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The way we see it is quite simple. With every investor and every company in the world seeking exposure to China and betting on continued and unabated Chinese growth, what happens if they are wrong? Is it at least worth having some insurance in the portfolio to hedge against the risk of being wrong? If nothing else, we recognize that we are sometimes (often) wrong! GMO’s James Montier recently shared the following thoughts with investors:

“Thinking about fundamental risk also reduces the “black swan” element of investing. Nassim Taleb defines a black swan as a highly improbable event with three principle characteristics: 1) it is unpredictable; 2) it has a massive impact; and 3) ex post explanations are concocted that make the event appear less random and more predictable than it was.

“It should be noted that some black swans are a matter of perspective. Rather than genuine black swans, most financial implosions are the result of “predictable surprises” . . . Like black swans, predictable surprises have three characteristics: 1) at least some people are aware of the problem; 2) the problem gets worse over time; and 3) eventually the problem explodes into a crisis, much to the shock of most.

“The nature of predictable surprises is that while uncertainty surrounds the details of the impending disaster, there is little uncertainty that a large disaster awaits.”

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises. As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise. But just because the timing is questionable doesn’t mean the risks should be ignored. More often than not, investors are rightly focused on the odds that circumstances turn negative. But every so often, it is much more important to consider the consequences of these low probability events. With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial, yet insurance to hedge against such a risk is almost free.

Consider that China’s local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997. In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council’s Audit Report. With more than 80% of those borrowings going to infrastructure, it’s difficult to imagine that the return on investment for each additional project has not declined. Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today’s real estate bubble even more detrimental to the command economy. Defaults are already happening, even with economic growth rates hovering near 10%. According to Reuters, China’s regulators plan to shift 2-3 TRILLION yuan off local government balance sheets – a massive bailout that is multiples of TARP relative to China’s GDP. With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth. Consider that in 1999, after borrowing and binging through the 1980s and 1990s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China’s GDP from 1988 to 1993. For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time. Contrast that with the banks current “reported” NPLs near 1% . . . and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

(Click charts to enlarge)

Consequently, we think a small investment today can serve as an effective hedge on a much larger portfolio, in case the global economy’s locomotive hits a speed bump along the way. That said, we are much more comfortable taking larger positions when we can say with confidence, “This is going to happen.” I’m not sure I can say that with confidence about a yuan devaluation, but I can say that the odds are currently much higher than what Mr. Market is offering today. Aussie housing is one of those “near certainties,” with or without a Chinese hard landing. And it appears that the risk in the Australian property market has elevated sharply over the past year. Part of this may be attributable to the slowdown in China. Part of it may be attributable to the Australian banks’ reliance on European financing. Or it may simply be bursting under its own weight, with a little help from the RBA and higher rates. Whatever the cause, the evidence is right in front of anyone who cares to look.

Gold Coast beachfront values have plunged by as much as 50 percent since the peak of the boom in 2008, states The Australian Newspaper Online. We are beginning to see signs of the “blame game” emerging even as we are very early into the expected decline in property prices – check out the collapse of Ray White Broadbeach. Despite claims of a “housing shortage,” which is typical of just about every housing bubble, Real Estate Institute of WA president Alan Bourke said that there were now thousands more properties on the market than needed to meet demand. Meanwhile, real estate agents are cutting their sales commissions to compete for fewer buyers – some below one percent. Major banks have warned that loan arrears have increased, real estate data show house prices in affluent suburbs have fallen more than the overall market and new loans have dropped sharply. High-income earners are also experiencing mortgage problems but nobody is talking about it – they are financially overstretched and quietly making lifestyle changes, deleveraging and selling investments to reduce loans and other debt, and avoiding unwanted public attention they would have if they had to foreclose on their mortgage.

Coming back to China, the 1880s – 1890s boom provides an interesting parallel. In 1890, more than half of Australia’s exports went to Britain, with wool making up the majority. This concentration of exports was a critical vulnerability then, as it is now. Today, Australia’s exports are again dominated by commodities (iron ore) and its future is almost entirely tied to its largest customer, China. That said, the magnitude of the housing boom in the 1880s is dwarfed by what we’ve seen in the past two decades – where prices have more than doubled in real terms versus a gain of a third the first time around.

Then, the withdrawal of foreign capital served as a catalyst for recession, credit crunch and price declines. Today, Australian banks find themselves in an eerily similar position – almost entirely reliant on foreign funding (chart below from RBA), which Moody’s recently cited as it downgraded the major banks. “With the domestic economy increasingly biased to the commodity sector, terms of trade that are exceptionally favorable by historical standards, and high asset prices, there is a potential for confidence shocks to impact the bank’s access to funding.” We believe slowing Chinese demand will be a catalyst for an abrupt reversal in Australia’s terms of trade, likely followed by a collapsing currency, vanishing foreign capital and significant stress on the banking system. Aussie bank CDS look very cheap relative to global peers. The sovereign looks even cheaper when one considers the potential cost of a bank bail-out.

Disclosure: At the time of publication, the author was short the Chinese Yuan, Australian Dollar, Australian interest rates and various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.

Source: Predictable 'Surprises': China and Australia Economic Woes