The Chinese Minsky Ladder Gets Its First Broken Rung

Includes: DBB, DIA, FXI, HAO-OLD
by: Erwan Mahe

The coincidence between my return from holidays and the plunge in Asian stock markets, particularly in China (Shanghai -5.80%) with our last Thaler’s report (Thaler's Corner 27-07-09: The horrible Minsky Journey of the Chinese Politburo!) is sufficiently remarkable that I cannot help but return to this issue today.

We have been constantly harping for weeks about the perfect illustration represented by the behaviour of asset classes influenced by Chinese stimulus spending with the situation described by the author of the Financial Instability Hypothesis, which we will qualify for these purposes as the Minsky Scale.

As it turns out, it seems that one of the upper scale bars has just broken, with the (very late) realisation that over 30% growth in durable goods expenditures, under orders from a Politburo freaked out over the collapse of exports, can only last so long, particularly given such huge overcapacity!

Check out in the graph, below, how Fixed Asset Investments, i.e. durable goods such as factories, capital goods, but also buildings and land, have grown from an annual pace of 26% in 2006 and 2007 to over 30% since April 2009, although exports have not picked up since October 2008 (Lehman effect), instead contracting at 23% per annum.

As for the first indicator of weakness in this scale, new loans provided by Chinese banks to their economy have just posted a stiff downturn.

While these had been averaging around 200bn yuan per month for the last decade or so, they surged to 2,000bn yuan in March 2009, representing a ten-fold rise in loans injected into the Chinese economy.

But they have contracted sharply since then, to 335bn yuan in July, which will surprise none of our readers. We had abundantly cited concordant statements from Chinese leaders pointing to this direction.

This shift was reasserted in recent day by Mr Liu Mingkang, president of the Chinese Banking Regulation Commission (CBRC), who expressed his worries about the rise in NPLs (non-performing loans) in the balance sheets of financial institutions, and by NBC chief Mr Xu Xianchun, who worries about the inflationary consequences of the loans.

FAI, Exports and New Loans in China

The direction seems clear …

As such, it should come as no surprise to see Chinese stock markets correct for a portion of the gains in recent months by taking away a third of the incredible 102% gains made in the past nine months.

You can see in the graph, below, how the Shanghai exchange profited from these loan injections into the economy, with M2 growing from annual 16% to 28.50% in recent months!

We have been arguing for a very long time now that these liquidity injections largely explain the unwarranted surge in commodity prices in recent months.

The steel market is also worried about the signals sent by Chinese authorities. We advise investors to keep a close eye on the next victims, such as nickel, copper, aluminium and others.

M2, steel prices and the Shanghai Index

If M2 fell back…

Commodity prices overall may fall back, given the absence of real demand, as evidenced by the following examples.

Iron stocks in Chinese ports now total 71.5m tonnes, representing 2 months of usage, well above the usual inventory level of 30m tonnes, at a time when Chinese steel makers are saddled with huge stocks and as China is being attacked at the WTO for unfair trading practices on this segment!

And the 35% reduction in iron ore prices just obtained by the Chinese with Australian exporter Fortescue (OTCQX:FSUMF), as BHP and Rio (RTP) wait in the wings, will hardly help matters …

According to Barclays Capital, the amounts “financially” invested in commodities at 30 June totalled $209bn via Index Swaps, structured products and commodity ETFs.

When these investors in paper realise the sort of trap into which they fallen, watch out for a big swing back!

As a case in point, the natural gas ETF in the United States, UNG, is down 75% since its creation, as opposed to 52% for its benchmark, due to futures rolls which regularly depreciate it. Given the lack of buyers willing to take physical delivery with the front maturity futures, no surprise there…

As such, we will not be surprised to see that we are making no real changes in our asset allocation process:

Favourable to fixed interest rate instruments and cash equivalents, we continue to prefer the safety of capital to higher yields.

Negative euro vs dollar, and equities.

Disclosure: Long 20 years OAT 0% Coupons, EDF Corp 5 Years 4.5%