Investors Take Note: China's 'Lehman Moment' Is Looming, Help Is Not On The Way

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Includes: CXSE, FCA, FXI, FXP, GXC, MCHI, PGJ, TCHI, XPP, YANG, YAO, YINN, YXI
by: Steve Picarillo

Summary

Recent defaults in China are threatening to change investor perceptions of the safety of Chinese investments.

The weakening property markets in China could slow the Chinese economy and potentially weaken Chinese banks.

Investors have seen this before with Bear Stearns, Lehman and the Irish Banks, so we know how the book could end.

Help may not be on the way as it appears that the Chinese government is willing to see defaults as it shifts to a more market-driven economy.

China's first-ever default of a corporate bond may not have been China's "Bear Stearns moment" or its "Lehman moment" but China's Lehman moment can happen at any time and investors should take note.

Unlike the fall of (the independent) Bear Stearns and the demise of Lehman, Chaori Solar's recent default did not change the market's perception of credit risk inherent in the Chinese economy and Chinese investments. The reason? It was widely known that the solar company was in distress and at risk of being the country's first corporate default. Moreover, unlike Lehman and Bear, the Chaori default did not add uncertainly as to the government's intentions.

The Lehman and Bear events caused market panic as investors believed that the US government would have provided some form of support to prevent such a material default. Indeed, the fall of the independent investment bank Bear Stearns and the bankruptcy of Lehman Brothers marked key market events during the great recession. Investors across the globe certainly noticed these events which trigger other defaults across the globe. It is fair to say that investing and banking in the US has been altered for years to come. Chaori's default did not trigger such market events; however, it led to fears that it could be the start of a surge of Chinese bond defaults. This fear remains well founded and may prove to be very accurate.

In the weeks since the Chaori default, shares in various Chinese property firms have fallen after the Chinese developer Zhejiang Xingrun Real Estate collapsed as it could not repay its estimated $500 million of outstanding loans. This default may be the defining event in China as it is the latest sign that the Chinese government will like to see some "dead bodies" as it moves toward a more market-driven economy. Government help does not appear to be on the way, as China's central bank has denied reports that it is in emergency negotiations with the company.

China's property sector is the main threat to the stability of the world's number-two economy. Property developers in China have been a particular source of concern as many have increased their debt loads in recent years to buy land and build. The ripple effect of a deteriorating economy in China may very well lead to market disturbances across the globe. Investors will shift funds from China seeking investments that they perceive as safer. Moreover, a struggling Chinese economy, given its size and scale, will negatively impact exports of its major trading partners, thereby threatening to weaken the global economy.

Chinese financial institutions are at risk due to the brewing housing bubble. The average price of a new home in 70 Chinese cities increased at a slower pace than in recent months. Indeed, average new home prices in major Chinese cities rose 8.7% (year on year) in February, according to the National Bureau of Statistics, cooling from a 9.6% rise in January. While this does not sound all that concerning on its face value, however the trend is certainly worth noting. Cities in China have taken to battle rising home prices amid fears of a bubble, and banks have increasingly tightened lending to real estate firms. This disturbing trend is extremely similar to those that led to the Great Recession in the US, the UK and in Europe. So we may know how this book ends.

As demand slows, developers will feel financial strain. The concern is this most recent default will trigger a series of similar distressed situations across weaker companies in the property sector. The most recent financial crisis in Ireland was sparked by the same types of events, a weakness in the property sector, leading to the near nationalization of the country's banks. Similarly, Chinese banks have significant exposure to the property sector. Should defaults increase, banks would need to set aside more funds for bad loans and would likely become more risk averse, thereby further slowing growth or worst, potentially de-stabilizing the balance in Chinese banking.

The property sector has become a backbone of growth for the Chinese economy, accounting for 16% of gross domestic product, 33% of fixed asset investment and 25% of new loans in 2013, according to market estimates. Slowing property markets lead to a slowing economy.

There are a many potential triggers for a correction in the property market including a rise in interest rates, decreased credit availability or the introduction of a property tax. This risk of spreading "ghost towns" across China is a real reality as developers abandon projects due to lack of demand and financing.

Given the magnitude of property to the Chinese GDP, if this sector slows severely, there is no obvious replacement to support economic growth. So whether it is a Bear Stearns, Lehman or Irish bank moment, a defining moment is looming.

About the author: Steve Picarillo is an internationally known and respected financial executive, analyst and author. Steve has spent most of his career on "Wall Street" as a lead analyst covering large financial institutions, corporates and sovereigns in the US and in Europe. In addition to being an expert on global banking, credit ratings, banking regulations and compliance, Steve is a student of the global economic environment, a motivational speaker and an active philanthropist. The opinion in this article and other articles are the opinions of the author and of Creative Advisory Group, Inc.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.