Is China in Trouble?

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From Seeking Alpha, Global Markets, China

A few months ago, the buzz about China centered on the debate over revaluing the yuan. Now, the focus has shifted to whether or not the growth sustained in the mainland has created a bubble of epic proportions. The focus has been on a few things: the housing market, banks and the massive engine that is the Chinese economy.

In the United States it is a well-known fact that the housing market has gone through a massive correction. There may be more downward pressure ahead, despite or as a result of a tax credit extended by the US government that expired in April. The housing bubble in China is the result of loose lending practices and overextension of credit, much like what preceded the collapse in the US. The probability of the housing bubble bursting is low, according to industry experts, if Beijing can successfully implement policy. However, even if Beijing succeeds, a 20-30% correction is expected. Excuse me, but isn’t that a bit steep for something that is not regarded as a burst bubble?

As a result, the powers that be have introduced higher down payment requirements, raised mortgage rates, restricted purchases of multiple homes and increased property transaction taxes. This is meant to stymy the red hot housing sector without having too much of a negative impact on the overall economy. It has worked so far, with prices leveling off in the middle of this year, but the negative impact on the construction sector is yet to be reflected in GDP growth rates. Even with all these measures in place, it has not been enough for the many analysts who believe a downturn is inevitable. With volume languishing and prices steady or declining, there is a growing group of analysts that believe increased transparency is necessary to really see what is going on in China.

In response to this growing sentiment, led by Harvard professor Kenneth Rogoff, China’s banking regulator recently told lenders to perform a series of “stress tests” similar to those the EU went through last month. You can read about some of the risks associated with China’s banks here. The stress tests will hopefully conclude whether the banking system can sustain drops in housing prices of up to 60% in some areas. Now, it seems as though most of the bigger Chinese banks are healthy; a few banks have even issued IPOs in recent months to raise capital.

The problem, as we’ve seen in the Western markets over the last three years, comes when the unexpected happens. VaR (value at risk) failed because it did not account for that worst case of one percent; what happens when being 99% certain isn’t enough? So, what happens when the Chinese real estate markets collapse more than 60%? This is not outside the realm of possibility if civil unrest, tensions with the US over the Yuan or a multitude of other potential issues come to a head simultaneously. Remember, it was just that type of perfect storm that cast us into this mess in the first place, and lightning can strike twice.

In addition to housing and banking, the economy as a whole has slowed. Consensus from Barclays and JPMorgan show China’s annual growth rate slowing to 10%, overall, down from predictions closer to 11%. The thing to remember, says HSBC's Sun Junwei and Qu Hongbin, is that “China’s economy is moderating – not melting.” This moderation comes at a time when the world is largely dependent on China to help sustain a faltering recovery. The problem is that China cannot create enough domestic demand. Their cost of living is not high enough and their demand for complex technological items that the EU, United States and Canada export is not substantial. As a result, their trade surplus (nearing $28 billion on $50 billion in exports in July) is producing a drag on other world economies.

The steps that China is taking are promising. They have accepted (finally) that they cannot rely strictly on exports to spur growth, as was the case prior to the 2007 recession. However, it may take longer than other world powers would like to spur domestic demand in the mainland. Rebates for cars, social spending and increased wages will take time to implement and right now the world needs China to consume more than ever.

So, what is the verdict on China? I believe the Chinese economy has hit a bump and needs more domestic demand to be sustainable in the new global environment. They are still ultra-focused on what is best for China, sometimes neglecting the negative impacts their decisions have on allies and trade partners. China has long been a savvy dealer of information (or misinformation for that matter) and it seems as though this will be more of the same. Just as a revaluation of the yuan does nothing in the short term to benefit the Chinese people, transparency in the case of bad news is similarly useless to China. As a result, I will take the news that comes out of China in the coming months with a grain of salt… or an entire shaker full.

Author: Clayton Reeves

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