Stocks finished with modest gains on Tuesday after five days of serious selling pressure. The catalyst? A cagey announcement out of China that the troubled (and poorly named) $500 million “2010 China Credit / Credit Equals Gold #1 Collective Trust Product” would be bailed out by an unknown benefactor. This removed the fear that, heading into China’s Lunar New Year celebrations, the country would suffer a confidence-rattling default within its already shaky shadow banking system. And it also provided a good news distraction from the ongoing currency volatility in places like Turkey and Argentina.
Still, China Is in Trouble
Setting aside the ongoing problems with emerging market currencies, China’s stick save of the Credit Equals Gold trust problem — which was backed by a troubled coal company — doesn’t solve the issues bubbling up in the backwaters of China’s financial system. It merely postpones the inevitable fallout, as did the bailout of Bear Stearns here at home during the housing crisis. The two important things to keep in mind here is that:
- China’s economy is slowing as its export-, investment- and credit-dependent growth model sputters.
- China’s $6 trillion large shadow banking system, according to JPMorgan’s calculations, is more vulnerable than the bulls will admit.
Credit growth in China has been outpacing GDP growth since early 2012 — a classic sign that a bubble in borrowing has reached its final stage as lending loses its ability to generate real economic activity. Years of overbuilding has resulted in in countrywide excess capacity of nearly 40% according to some estimates, as steel mills and mines are idled and lost revenue and fixed expenses pinch profit margins and the ability to service credit obligations. And the credit that has been generated over the past year has been issued at ever-increasing interest rates — a sign that borrowers, desperate to keep the music playing, are willing to pay whatever is asked. You can see this dynamic in the chart below. You can sum it all up like this: In the view of Societe Generale’s China economist Wei Yao, “there is no other ending to China’s massive resource and credit misallocation than a painful bursting of the bubble.” The only question that remains is “when it will start unwinding and at what pace.” Of course, there is more to this story. Beijing has been trying to actively and gently manage the reorientation of the Middle Kingdom’s economy away from credit and fixed asset investment, and toward domestic consumption. It has been trying to tighten the cost of money in the interbank lending market, but has repeatedly relaxed its grip at the first sign of stress. Add it all up, and Chinese officials are stuck with a classic moral hazard dilemma. The longer they prevent panic, the more complacency they foster, making the eventual crash that much more painful. That’s exactly what happened here at home in 2007 and 2008 before Lehman Brothers was allowed to fall. And if China, the world’s second-largest economy, suffers a credit crisis, the rest of the world will suffer as the U.S. dollar rises on safe-haven inflows — exacerbating the currency crisis underway in other emerging-market countries. The situation is too complicated, and too complex, to expect a bailout of a single trust product to solve. For now, I continue to recommend investors maintain a cautious, defensive stance as these issues play out, focusing on areas like U.S. Treasury bonds via ETFs such as the leveraged Direxion 3x Treasury Bond Bull (TMF) which is up 7.4% since I added it to my Edge Letter Sample Portfolio on Jan. 10.