they know little about the true condition of the balance sheet increases uncertainty, increases the desire to sell, and reduces the credibility of policy aimed at improving conditions. If you don’t believe me, just ask the pre-2007 investors in Greek government bonds or in sub-prime mortgages – both were markets where very poor transparency was ignored or even celebrated when markets were strong and obsessed about when markets weakened. In fact I would argue that lack of transparency is one of the most powerful of positive feedback mechanisms – it lifts you on the way up and crushes you on the way down.
Second, even if it is possible to hide the condition of insolvency, it is not possible to eliminate the cost. The only way to avoid defaulting on debt is to service it. If there is too much debt and the borrower cannot repay except by turning to the government, this only means that repayment will occur with the aid of explicit or hidden transfers, almost always from the household sector.
Of course as the household sector is forced to cover the losses, its own income is reduced and with it its consumption. This was how the banking crisis in China ten years ago was “resolved”. Foregone consumption means foregone demand, and the real economic growth that would have occurred as companies invested and created goods and services to service that demand is also foregone. Debt is always paid for one way or the other.
And that is why for the next couple of years I going to be watching Chinese debt levels and debt structures closely. My understanding of the Chinese growth model suggests that we are in the midst of an unsustainable increase in debt and that it is debt ultimately that will determine the timing, extent and duration of the adjustment process. There are many in Beijing who want to speed up the adjustment and slow down investment for precisely this reason. Others however who want to maintain high growth and see no reason to reduce investment sharply oppose them, and so far they are in control of policy. But there is reason to move quickly, and the reason is the unsustainable rise in debt. The sooner investors and policymakers understand the debt dynamics implicit in the growth model the better for China.
It’s difficult to know which view on China is more credible: the Australian Treasury’s endless boom or Mr Chanos’ impending doom. The truth probably lies somewhere in between. China does have a great deal of latent growth in its rapid catch-up to the productivity and capital intensity levels of developed economies. But it has also clearly developed a nasty imbalance.
However, with the Australian economy so levered to the China growth story, not too much has to go wrong for the economy to get hit hard. After all, how realistic is it to expect commodity prices to stay near century highs for an extended period, without hitting some pot holes along the way?
What deeply concerns me is that the Australian Government has done little to prepare the economy for when the commodity boom has run its course. With manufacturing and other tradeable industries being gutted, and no sovereign wealth fund to fall back on, who is going to support the economy then?
Some real leadership would be nice for a change…
Cheers Leith
