RBS Issues Warning that China Credit is About to Burst

December 7, 2010 Posted by China Briefing Reading Time: 4 minutes

Dec. 7 – Dire warnings about the true extent of China’s credit bubble are now materializing in mechanisms designed to protect against a sovereign debt default, as the Royal Bank of Scotland has advised clients to take out protection against the risk of a sovereign default by China as one of its top trading tips for next year.

“Many see China’s monetary tightening as a pre-emptive tap on the brakes, a warning shot across the proverbial economic bows. We see it as a potentially more malevolent reactive day of reckoning,” said Tim Ash, the bank’s marketing director, according to comments carried in The Guardian. RBS warns that the Chinese government will have to puncture the credit bubble before inflation reaches levels that threaten social stability.

Official statistics released by Beijing state that inflation was 4.4 percent in October, and may have climbed to 5 percent in November. However, this is not borne out by on the ground economics, which show that the cost of vegetables have risen 20 percent in the last 30 days.

The bank is recommending credit default swaps on China’s five-year debt. This is not a forecast that China will default. It is insurance against the risk of a hard landing, a situation that would have serious implications throughout Asia.

The newspaper quoted Diana Choyleva of Lombard Street Research, who said that China’s money supply rose at a 40 percent rate in 2009 and the first half of 2010 as Beijing kept up the pressure on a credit boom in order to sustain growth, but that the costs of this policy now outweigh the benefits. Experts agree that China’s economy may be entering a depressing cycle of stagflation – where credit-pumping leaks into speculation and price spirals, even as growth slows. The excess is being transferred into property, and there is intense debate whether or not China has managed to outdo America’s subprime bubble, or even match the Tokyo frenzy of the late 1980s. The International Monetary Fund’s position straddles the two opinions and has advised in Beijing’s favor by suggesting there is no meaningful property asset bubble of concern, but that home prices in Shenzhen, Shanghai, Beijing, and Nanjing seem “increasingly disconnected from fundamentals.”

However, real estate prices are a multiple of 22 times disposable income in Beijing and 18 times disposable income in Shenzen, compared to 8 in Tokyo. The U.S. bubble peaked at 6.4 and has since dropped to 4.7. The price-to-rent ratio in China’s eastern cities has risen by over 200 percent since 2004. The IMF said land sales make up 30 percent of local government revenue in Beijing. This has echoes of Ireland where “fair weather” property taxes disguised the erosion of state finances.

Choyleva said China drew a false conclusion from the global credit crisis that their top-down economy trumps the free market, failing to see that the events of 2008-2009 did equally great damage to them – though of a different kind. It closed the door on mercantilist export strategies that depend on cheap loans, a cheap currency, and the willingness of the West to tolerate predatory trade.

“China is trying to keep the game going as if nothing has changed, but cannot do so. It dares not raise rates fast enough to let air out of the bubble because this would expose the bad debts of the banking system. The Chinese growth machine is likely to continue to function in the minds of people long after it has no visible means of support. China’s potential growth rate could well halve to 5 percent this decade,” Choyleva said.

Fitch Ratings has just completed a study with Oxford Economics on what would happen if China does slow to under 5 percent next year. Fitch said private credit has grown to 148 percent of GDP, compared to a median of 41 percent for emerging markets. It said the true scale of loans to local governments and state entities has been disguised.

The result of such a hard landing would be a 20 percent fall in global commodity prices, a 100 basis point widening of spreads on emerging market debt, a 25 percent fall in Asian stock markets, a fall in the growth in emerging Asia by 2.6 percentage points, and a risk that toxic politics could make matters even worse.

Albert Edwards from Societe Generale has also stated that the OECD’s leading indicators are signaling a “downturn” for Asia’s big five (Japan, South Korea, China, India, and Indonesia). The China indicator composed by Beijing’s National Bureau of Statistics has fallen almost as far as it did at the onset of the 2008 crash.

“I remain convinced we are witnessing a bubble of epic proportions which will burst – catching investors as unawares as the bursting of the Asian bubbles of the mid-1990s. Ignore these indicators at your peril,” Edwards said.

However, China could use inflation as a crude way of curbing the country’s export surpluses and therefore of resolving the key trade imbalance that was behind the global credit crisis. China’s aging demographics also do not help, and the nation may potentially hit the “Lewis turning point,” named after the Nobel economist Arthur Lewis. It is the moment for each catch-up economy when the supply of cheap labor from the countryside recedes, leading to an increase in industrial wages. That has certainly been happening across the country, and is expected to result in a doubling of the minimum wage in the next five years.

China’s problem is that this is happening just as population aging starts to impact. The number of workers will decline in absolute terms within four years. China’s society may then tip into a sharp demographic decline. Unlike Japan, it will become old before it is has built a cushion of wealth.

If there is a hard-landing in 2011, China’s reserves of US$2.6 trillion, or over US$3 trillion if counted fully, may not be much help. Professor Michael Pettis from Peking University says the money cannot be used internally in the economy. While this fund does offer China external protection, Pettis notes that the only other times in the last century when one country accumulated reserves equal to 5 percent to 6 percent of global GDP was the United States in the 1920s and Japan in the 1980s. Both events ended in financial disaster. China insists that they have studied the Japanese incident closely and will not repeat the same errors, however a mix of political desire to prove the capitalist system wrong in dealing with the issues at hand may yet derail China’s growth. If not, then the phrase “with Chinese characteristics” will have far reaching consequences for political economists as they seek to establish the Chinese solution as the “middle way.” But many are growing increasingly edgy that China has overplayed its hand, that its statistics are incorrect and that a built in blindness to real economic data and hard facts may prove increasingly hard to manage.