In GMO's excellent piece, Feeding the Dragon: Why China's Credit System Looks Vulnerable, the authors do a thorough job detailing China's susceptibility to a credit crisis. Unless you fall in the "This time is different" camp, it is difficult to ignore the numbers:
- 2012 new non-financial credit expanded by 15.5 trillion RMB ($2.5 trillion USD), 33% of 2011 GDP.
- From 2008 to 2012 the ratio of credit to GDP climbed 60% to 190% of GDP. This is faster than the U.S in the run-up to the 07-08 financial crisis and Japan in the years leading up to the popping of the asset price bubble in 1989-1990.
- China's Public Debt, officially at 30%, is closer to 90% when all off-balance sheet liabilities of the government including state owned bank loans to local governments, debts of governmental ministries like the Ministry of Railways, etc. are included. This is close to the USA's ~100% gross debt/GDP ratio.
GMO reemphasizes that it is periods of rapid credit growth, rather than the absolute amount of outstanding credit, that historically precede financial crises.
It seems clear that China will face a day of reckoning. Astute investors like Jim Chanos and China-watchers like Michael Pettis have been predicating this since the surge in credit in 2009 (45% of 2008's GDP) that China unleashed to combat the global financial crisis.
But the question is when? Many investors and pundits rightly predicted the U.S subprime crisis, but were too early and suffered years of losses before being proven right. The market can stay irrational longer than you can stay solvent. GMO mentions two potential scenarios that may trigger a credit crunch and subsequent crisis.
The first is an outflow of capital from China. This may already have begun. The WSJ estimates that capital outflows in the 12 months to September 2012 were ~$225 Billion USD. China's foreign exchange reserves have stopped growing in Q4 2012. They were growing at 40% annually in 2008 when the global financial crisis broke out. The increase in China's foreign exchange reserves in 2012 was only $99 billion vs. $385 billion in 2011.
If Chinese savers and investors believe that the RMB will depreciate due to the rapid expansion of money (M2) the last few years, this could further exacerbate the outflow of capital. China's M2 is currently 15.7 trillion USD-2X GDP while the US is at 10.4 trillion USD - 70 % of GDP.
The second possible trigger for a credit crisis, according to GMO, is a loss of confidence by investors in the wealth management products (WMPs) and Trust products (mostly invested in real estate and local government financing vehicles) that have become popular in the past 3 years as they offer higher yields than bank deposits. Outstanding WMPs rose to 13 trillion RMB (~2.1 trillion USD) in 2012, an increase of 50% from 2011.
GMO argues a major problem with the WMPs is a duration mismatch - the money is borrowed short term then invested manly in longer duration assets. Until now there have been very few defaults on WMPs and Trust products, as most of the issuing companies have made good on the principal even in the case of defaults by the underlying borrowers. But if there are a string of defaults and the public loses faith in the products, the issuers may lose access to the WMPs and Trusts as a source of funding for their longer duration assets.
There are already some signs of trouble brewing in the WMP market. Huaxia Bank sold a 100 million RMB WMP to investors that defaulted in December. Caixin published an excellent article this week titled "Failure of trusts sends ripples through Industry" that details how CITIC, China's largest issuers of trusts, has said it will not guarantee payment to investors when underlying borrowers have trouble paying back the loans. Up to now, there has been an implicit belief by investors that the issuers of the WMPs and Trusts (or the government) will guarantee the investments. When investors no longer believe this is true, there is risk of a rapid drop in the ability of companies to raise money from WMPs and Trusts, forcing them to look elsewhere for funding.
In summary, although it is impossible to predict when the credit crisis will happen in China, there are now 2 potential triggers: 1) An outflow of capital 2) A drying up of funding from wealth management and trust products.
Many of the assets that will suffer from a China credit crunch and corresponding slowdown in economic activity have run-up sharply and offer good entry points on the short side.
The most compelling is probably Iron Ore. Steel is the main ingredient in China's investment led growth and corresponding overcapacity. It is estimated that China currently has capacity of 980 million tons/year steel, an excess of 300 million tons. A slowdown in fixed asset investment would severely crimp the steel industry and corresponding price of iron ore, the primary input. China Imports 60% of all seaborne iron ore and consumes 65% of iron ore produced worldwide. Benchmark Seaborne iron ore prices briefly dipped to $87/Ton in September 2012, but have since recovered above $150 on renewed demand from China. Prices at the end of 2007, before China's credit expansion really took off, were $37/ton. If China does experience a credit crisis and fixed asset investment in infrastructure and real estate slows sharply, Iron ore has a long way to fall.
The most obvious short candidate is Vale (VALE). It is the world's largest producer of iron ore and supplies 30% of all worldwide seaborne iron ore. Approximately 90% of Vale's operating earnings are generated from Iron Ore. It is also geographically (Brazil) the furthest from China and the other Asian consumers so incurs the highest shipping costs and shipping lead times. Finally, Vale is a quasi-government company, with the Brazilian government and an associated holding company owning ~60% of the company. This makes it susceptible to government interference and possible non-economic decisions that could be detrimental to shareholders.
The second candidate is Rio Tinto (RIO). 80% of Rio's operating profits come from Iron Ore, despite its reputation as a globally diversified miner.
The third candidate is Fortescue Metals (FSUMF.PK), which generates almost all of its earnings from Iron ore and has higher production costs than the big 3 (RIO, BHP, Vale). It is also highly leveraged with a debt/equity ratio of 2.25.
Caterpillar (CAT): Although the majority of CAT's earnings are from outside China, CAT has invested heavily in China and has seen a massive slowdown on its business there. Cat currently has 23 manufacturing facilities in China and IS building 4 more. On CAT's Q4 conference call an analyst from JPM estimated from channel checks that CAT has 1 year of year of inventory on the ground in China at today's demand levels. A fall in commodity prices and associated mining industries from a Chinese credit crisis would also severely impact Cat's bottom line. Although CAT had a strong 2012 in its resource industry segment (ex-Siwei write down), it is predicting for 2013 a $2 billion decline in sales and revenue and that "more than all of the decline in sales and revenues is expected to be in our Resource Industries segment."
Cummins (CMI): The engine maker reported in Q4 2012 results that international sale declined by 15% with the most significant declines in Brazil, China, and Europe. 2012 revenues from China were down 20% and despite the talk of a pick-up in the economy in Q4 after the leadership changeover, Cummins reported that "The Chinese construction industry continued to experience weak demand for new excavators through the end of 2012 with fourth quarter sales of excavators down 25% year-over-year. Full year industry sales declined 35%, in line with our previous guidance. There is still a significant overhang of inventory both in distribution channels and in OEMs that will dampen new equipment production in 2013 even after the end markets begin to recover. Demand for Power Generation equipment (also) declined sharply in the second half of 2012 as the Chinese economy slowed."
U.S treasury yields have risen sharply the last months from a low of 1.4% to ~2% now. A credit crunch in China or significant outflows of capital from China and other emerging markets should send investors fleeing back into the safety of treasuries, just as the European crises in the summer of 2011 and 2012 did, driving yields back down. Treasuries should also benefit from a continuing sluggish US economy (the CBO estimates there is a 6% output gap) and from rising geopolitical tensions, especially the Japan-China dispute over the Ryaku/Diaoyu islands and a potentially escalating conflict in Syria.