Panic In China: Malinvestment, Deflation, And The Next Emerging Market Crisis

| About: iShares China (FXI)

Back in 2009 and 2010, the world was still very focused on the US financial crisis and its aftermath. In a sea of gloom and doom, a popular view emerged that the US would eventually be overtaken by China as the world's great economic power.

Jim Rogers was one of the most famous investors heralding China as the future. Rogers was bullish on China, gold, and commodities and compared moving to China in 2007 to moving to New York in 1907. Rogers even went so far as to berate short-seller Jim Chanos for his critical commentary on China's credit bubble, quipping that 'Jim Chanos couldn't spell "China" 10 years ago.'

Rogers may have been the most notable China bull, but there were so many others. Byron Wien of Blackstone Advisory argued that China's authoritarian political model was superior to the US, because their leaders could address problems quickly. Motley Fool blasted out a large number of bullish China articles, with writers such as Tim Hanson and Rick Munariz, leading the charge.

It would be simple enough to find records of dozens of other prominent investors pounding the shoe for China in 2009 and 2010. The theme was always similar: China's growing population, rapid urbanization, and centralized planning would provide it with rapid growth.

The Flaws in the Bull Thesis

There have always been major flaws in the China bull thesis. China's seemingly spectacular growth has been built via a "perma-stimulus" that has helped fuel a massive credit expansion. That credit frenzy has created one of the most massive episodes of malinvestment in world history. "It's Dubai times 1,000," short-seller Jim Chanos once argued, referring to Dubai's property bubble collapse in 2008 and 2009.

It's difficult to pinpoint an exact start to the problems, but certainly 1997 seems to provide an early key moment. While China had pegged its currency, the Renminbi (aka "the Yuan"), to the Dollar before that, it was around 1997 that the PRC changed its strategy a bit. China's economy was growing rapidly after many reforms and trade liberalization. This meant that China's currency was also appreciating rapidly, reflecting the strong economic growth.

Instead of adjusting the peg to account for this growth, China decided around 1997 to leave it steady in spite of the fact that the Yuan was appreciating at a rapid rate. By leaving the Yuan pegged, it became significantly undervalued, allowing exports to become artificially cheap, and providing a backdoor subsidy to many Chinese companies. Japan had used a similar trick in the 1970's and 1980's, and China was borrowing directly from Japan's playbook.

Meanwhile, "easy money" policies started to slowly became the norm. China kept interest rates artificially low for the state-run banks. The politically connected could borrow at these low rates and re-invest with much higher rates of return. This created major incentives to invest in real assets, which then fueled inflation across the economy.

The artificially low rates also helped create a large "shadow banking" system. In China, "shadow banking" refers to lending primarily done in the informal market, such as high net-worth individuals lending out to business owners. Since depositors at the state-run banks received artificially low interest rates (and negative real returns), lending out at higher rates in the shadow banking market became commonplace. By 2011, the average interest rate in the shadow banking system had reached 24%, and there are certainly stories of rates eclipsing 80%.

One particularly egregious strategy was for a politically connected individual to borrow from the state-run banks with a low interest rate and then re-lend out in the shadow banking system at dramatically higher rates.

Upping the Ante: How the Perma-Stimulus Grew Larger

Under pressure from Western nations, China finally allowed the Yuan to float in 2005, but reversed course in 2008 in the midst of the US financial crisis. In November 2008, China went a step further and announced a $586 billion stimulus package. That was about 15% of China's annual economic output at the time. Compare that to 1998 when, during the Asian financial crisis, China initiated a stimulus package of about 1.2% of economic output.

Between the Yuan's subsidy to exporters, constant (and growing) stealth monetary stimulus, artificially low interest rates, and a large fiscal stimulus, it's no surprise that China's economy boomed; or at least appeared to boom. Overall credit in China increased from $9 trillion in 2008 all the way to $23 trillion in 2013. Most of that new money was going into fixed asset investment, with a large amount going directly into real estate.

If China's economy were growing because useful industries were being created, the growth might have been sustainable. But as often happens in credit-fueled booms, particularly ones driven heavily by government stimulus, the money commonly gets directed to projects with low or negative rates of return. When credit is growing rapidly, everything looks profitable, until the credit starts to contract again and the harsh realities are slowly exposed.

China's excess liquidity went towards fixed asset construction, such as high-rise apartments, highways and railways, and new facilities, but a large amount of these fixed assets weren't particularly needed. A phenomenon developed within many major cities where large high-rise condo buildings and shopping malls would remain completely vacant. Many of the new highways and railways have gone virtually untraveled, and China has a lot of excess capacity in manufacturing already.

The worst example of excess might be the city of Ordos, an entire ghost city, complete with luxury high-rise condos, built to house a population in the hundreds of thousands. Only problem is that no one ever moved there.

Short-Run Inflation Turns to Long-Term Deflation

Credit-fueled booms are inflationary at first. New money is created, which then gets pumped into fixed assets. Fixed asset prices push upwards, and consumer goods slowly follow. But since the booms are only sustained through constant stimulus, state actors eventually must make a decision as to whether to deal with increasingly high inflation, or to tighten policies.

In the developed economies of the world, it's normally inevitable that too much inflation creates political pressures, which force governments to pull back. But once a government tightens, that's when the deflationary cycle begins. Theoretically, it might be possible to tighten slowly enough to maintain economic stability, but in reality, when a giant credit-fueled boom has been running for several years, it's difficult to balance things out, and a deflationary crash most likely ensues.

Thursday's market crash may be the first peek at China's "hard landing."

What Will Get Hit?

The situation in China will impact world markets significantly. Commodities may get hit the hardest, with copper may be the biggest casualty. In late 2011, I detailed how copper prices could fall significantly and how copper miners profits would be hit disproportionately hard by price drops. Freeport McMoran (NYSE:FCX) and Southern Copper (NYSE:SCCO) would be obvious losers in such a scenario. However, I'd also suspect that silver miners, such as Pan American Silver (NASDAQ:PAAS) and related companies, such as Silver Wheaton (NYSE:SLW) will get hit as well.

Also, don't put much faith in gold (NYSEARCA:GLD). Contrary to popular belief, the huge surge in gold prices that happened from 2009 - 2011 (and also from 2002 to 2008) was more related to what was happening in China than the US. Loose monetary policies in China created major inflation, providing a huge incentive for Chinese investors to put their money in real assets. It's not a coincidence that gold peaked around 2011, which was about the same time China's economy (and inflation) peaked. As boom turns to bust in China, gold prices will also fall.

China will also need less steel, meaning that we could see another multi-year steel depression that impacts companies like US Steel (NYSE:X), Arcelor Mittal (NYSE:MT), and South Korea steel maker POSCO (NYSE:PKX). With less demand steel, there is also less demand for coking coal, meaning that even if natural gas prices rise in the US, many coal miners (particularly miners with excessive debt loads) could still suffer.

Perhaps the most obvious loser in a Chinese crash would be the big Chinese banks: Bank of China, China Construction Bank, Industrial and Commerce Bank of China, and Agricultural Bank of China. All four of the major banks may be de facto insolvent, and it could be difficult for the Chinese government to bail them out as easily as it did in the last crisis.

On that note, the Big 4 Chinese banks comprise 28% of the iShares FTSE China 25 Index ETF (NYSEARCA:FXI). If you add insurance, real estate investment, and other banks, then about 52% of the assets of FXI are concentrated into financial firms. If you assume that many of these firms are insolvent (or at least need a bailout from the Chinese government to survive), then 52% is a very large number. Even with a low P/E ratio, I suspect that FXI is very overvalued once you factor in all the problem assets at China's big banks and other financial firms.

Emerging Markets Crisis and Other Consequences

There's a good chance that the deflation of the Chinese asset bubble will also be the main driver behind the next emerging market crisis. We're already seeing some evidence of this, with the problems in Brazil. Remember that much of Brazil's growth was the result of growing exports to China, mostly coming from Brazil's mining sectors.

Other nations that could be heavily impacted include South Africa (NYSEARCA:EZA) and copper-dependent Chile (NYSEARCA:ECH). It's not just emerging markets that could get hit, as Australia (NYSEARCA:EWA) and Canada (NYSEARCA:EWC) have both benefited from the commodity boom and will likely see a slowdown in growth as it turns to bust.

Russia (NYSEARCA:RSX), Mongolia (NYSEARCA:AZIA), Thailand (NYSEARCA:THD), and Peru (NYSEARCA:EPU) are all heavily dependent on exports to China, as well, suggesting that they could all become vulnerable in the upcoming years. You can actually take a glance at which nations are most dependent on trade with China on Wikipedia (based on data from the CIA world factbook), and it's an interesting list. It's worth noting that 62% of North Korea's trade is with China, meaning that it could suffer even more if China's economy slows, and political pressures could increase in Pyongyang.

What Will Benefit?

While the deflation of the Chinese asset bubble will have a global impact, not everyone will be negatively affected. It's worth noting that China is following almost the exact same path as Japan in the 1980's. While China might be described as "1980's Japan on steroids", it's important to keep things in context. The crash of the Japanese asset bubble did not devastate the US economy. Indeed, the impact in the states was subdued.

A China crash may actually benefit the US in the long run, since it could force China to devalue the Yuan, and prevent the large trade distortions that occur with the Dollar peg. This could make US exporters more competitive and will lower input prices for companies in the US; not to mention Japan, South Korea, and Western Europe.

As more foreign investors pull out of China, this will reduce the amount of US Dollar-denominated assets that China needs to buy. This may cause interest rates on US treasury bonds to rise. Indeed, I suspect that this is precisely what happened in Thursday's market rout. Commentators (such as Larry Kudlow) focusing on Bernanke's actions were missing the bus. China was causing treasuries to plunge, not Bernanke. Higher interest rates will harm the US in the short run, of course, but I suspect that the end of the huge trade distortions will offset that in the long- run.

Rising yields on fixed-income securities could benefit certain insurers. Indeed, The Hartford (NYSE:HIG), one of our core holdings, was one of only a handful of stocks that were up in Thursday's sea of red. So long as the Fed's "easy money" policies continue, some US banks could benefit, as well.

I suspect there will be other big winners, but it may take awhile for things to develop. China won't crash in a day, and the winners won't succeed in a day either. In the short-run, it's more likely that US markets fall on poor news out of China, but in the long-run, I see fewer trade distortions as a positive for the US. And if you think that sounds insane, keep in mind that the last major period of economic expansion in the US came directly after the collapse of the Japanese asset bubble.

Can Chinese Asset Deflation Be Avoided?

There are a few arguments out there that China can end the pain any time it wants. The claim is that current leaders are adopting hard money policies to weed out the weakest links and show the international community it's serious about reforming its economy, but that a few rounds of easing could end all of this. There's some truth to this, but it also would merely delay the inevitable.

Sure, China can start easing policy but one way or another, their economy cannot flourish until the asset bubble is deflated. The perma-stimulus policies promoted by China over the past decade have created malinvestment on a grand scale, with too many productive assets going towards massive fixed asset construction, and not towards the places it needs to go, which we could broadly label "consumption."

Unless China wants permanent runaway inflation, the fixed asset bubble is going to have to be deflated. The only questions are "when" and "how".


We may very well be witnessing the beginning of the Great Deflation in China. Thursday's brutal market action was likely driven by the major issues in China. China's property market is in a bubble that will have to be deflated in upcoming years if China wants to avoid the other alternative of hyperinflation.

The biggest theme will be waning demand for commodities, such as copper, silver, steel, and coking coal. This could create an emerging market crisis, impacted nations as diverse as Peru, Mongolia, and South Africa. We could also see slowdowns in other commodity-heavy economies such as Chile, Australia, and Canada. The US may suffer short-term if treasury yields climb upwards, but could be a long-term beneficiary.

Disclosure: I am short FXI, SCCO, EWC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long HIG.