Thursday, January 10, 2013

The canaries in the Chinese coalmine

Notwithstanding the upside surprise in the Chinese December trade data, Kate Mackenzie at FT Alphaville recently highlighted some SocGen analysis showing the dire effects of a hard landing in China (sub 6% growth). Here is the bottom line:

World GDP: -1.5 per cent (0.3 per cent a direct effect of China’s slowdown and the remainder through transmission mechanisms outlined below)

Trade partners:
  • Taiwan: -4.5 per cent
  • South Korea -2.5 per cent
  • Malaysia: -2.5 per cent
  • Australia: -1.2 per cent
  • Japan: – 0.6 per cent
  • Eurozone: -0.3 per cent
  • US: -0.2 per cent
The analysis postulated a 50% drop in base metals, Brent crude to bottom at about $75 and an abrupt drop for gold but a recovery thereafter.

Trouble in shadow banking land
In a separate post, Mackenzie wrote about on China's shadow banking system, which is fast becoming China's version of subprime mortgage market [emphasis added]:
China’s shadow finance sector is big — UBS estimated last year it is equivalent to at least a quarter of the country’s annual GDP, and maybe as much as half. And it is growing fast; in the second half of 2012 it reached half of ‘total social financing’, the country’s measure of total credit.

When this all blows up, it won't be pretty. There are indications that the Chinese authorities plan to rein in the shadow banking system in 2013. Here is the problem. Loan growth has been anemic in the formal banking sector:

With slow loan growth in the formal banking system and tightening controls in the shadow banking system, where is credit growth going to come from? What will happen to the Chinese economy when credit dries up?

Watching the canaries in the coalmine
This analysis presents a dire outcome for the Chinese economy this year. Cue the SocGen hard landing analysis. Here is how they postulate a hard landing scenario would unfold (via Business Insider) [my emphasis]:

Whatever the catalyst, the excess capacity in the manufacturing sector – estimated at 40% in 2011 by the IMF – would be exacerbated by a sharp growth slowdown. This would cut corporate margins sharply, making profits plunge, and triggering a downward spiral in domestic demand. Bankruptcies and unemployment would occur on a large scale, endangering financial and social stability.

One factor that could accelerate the downward spiral is the high leverage of China’s corporate sector, which exceeded 120% of GDP at end-2011 and has kept rising throughout 2012. As the crisis progressed, non-performing loans would undoubtedly rise beyond the capacity of local governments to contain them, as their fiscal resources dwindled.

Even in China’s (semi-) controlled system, banks could choose to freeze lending as a knee-jerk reaction, while the authorities rushed to draft a decisive response. The rapid development of the non-bank credit market in the last few years, especially shadow banking activities, has created a new vector through which a systemic liquidity crunch could take place. Capital outflow would likely ensue, stretching domestic liquidity conditions further.
Traders should be aware of these risks, but not panic. The current risk of an immediate meltdown is low and there is a timing tool available. I am watching my four canaries in the Chinese coalmine, namely the share price of the Chinese banks listed in HK:
  • Agricultural Bank of China Limited (1288.HK)
  • Bank of China (3988.HK)
  • Industrial and Commercial Bank of China Limited (1398.HK)
  • China Merchants Bank Co., Ltd. (3968.HK)
Should restrictions in the shadow banking system cause a credit crunch and collapse in the financial system in China, then we should see a corresponding response in the prices of these banks. Currently, the shares of these four canaries are near or at 52-week highs, indicating little signs of stress in the banking system.

Traders should therefore relax but be vigilant.

Hard or crash landing?
I have always been of the view that the world will see a cyclical downturn one day. The timing of that downturn is uncertain. I have no idea of whether it will happen this year, next year or in the next 5 years. When that cyclical downturn is upon us, however, China's export sensitive economy may not be resilient enough to withstand the slowdown. The result will not be just a hard landing (subpar growth of less than 6%), but possible a crash landing (negative GDP growth) that is not in anybody's spreadsheet.

That crash landing scenario would be disastrous for the economies of China's major trade partners and commodity prices and the ensuing tail risk will be in the same order of magnitude as the Lehman or Russia Crisis.

That's why it pays to watch the four Chinese canaries in the coalmine.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.


Knight-trader said...

They're not forecasting if China crashes a world GDP of -1.5% as you state but a change of 1.5% in their estimate which would still be positive

Cam Hui, CFA said...

Yes I know that they aren't forecasting a negative GDP growth rate - that's my forecast if we enter a global cyclical recession.

Unknown said...

Your 4 Chinese 'Canaries' are all of at leat 10% from their 52 week highs (at least according to Yahoo). Time to take some chips off the table?