Chinese Deleveraging Is Starting To Spill Over Into Other Countries; It Will Eventually Hit America

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by: D. H. Taylor

Summary

30% of business loans in China are nonperforming. Government is intent on removing these.

Liquidity in China is drying up sending interest rates sharply higher.

Spillover is starting to happen with neighboring stock markets moving due to this.

The government of China has been deleveraging the banks and loans in the country. This is starting to wreak havoc in China and it is starting to spill over to the financial markets around the world. The process of China's deleveraging as well as the effects of this are going to be far bigger and far more tumultuous than what has been seen so far. Interest rates in China are moving sharply higher while the Chinese stock market is declining. This will start to spill into markets around the world with a flight to quality. The Chinese economic tsunami is about to hit the shores of the rest of the world; expect a great deal of volatility in the markets in the coming days and weeks.

The Debt/GDP ratio in China is some of the highest levels in the world. Corporate Debt/GDP ratio is approximately 170%. Government debt/GDP is another 45% and private debt/GDP comes in approximately 45% as well. Total debt/GDP ratio is 260%. The International Monetary Fund (NYSE:IMF) believes that nearly 30% of the corporate debt is nonperforming. To put that into perspective, the United States, according to the same data statistics, is at 1.5% with nonperforming loans.

The Chinese government has been resolute in cleaning out these so-called "zombie" loans. At the same time the government has implemented programs to address real estate imbalances in the country as well. In major cities, real estate is bubbling. Outside of major cities there are virtual ghost towns of towers built but are unoccupied. The Bank of China has implemented programs restricting mortgages. The end result is a sharp increase in the demand for money with a shrinking loan output from banks. Interest rates are moving sharply higher in response as the demand for money outpaces the supply of capital.

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The stock market is fairing no better. Growth concerns in the nation have driven down the stock market from recent all-time highs of 3,450 to 3,250, a correction of some 6% in just about two week's time. This is still short of the technical definition of a bear market correction. However, this is only the beginning of the move lower.

When you think of this move lower, keep in mind the 30% nonperforming loans that the government is trying to take off banks' books. If the target is something normal, perhaps rates approximate to what the United States has, then there is some 29% of loans to go. The damage from this will be systemic as the government's policies continue to tighten up availability of credit.

Already, loan growth rates have been shrinking a great deal:

It is my belief that the loan growth rate will fall into the low single digits over the course of the rest of the year, if not declining into negative territory.

The signs that the deleveraging is hitting businesses have been appearing for some time. However, over the past few days bank shares in Shanghai have sold off as the strains of the deleveraging continue to weigh on financials; Bank Wealth Property Issuance crashed 15% month-over-month, a company that is part of the$4 trillion shadow banking system in China. The potential for economic contraction due to the weight of the government's efforts is starting to take hold as economic data is showing declining manufacturing and as well as declining consumer growth.

Sometime soon, what is likely to happen is if there are further declines in the equity indexes, money will start to rush out of China and into the safety of lower-risk, safe-haven investments such as the United States Treasury instruments. Any firms with exposure to China will start to see their own share prices decline as more and more news begins to trickle out of China. Neighboring equity markets will start to sell off and eventually contagion will ensue; Hong Kong's index has already begun to fall. Eventually, there will be declines in Europe and American equity markets.

For now, the Chinese yuan has been contained in its movement. But, that is being helped by the Bank of China spending its reserves to prop up its currency. That has its limitations, however.

I am expecting a continued move lower in the CNH across the board as money leaves China in search of safer investment instruments. The U.S. debt markets are a good first stop. Also, there will be continued moves lower in the equity markets and that will start to spill out of China and into the rest of the world. The ripple effects of this have the potential to be a significant drag on worldwide financial markets. After all, China is the world's #2 largest economy. Business debt/GDP ratio is some 160%, of which 30% is nonperforming. The government is doing all it can to clean out those loans. The potential for a sharp economic contraction is quite large. And, given the size of the Chinese economy, the effects of this will be felt in some way or another around the world. These moves are just beginning. It will only be a matter of time before the rest of the world sees this appear on their doorstep.

It is easy to be in the United States and think nothing of what might happen in China. Don't. Back in 1997 and 1998 there were two events that took place that shuddered the world financial markets. In July of 1997, it was the Asian Currency Crisis. In 1998, it was the Russian debt default.

During the Asian Financial Crisis, the Asian Tigers, as they were nicknamed then, were facing an economic collapse. It all began in Thailand where the Thai currency was pegged to the U.S. dollar, but the Bank of Thailand was running out of reserves to support the currency. The country was effectively bankrupt. The Bank of Thailand let their currency float. It collapsed.

In China, there is a pseudo-peg with the dollar. However, the massive of debt that is nonperforming is effectively a bankruptcy for many companies. This will drag on many other companies in China since there is a great deal of business loan guarantees within the country. Those guarantees will come due, pressuring other businesses. The Bank of China has already blown through 25% of its currency reserves supporting the yuan. I am betting that another 25% will go in the next 12 months. I am also betting the currency falls sharply.

The potential ripple effects through the world financial markets are unwieldy. You will want to consider what is happening over there…. Before it lands over here. I am.

Disclosure: I am/we are short CNHS, (LONG USDCNH).

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.

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