China’s Hotspots

The six dangerous hotspots of the chinese economy right now

1. Overcapacity

In basically each industrial sector, the chinese factories have currently much bigger production-facilities (and number of employees) than really needed. In the steel-sector for instance, the overcapacity is about 350 million tons/year sending steel prices on the market down the tube.

But China has not followed through on the attempts it has made over the last decade to address overcapacity. The ‘efforts’ of the central chinese regime and local governments to tackle the problem remained ineffectual so far due to regional protectionism. In addition, the necessary steps – slash production – could lead to social unrest, when millions of workers lose their jobs. Yet, this step will be inevitable sooner or later.

2. Currency/FX-reserves

The erratic actions – and crude interventions – by the People’s Bank of China (PBOC) made the Yuan a target for high profile speculators who bet big against the chinese currency. ‘China takes one step forward and three steps back’, says Michael Every of the dutch RaboBank. US- Hedgefund manager Kyle Bass predicted a 40% decline of the Yuan against the USD in the coming 3 years and George Soros warned of a ‘hard landing’ for China. In a first official chinese reaction, the typical and expected ‘shooting the messenger’ took place. Behind the curtain of propaganda, the chinese in charge know exactly, that Soros & Co have a point – and the chinese are very well aware, that the huge capital flight by chinese citizens in recent months is nothing else than a clear and present sign of mistrust towards their own currency. To defend the Yuan, the PBOC had to sell foreign reserves in value of about 500 billion USD. This is how fast China’s reserves have gone down recently:

• China’s reserves declined by 500 billion USD in 2015.
• They now sit about 750 billion USD below their 2014 peak.
• Reserves declined by about another 300 USD billion in the last three months alone
• Currently, reserves are about 3.2 trillion USD according to british bank Barclays.

That latest figures look pretty huge but consider just this: if only 4% of Chinese were to move Yuan in value of 50’000 USD out of the country in a single year (for instance, to protect it from devaluing when the Yuan collapses) then this capital outflows would theoretically wipe out the entire foreign reserves of China. Pretty scary, but this is an unlikely scenario at least for the moment.
Very realistic however is the outlook, that China has about 6 to 12 months before their foreign reserves fall below comfort levels.

3. Foreign Trade

The downfall of the chinese foreign trade is accelerating in 2016. Imports in January were almost 15% lower than a year ago exports fell behind by 7%.
But don’t expect that for instance the chinese media would highlight and critically question the fact, that the official growth figures of 6,9% for the chinese economy as a whole somehow do not really correspond with the developments of the foreign trade. The Chinese news media exists primarily to serve as a propaganda tool for the Communist Party. Chinese President Xi Jinping made that clear again just a few days ago: ‘All news media run by the party must work to speak for the party’s will and its propositions, and protect the party’s authority and unity,” Mr. Xi said on a visit of ‘China Central Television’ in the capital Beijing on February 19.
And in the same week, government agencies announced new regulations that would prevent foreign companies from publishing and distributing content online in China. That tightening of control should take away some of the pressure Mr. Xi faces about China’s economy, party wide corruption and widespread public frustration over pollution and environmental degradation. So, instead of tackling the problems, it’s again the principle of ‘shooting the messenger’ – as if issues would magically disappear by not allowing to talk or to write about them.

4. Stock Market

Between mid-2014 and the summer of 2015, the Shanghai stock market gained a cool 150%. Millions of regular chinese opened their first brokerage account to join the party. They made two horrible mistakes. They were late in the game and they bought the already high priced stocks on margin (credit). The inevitable happened, stocks tanked, the ‘investors’ left with nothing but debt. Not helpful to calm the investors were the following erratic acts by the Chinese government with all kind of measures like sell-restrictions, forced trading-stops and finally the head of the stock market oversight got the boot. All this showed no impact at all so far. Just this week, stocks fell again sharply. The market in Shanghai is currently suffering from lower liquidity and nervous investors ahead of the earnings season given China’s slowing economy.

5. Debt

Since 2007, Chinas debt is rising like a rocket after a successful lift-off. Particularly state owned companies and local governments piled up a massive debt in recent years. Massive – but not always necessary – infrastructure projects were undertaken to keep the economy running. And the unprecedented jump in new loans at the start of 2016 is fueling concern that excessive credit growth is piling up risks in the nation’s financial system. With the projected debt-to GDP ratio of almost 300% by 2019, China might follow Japan’s way into deep trouble. At least in this hotspot, the news from this week showed signs at least some of the risk is easing.
That’s in part due to the mainland’s efforts to restructure its huge pile of local government debt. According to Moody’s Investors Service the government is finding a handle by capping it at 16 trillion yuan (2,5 trillion USD overall and improving the structure by swapping some existing debt into bonds at lower cost and longer maturity. In consequence, Moody’s doesn’t expect local governments, provinces and main cities, to default on bonds issued in their own name, calling the probability ‘quite low’.
Well, let’s hope, the rating agency is doing a better job this time in the east, than they did in the run up to the western financial crisis in 2007/2008 (see chapter 33).

6. Banks

Closely related to the debt-situation is the coming banking problems. Chinese banks aggressively expanded their balance sheets in January 2016 to top all prior months of lending in history. A sign of desperation to shore-up borrowing and spur economic growth. At the same time, it’s quite likely that no small part of today’s borrowing will transform into tomorrow’s non performing loans (npl) which will badly hurt the banking system throughout China.
In 2015, the official npl-figure reached 1,95 trillion Yuan or about 300 billion USD – in other words: each and every business day, loans in value of more than 1 billion USD went sour. And this is only the official number, the real figures are much higher, since chinese banks often under-reporting bad loans by using methods such as re-financing unprofitable state-owned enterprises and under-recognizing overdue debt to muddy the numbers.
In plus, the banks are increasingly using trusts or asset management plans to lend and recording them as funds to be received rather than as loans, which are subject to stricter regulatory oversight and capital limits.
A debt-related meltdown of the banking sector in China may be not be imminent yet, but if no drastic measures were set up in the coming months, this meltdown will be inevitable one day with profound consequences for China and – four of the five largest banks in the world are chinese – the rest of the world.

The overcapacity of China’s steel market is well known for years so far but only insufficient tackled by the chinese authorities.