Chinese Fairy Tales

What you don't know can kill you!

by Mark J. Grant

It is difficult enough, in our world, to ferret out the truth and then make rational decisions based upon what you have found. Europe is a good example of this as liabilities are not acknowledged or counted while the propaganda machines roll out the officially mandated numbers. It doesn't take Sherlock Holmes to get at some of the truth though and liabilities, counted or not, still have to be paid. In the case of Europe a great deal of enlightenment may be found in the data available from the Bank for International Settlements and that has been my primary source for arriving at some reality.

Every Chinese joke starts in the same way. "First you look over your shoulder."

In the case of China, and trying to find some glimmer of truth there, the situation is far more difficult. There is no source of real data available and the official numbers do not often add up in any rational way. The country operates as a one party system and it is just the normal course of business that they provide the data they want and when they wish to provide it. It is quite problematical especially if it begins to appear that a severe slowdown in growth is underway. It is difficult to substantiate or quantify what is actually happening.

The game of "Hide and Seek" is a great sport for children. When the Chinese learned to play it though they marked it, "Adults only."

Fitch, recently, began to examine this. They said that the growth driven model is falling apart and that some sort of Japanese deflation scenario could well ensue. Fitch said, "We have no idea who the lenders are, the borrowers are, and what the quality of assets is…" China reports non-performing bank loans at just 1% but this number, on its face seems quite suspect. Then if you consider trusts, wealth management funds, offshore vehicles, inter-corporate lending and special state agencies which provide more than 50% of all of the new credit with no reporting on the health of these loans you begin to get the sinking feeling that something might be amiss.

A student is on one side of a raging river. There are no bridges. He has no boat. He shouts out to Buddha on the opposite bank. “How do I get to the other side?”

Buddha shouts back: “You are on the other side.”

One Chinese bank, Bank Everbright, did not live up to its name recently as defaulted on an inter-bank loan. Fitch further noted that wealth products, with a notional value of around $2 trillion, also hides a lot of lending and allows for off-the-run assets as well as liabilities. To be quite blunt; we do not really know what we are looking at when we assess the Chinese banks. We have recently seen some wild moves in "Shibor" which may indicate that liquidity is becoming a problem but even here it is tough to know to what extent.

One figure you can muse at, that may have some meaningfulness, is China's reported overall credit. Since 2009 it has grown from $9 trillion to $23 trillion. If you consider this carefully, in the light of the rest of the world since the American financial crisis got underway, the increase is staggering.

The reported credit to GDP ratio is now at 200%. This number is the largest on the planet and, if nothing else, indicates a good deal of risk on the table. Fitch addressed this issue saying, "There is no way they can grow out of their asset problems as they did in the past... With credit at 200% of GDP the numerator is growing twice as fast as the denominator. You can't grow out of that." One telling sign here is GDP growth as generated by loans. This figure has dropped from 0.85% to 0.15% in the last four years and it indicates a marked economic slowdown regardless of the Chinese hieroglyphics that are handed to us.

Soc Gen recently reported that the debt service ratio of Chinese companies was 30% of their GDP. This is a telling number and a level that has historically caused problems. If we assume that the debt ratio is 20-30% higher than what is reported then we may be on the verge of a very serious financial situation. The China Securities Journal, last Friday, issued a number higher than Fitch indicating a credit to debt ratio of 221%. This would put interest payments alone at about $1 trillion which is a staggering amount of debt that must be serviced.

I think some people/institutions in China and Asia are beginning to recognize that the scent of jasmine is no longer in the air. Foreign withdrawals from Chinese equity funds were the highest since 2008 for the week of June 5. In the same timeframe withdrawals from Hong Kong funds were the most in a decade.

Breathe in. Breathe out.

Breathe in. Breathe out.

Forget this and understanding the markets will be the least of your problems.