Trusts And Bubbles

14/03/2014 at 6:15 pm

China. My goodness but we’re all worried about her at the moment!

There was another splash on the FT this morning about warnings of hard times ahead for some private investors as bond and trust investment defaults are expected to increase (further from zero) in coming months. And of course there has also been much attention given to the Chinese property market, which may be in a bubble; which may be primed to burst.

All this sounds rather worrying. Before commenting further there are three facts we need to observe:

  1. China approaches any potential bear period in the default cycle from a strong position. The required deposit reserve ratio for major banks stands at 20%, headline real GDP growth of 7.5% per year counts as a recession and managing the strengthening of renminbi in a stately fashion has built up foreign currency reserves of $3.8trn (comfortably more than twice total gross government debt as forecast by the IMF for 2013 – which itself stands at an unterrifying 23% of GDP).
  2. Commentators cried wolf on the property market ages ago. Two years back – a very bearish time, let us remember – there was a lot of talk abroad about the imminent collapse of Chinese real estate. In fact, even before then (worried about something called “inflation”), the Chinese had been tightening monetary policy via interest rates, exchange rates, and that bank reserve ratio in a deliberate attempt to slow the economy which had already seen the country’s real estate climate indicator fall sharply (it remains well below its ten-year average today).
  3. Chinese reported EPS, as measured by the CSI 300 Index, have grown faster than earnings for the S&P 500 since the nadir of 2008, grew faster in 2013 and are forecast to grow faster this year too. This is a good reflection of relative rates of growth in GDP. The difference in price behaviour has resulted in a US valuation multiple of 17x, well off the 2009 low and above the ten-year average; and a Chinese earnings multiple of under 10x, well below the ten-year average and lower even than the previous nadir reached in the middle of the Great Recession.

So it seems very unlikely, to say the least, that trust and real estate worries in China will lead to anything like the effects of (say) the subprime mortgage debacle on the US, or if they do, that this is not already priced in.

That is not to discount the possibility of distress entirely of course. The boy who cried wolf, morals about honesty aside, was proved right in the end.

So let us turn to China’s undeniable problem: it is a deeply unfree country. Looking at the World Bank indicators on national governance, China ranks broadly in line with other EM economies such as India and Brazil on measures such as the efficacy of government, the rule of law and the control of corruption. But in terms of popular voice and government accountability she is among the worst in the world. Coming in at the 5th percentile China is less free than Iran, Belarus or the Congo, and significantly less so than Russia (which does appallingly on the other measures by comparison).

This means very limited freedom on investment opportunities for the Chinese (generating disproportionate interest in real estate, for instance, and complex trust structures), coupled with controls on capital movements and profit repatriation with which Western investors are very familiar.

In itself this lends only a limited amount of credence to the idea that the big, bad wolf stands at China’s door. It remains much easier to see Western economies being bankrupted by their banking systems. But for anyone looking for the structural problem with the Chinese economy: that is it.

As a final aside, we should also remember how those trillions in imported reserve dollars are invested. China is the biggest foreign holder of US government debt in the world, and towards the end of last year sold nearly $50bn worth (out of a $1.3trn total). That’s five times the amount of monthly “tapering” being undertaken by the Fed.

In other words, if the bears are right about China being on the brink of some kind of systemic collapse, it is utterly impossible for the world to remain immune; not least the Treasury market, which has had a nice rally this year so far. The decoupling of emerging market and developed-world performance has been an eye-catching feature of recent quarters, but – one way or another – it is not really sustainable.

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