The Bear Case To Investing In China

August 18, 2017

The Bear Case To Investing In China

  • The first risk is a possible contraction in the Chinese credit cycle.
  • However, any kind of interest rate spike leads to immediate PBOC intervention.

Introduction

I have been pretty bullish in my previous articles about investing in China as I think it’s a positive risk reward situation. Nevertheless, a positive bull case wouldn’t be fair without looking at the risks China carries. So in today’s article we’ll discuss the main risks plaguing the Chinese economy and stock market. Understanding the specific risks will also help in better positioning your portfolio to the ugly things that might happen and carefully selecting the stocks that will be less affected.

The Main Risks Of The Chinese Economy

The main risk for the Chinese economy is that it’s in a bubble about to burst. Many have been mentioning this since 2005 and nothing significant has happened yet, despite the stock market having crashed twice and the many government stimulative actions.

Credit Cycle Risk – Wealth Management Products

One of the most prominent advocates of a financial bubble in China is Kyle Bass, founder of Hayman Capital Management. He’s especially concerned about the wealth management products that have swelled to $4 trillion in the last few years. The issue is that Chinese banks and insurance companies that manage these products mostly use short term liabilities to buy long term assets.

An example is the acquisition of the Waldorf Astoria by the Chinese insurance group Anbang for $1.95 billion in 2014. Anbang mostly uses short term liabilities to fund such long term acquisitions.

Figure 1: The Waldorf Astoria. Source: Hotels.com.

As long as the insurance company and other financial institutions doing the same are able to continually refinance the short-term obligations, the bubble won’t burst. But if those long-term assets start to falter, lenders will get scared which will lead to an immediate dry up in liquidity. When there is no buyer for the refinanced bonds, all hell could quickly break loose. To quote Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”

A dry up in liquidity would have a similar effect on most global economies. As for the timing, Kyle Bass says that the Chinese bubble is already 10 years in the making and nobody can precisely know when it will burst, but that he feels we are close to the Chinese credit bubble bursting.

An initial trigger that could burst the bubble is the interbank rate which, in the case of China, has recently spiked from 3% to almost 5% but is still in the average historic corridor.

Figure 2: Chinese 3-month interbank lending rate. Source: Trading Economics.

A spiking interbank lending rate means that there have been some defaults and that the risk has increased. Nevertheless, the People’s Bank of China (PBOC) immediately intervened and injected money into the interbank system. Additionally, it guaranteed loans to keep the interbank rate low.

Kyle Bass usually compares the risky $4 trillion wealth management credit assets in China to the U.S. in 2008, but what’s different is that now central banks immediately intervene, which wasn’t the case in 2008. Nevertheless, all economies move in credit cycles and an eye should be kept on the Chinese credit cycle. Your portfolio exposure to China also has to be properly assessed in relation to the possibility of a credit contraction in China. If you were to listen to Bass, it’ll happen sooner rather than later.

What will happen according to Bass is that the PBOC will expand its balance sheet, give liquidity to its banks, and lower interest rates with one of the main consequences being a weaker Chinese currency. A weaker currency will have repercussions on Chinese dollar denominated earnings, valuations, and create unwanted repercussions on global financial markets.

You probably see Chinese banks and other financials trade at a valuation of around 5. Well, the above risks are one of the reason for such a low valuation.

Credit To GDP Risk

Continuing on the credit bubble, the Chinese debt to GDP ratio has been surging in the last two decades. The fact that debt grows faster than GDP is a clear indication of a boom bust cycle that will eventually burst and deleveraging will be the forced consequence.

Figure 3: Credit to GDP imbalances are sky high in China. Source: CRESCAT.

According to history, at some point the leverage will have to weigh on current consumption and slow down economic growth. A recurring topic related to Chinese debt is that most of it is spent on large infrastructure projects that aren’t economically viable and are actually destroying value. Nevertheless, China continues to spend on its infrastructure and increase GDP because without the government’s spending, China would already be in a recession.

The Chinese Housing Bubble

Another common mention is the alleged Chinese real estate bubble where westerners perceive the growth in Chinese real estate prices as unsustainable.

Figure 4: Chinese real estate prices continue to grow. Source: CRESCAT.

Such growth in real estate prices is considered unsustainable, especially when related to the Chinese working population peaking in 2017.

Figure 5: The peak of the Chinese working age population. Source: Economica.

Fewer people working has to lead, logically, to less demand for housing. However, we must also understand that China is still 5 times less developed than average developed countries and there is still so much room for growth. Therefore, I wouldn’t rush into saying that China will go bust that quickly.

Conclusion

The above is just a small part of the risk plaguing the Chinese economy. Like every other economy, China has its specific risks that have to be dealt with and solved eventually. Up until now, China hasn’t really felt the consequence of the large debt burden or shadow banking as the government seems to be able to keep it all under control. We must also understand that China is still mostly a communist country, therefore we can’t use western economic laws to analyze the Chinese economy.

I’ll conclude by saying that China will definitively evolve through cycles, as is the case for every economy, and investors have to be ready to take those hits and position their portfolio accordingly.