Most People Think Greece Is The Problem; It's Not, It's China

by: William Gamble

The problems in Greece have caused an international financial crisis. Like the subprime meltdown in the U.S., the question is why weren’t the problems in Greece identified sooner? The reason is simple. The problem was hidden. But Greece is a small country of barely more than 11 million people. Shanghai alone has over 16 million and if China is hiding a disaster it is a much bigger problem. Odds are that it is.

In Greece the present debacle was discovered when the newly elected Socialist government revealed a double-digit deficit in October 2009, a deficit that was almost three times the previous forecast. It wasn’t a mistake. The Greek bean counters had been at this game for a long time. According Eurostat, the European Union statistical agency, Greece distorted its numbers to get into the EU in 2001.

The terms of Greece’s bailout require it to clean up its numbers. It had to create an independent watchdog headed by a former International Monetary Fund official to police Elstat, the Greek statistical agency. Greece’s numbers have gotten better, but not without a fight from the Elstat’s union and board of directors. According to a former statistical service official “It seems that board members wanted to go back to the old days when officials at the finance ministry and the central bank got together to produce figures that served the national interest, regardless of accuracy.”

But Greece is a democracy with a free press and subject to the restrictions of the EU. China actively suppresses information. To determine the state of the Chinese economy it is sometimes necessary to look outside some of the official reports. Like discovery of the structure of DNA, it is necessary to look at shadows and in China’s case the shadows are looking very scary.

A very large shadow is underground banking system. Chinese state owned banks loan money mainly to local governments and state owned enterprises. They also pay interests on deposits that are only 3.5%, almost 3% less than the reported inflation rate of 6.2%. So wealthy individuals lend money to capital starved private businesses at higher interest rates. Recently the businesses have been going bust.

The newspaper of the Communist party, the People’s Daily, referred to this problem as “a Chinese-style subprime crisis.” It is not just the businesses that are going bust, but private lending operations. No one knows exactly how big the private lending is in China, but estimates are that lending in 2010 alone was $4 trillion renminbi.

Often when loans go bad, they are referred to as a bankruptcy or a default, but these are western terms. They imply that creditors receive something. China has a bankruptcy law, but like most laws in China, it is ignored. Bosses of small companies just disappear with any assets they can carry.

It is not just the locals in China that are getting burned. The shadows are extending beyond China. Chinese real estate developers alone have sold $19 billion in debt on international markets. International investors faced with nominal interest rates in the U.S. and Europe and hungry for yield gobbled them up assuming constant Chinese growth. The yields have increased it is true, but for the wrong reason. Prices of these bonds have plunged an average of 22 cents on the dollar in the past two months alone and at least a dozen developers are in danger of default. If past experience is any guide, creditors of a defaulted Chinese company can expect little or nothing.

Chinese sovereign debt has been sold as some of the safest in the world. The Chinese leadership has disparaged the downgrade of U.S. debt, proudly espousing the superiority of their system. But thing may change. The credit-default swap (CDS) market has been the bane of sovereign credit in Europe. It may have found a new victim. Two years ago the Chinese CDS market was only $1.6 billion, the 227th in the world. Now it is 10th at $8.3 billion, larger than the markets for Portugal or Bank of America. It is beginning to flash red. This week China CDS hit a two-year high of 208 basis points. It has fallen since then to 173 about the same level as France.

In the past the United States was often a country’s largest trading partner. Today it is often to be China. As China slows, so do their economies. The PMIs for both Australia and Taiwan are showing a major drop to 42 and 44 respectively. The price of commodities like copper and soy have fallen 27% and 11%, which will eventually impact the economies of Chile, Peru and Argentina. Most of Asia is exposed.

Most of the world thinks that Greece is the problem. They are wrong. It’s not.

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