INSIGHT

CHINA PUZZLE

IS CHINA HEADING
TOWARDS A
TURBULENT LANDING?
The economic indicators from China have been turning negative
for some time. For the first time, corporate credit spreads have
begun to reflect the reality of underlying credit issues.
BY GAURAV SINGH & BIJON PANI

hina has gone

through a 25-year period of extraordinary growth, and in the process has
transformed itself. A lot of the credit
for this achievement has deservedly
gone to Chinese policy-makers who
have steered the economy with a
steady hand and long-term vision.
Bu t h o w s u s t a i n a b l e i s t h i s
breakneck growth? It is instructive
to look at global precedents herea
study conducted by Credit Suisse in
collaboration with academics from
the London Business School has
looked at GDP growth data since
1900. In these 113 years, it found
that among major countries Chinas
record clearly stands apart, with
an unbroken streak of eight per
cent plus growth for 10 years. Only
Singapore (in the early 70s) and
Germany (in its post World War II
rebuild phase) come anywhere near
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INSIGHT

this record, with eight years each of

unbroken eight per cent plus growth.
Has China now reached a stage
where its growth engine is faltering?

THE REAR-VIEW MIRROR

IMAGE
That economic growth is slowing
in China is hardly news. The latest
quarterly gross domestic product
(GDP) print came at 7.4 per cent, and
the falling trend is clear. However,
the consensus on the street is that
as in the past, policy-makers and
the Peoples Bank of China (PBOC,
the Chinese Central Bank) have the
situation under control and will be
able to dexterously steer the country
to an economic regime where growth
will be lower but still robust.
This is a dangerous consensus,
and in our opinion based on lazy
thinking that the past history of
policy effectiveness can continue
indefinitely. There is certainly plenty
of data to suggest an alternate view:
that economic fundamentals of China
have slowly been weakening over the
last decade, that the next five years for
China could be very different from the
last 25, that central planners in China
have potentially lost control of credit
creation, and that there is a huge
problem of mal-investment and excess
capacity that will have to be shut down.
It has not been the first time that
China has faced challenges to its
continuing growth. In the aftermath
of the South East Asian crisis in the
90s, China witnessed rising net
productivity levels (NPL) levels and
had to resort to restructuring the
balance sheets of its banks. But this
time, the size of the looming crisis
is much larger and possibly more
difficult to control. A small but
influential group of people in the
investment world have increasingly
started voicing their worries
George Soros, Marc Faber, Bill Gross

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In our opinion, the time

to start worrying is now,
and the trigger could very
well be the rising defaults
emanating from the
shadow banking sector...
official policy is now that
China will allow defaults.
of PIMCO, hedge-fund veteran
Jim C hano s and Harv ard academician Kenneth Rogoffare among
the people who have issued warnings
about China.

TOO MUCH INVESTMENT

CAN BE A BAD THING
The root of the underlying problem
is irresponsible credit creation. In the
aftermath of the 2008 financial crisis,
Chinese planners realized the need to
look beyond the export-led model of
growth, and started the move towards
a more domestic-led model. However,
while the aim was to increase domestic
consumption levels, the route taken
was to ramp up domestic investment.
A $586 billion stimulus program
followed, and simultaneously the taps
of credit were opened fully.
What followed was unprecedented.
Ex-Fitch banking analyst Charlene
Chu has pointed to close to $15
trillion of credit created in the banking
system since 2009. To put that in
context, this increase is roughly equal
to the total stock of the US banking
assetsChinas banking system has
added the equivalent of the entire
US bank balance sheet to itself since
the financial crisis! This has also

been accompanied by a big spurt in

corporate leverage levels.
Even more worrisome is the shadow
banking system, the moniker given
to largely unregulated credit creation
outside of the formal banking system.
This has grown in less than 10 years
from a virtually zero base to over 60
per cent of GDP currently. According
to JP Morgan estimates, its assets
increased 46 per cent year-on-year in
2013 alone.
So where has all this credit gone? It
has resulted in excess investment and
asset bubbles across various sectors
in China and fuelled a property
and infrastructure boom that has
no equal in history. Cheap credit
extended to unviable industries has
led to steadily rising non-performing
assets on bank balance sheetsNPL
levels for Chinese banks are back to
2008 highs again.
The most egregious example of
excess investment is real estate.
According to J Capital Research in
Beijing, China has added 5.9 billion
square metres of commercial buildings
between 2008 and 2012, the equivalent
of more than 50 Manhattans. In 2012,
China completed about two billion
square metres of residential floor
space equating to 20 million units

INSIGHT
and by 2013 end, around 6.6 billion
square metres of new residential
space was being built. This means
China now has home ownership of
over 100 per cent (some cities have
over 200%) compared to 65 per cent
in the US. And yet, a two bedroom flat
in Shanghai is now more expensive
than a comparable house in London.
Wo r r y i n g l y, r e p o r t s t h a t t h e
Chinese property market is beginning
to collapse are becoming increasingly
frequent. China bulls who argue that
the real estate problem would largely
be localized and price falls can be
contained easily by the government
should look at precedents of Japan in
the 1980s or US in 2006 (or for that
matter Mumbai in mid-90s).

THE PROBLEM IS NOW

So when will the Chinese credit
bubble burst? After all, bubbles
can continue to inflate indefinitely
until the appearance of a trigger.
What could form Chinas Lehman
moment?
In our opinion, the time to start
worrying is now, and the trigger
could very well be the rising defaults
emanating from the shadow banking

sector. In a couple of the initial well

publicized cases (such as the China
Credit Equals Gold #1 Collective
Trust Product that redeemed in
January 2014), the governments
agencies stepped in to prevent
default. But increasingly, this will
not be the case and official policy is
now that China will allow defaults.
The first ever Chinese bond default
of Chaori, a small Chinese solar cell
maker, in March 2014 could be the
canary in the coal mine. A spike in
redemptions in shadow banking
products is approaching in the next
two years, and defaults in these
may very well set the stage for an
accelerating crisis.
The economic indicators from
China have been turning negative for
some time. Many real estate firms are
already feeling the pressure of higher
interest rates and dwindling buying
interest. The increased volatility of the
inter-bank rateShanghai Interbank
Offered Rate (SHIBOR)is also an
important indicator, in our view, that
lending markets are not functioning
as smoothly. For the first time,
corporate credit spreads have begun
to reflect the reality of underlying
credit issues.

According to J Capital
Research in Beijing, China
has added 5.9 billion square
metres of commercial
buildings.... yet, a twobedroom flat in Shanghai is
now more expensive than
a comparable house
in London.

HOW DOES THIS IMPACT

INDIA AND THE WORLD?
It is not difficult to imagine that a
significant crisis emanating from
China will cause severe market
disruptions in Asia and the rest of
the world. China is the dominant
global buyer of commodities, so it is
likely that this will be the first sector
to be hit. Also impacted will be Asian
banks and companies with exposure
to Chinese construction or real estate.
The hot foreign institutional investor
(FII) flow into Asia would start seeing
a reversal as investors start worrying
about the Asian growth story and
moving to the safety of the dollar
we are already seeing some signs of
reversal in the carry trade.
Dependent economies like Australia,
Singapore, Hong Kong and Japan are
likely to experience immense pain
as this situation plays out. Counterintuitively, hedging against them may
currently be the best way to hedge
against China risk, as markets are yet
to price fully the negative impact on
these economies!

Gaurav Singh has 20 years of experience in

investment banking, M&A, hedge funds and
portfolio management.Based in the UK for
the past 10 years, he earlier managed a special situations portfolio for Stamford Capital
(a hedge fund), and developed bespoke portfolios and trades for family offices and private
clients. In India before that,he was senior
member of the Investment Banking and
M&A team at DSP Merrill Lynch, and Head
of Infrastructure Advisory at CRISIL.Gaurav
obtained a Master in Finance from the London Business School, an MBA from XLRI and
a Bachelor of Technology from the IIT, Delhi.
Bijon Pani holds a Masters in Finance from
London Business School, Masters in Computer Sc. from Oxford University and Bachelor
of Engineering (First Class). He is a Senior
Advisor at Yati Capital advising our HNI clients in areas of Portfolio Management and
Investments.
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