I’d like to draw your attention to one of the most immediate threats to Aussie share prices: China’s shadow banking system. ‘China moves to avert shadow lender’s default’, reports Friday’s Wall Street Journal. Remember, trouble in the wider financial system usually starts with the most marginal, peripheral, and high risk firms and then works its way to the centre.
What’s so fascinating about China’s trouble with Wealth Management Products (WMPs) is how similar they are to the same securities that nearly destroyed the American financial system. You have banks making high risk loans to borrowers who can’t get credit otherwise. Then, the liability is turned into an asset and sold to investors seeking high yield. The mechanics are familiar, aren’t they?
In China’s case, the latest trouble comes from a coal company that may not be able to pay back a loan. As a result, investors who bought the securitised loan believing, perhaps, that it was simply a high yield savings vehicle, now risk losing their money. Unless the government intervenes to save everyone from themselves. The Journal reports that:
‘A coal company facing repayment of a three billion yuan ($500 million) loan has received government permission to restart one of its mines as creditors and officials scramble to avoid a default that could batter confidence in China’s loosely regulated shadow-banking sector.
‘China Credit Trust Co., a so-called shadow lender, notified investors in products linked to the loan on Wednesday about the permit to resume production, according to a notice reviewed by The Wall Street Journal. The restart could allow the debtor, Zhenfu Energy Group, a little-known company in Shanxi province, to generate revenue to help repay investors.
‘The scramble to stave off default highlights what economists and analysts describe as a predicament for the government. Though defaults have occurred on risky investment products in recent years, the government has arranged bailouts for investors. Some economists say that the bailouts only encourage reckless lending practices.’
These days, $500 million is a drop in the bucket. The government could arrange the bailout with no problems. Similarly, if the government doesn’t bail out investors, and if the coal company fails to repay the loan, it’s not the end of the world. The financial system could survive a $500 million ‘accident’.
We’ll know either way by January 31st. Payments are due to ‘investors’ on January 31st, when the Year of the Horse begins on the Chinese calendar. But the bigger issue is that 40% of China’s $3 trillion debt is local government debt.
And this gets back to what the theoretical and actual limit of poor capital allocation is. In a closed system, where there really is NO market, the central government can pick winners and losers, change terms, reschedule debt, and make investors whole at will. Losses aren’t necessary and systemic crisis, in theory, is perfectly avoidable.
But the underlying problems affecting lenders, borrowers, and savers are still a clear and present danger. The suppression of interest rates is an incentive for savers to become speculators and put money in high yielding ‘wealth management’ products. When a default creates a loss of life savings, it’s socially and politically destabilising. It’s not just a financial story anymore.
For lenders who act as a conduit between household savings and businesses that can’t get credit through traditional means, loss of confidence in wealth management products is a business killer. If you can’t package up loans and sell them as investment products, you’re going to have trouble attracting depositors, which isn’t going to help your ability to make loans.
And for the borrowers the danger is clear. If you can’t borrow more money, then you’d better be a real business. In the coal company’s case above, they hope to open a new mine to help generate cash flow to pay off the loan. But the Chinese coal sector is riddled with over capacity and unprofitable firms.
Still, that’s the real issue isn’t it? Money may grow on a printing press. But real capital is what you create when you take savings and turn it into new productivity, something that adds genuine value and creates a profit. Money borrowed for the sake of growth alone is just a poor allocation of capital. All it ends up doing, in the long run, is destroying the accumulated savings of a country.
None of the above means China faces an immediate capital crisis. But it has a major systemic problem. And its regulators walk a fine line. They can allow a failure or two and hope that it teaches savers a lesson without creating a panic. Or they can play it safe and bail everyone out, meanwhile permitting the continued boom in speculative (and unproductive) lending, which puts even more of the nation’s wealth at risk.
Regardless of the choice, my main point is that to the extent Australia is dependent on the seamless expansion of China’s economy at 7% a year, trouble in the shadow banking system is a threat. It’s going to be a threat for a long time. In the year of the Horse, wear a helmet and buckle up, cowboy.
It’s not all bad news for the Chinese middle class though. And for a change, it’s not all bad news for gold. While the mainstream pundits have become quite comfortable predicting that 2014 will be even worse for gold than 2013, evidence of a great ‘money migration’ in metal was produced this week.
Unofficial (meaning not the Central Bank) demand for gold from China reached 1189.9 tonnes last year, according to survey of gold demand published this week by Thomson Reuters GFMS. That’s a 32% increase in demand, year over year. Since 2003, Chinese gold demand has grown by five times.
So there you go. The gold price fell 28% in US dollar terms and the Chinese increased demand by 32%. That sounds like buying low to me. And while gold based ETFs reduced their holdings by 880 tonnes last year, Swiss refineries were busy melting that gold and selling it to retail investors in China.
Maybe the appetite for gold in China is a quaint relic related to old ideas about storing wealth. Maybe the Chinese are stupid for accumulating gold when they could, in Charlie Munger’s terms, be investing in productive enterprises. Or maybe the West will deeply regret the migration of so much gold from vaults in London and Zurich to the mattresses of homes in Beijing and Shanghai.
Dan Denning+,
Contributing Editor, Money Morning
Ed Note: The above is an excerpt from a recently published issue of The Denning Report.