China's Bear Stearns Moment

Friday, 12 Jul 2013 12:15 PM

By Robert Wiedemer

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Although the Chinese credit crisis in June has faded from the headlines, it is hardly over. While it may not have been the Lehman Brothers-like situation some thought, I do view it as a potential Bear Stearns moment.

Remember that the Bear Stearns bankruptcy happened in March 2008 and, after it passed, most people, including Federal Reserve Chairman Ben Bernanke, believed that all was well with our financial system. Whoops. Bear Stearns was simply the first sign of a much bigger problem with our financial system in 2008 and what just happened in China may be the same.

The situation began seemingly without warning. In late June, lending in China became very difficult very fast. The seven-day repurchase agreement rate between banks, which had averaged about 3.3 percent over the course of the year, shot up to as high as 30 percent.

The situation has cooled off since then, but still remains in the 5 to 6 percent range, well above its earlier average.

Why did this happen? Remember that Bear Stearns didn't have a problem until home prices started to decline. Suddenly the fundamental weakness in the firm's mortgage portfolio became a serious problem. And its bankruptcy was an indicator.

Likewise, the problem in China is that growth is slowing, and that is exposing a fundamental weakness in the Chinese banking system. For years now, the Chinese growth engine has been dependent on increasing amounts of debt and part of it is from its so-called shadow banking systems — analogous to the burgeoning sub-prime mortgage lending market in the United States during the housing boom. Much of the shadow banking debt is short term and much is invested in empty real estate. Changes in interest rates and property prices can have a quick effect on these loans.

This shadow banking system in China — which has been crucial to the growth of small and medium-sized businesses — has been part of a much larger and rapidly growing credit bubble that seems harmless as long as the economy is booming; but when the economy falters, it can cause serious problems in a hurry.

That credit bubble has gotten very big since the 2008 financial crisis when Chinese exports fell and the government rushed to offset that decline by making banks lend money to build infrastructure and real estate.

The ratio of total debt (public and private) to gross domestic product in China has risen from 148 percent in 2008 to 205 percent in 2012. The economic growth China has had since the financial crisis is heavily dependent on rapidly increasing amounts of debt.

One sign of that slowing economic growth comes from Morgan Stanley. After a trip to China to check on the Chinese steel industry, Morgan Stanley researchers reported that not only is steel demand slowing dramatically, but in their view, the Chinese economy itself is only growing about 3 to 4 percent on an annualized basis. That may sound impressive as compared with the U.S. growth rate, but it's about half the Chinese government's reported growth rate of 7 to 8 percent.

I've been saying all along that I think China is over-reporting its growth, and not by a small margin. Now even Morgan Stanley is agreeing. I called it a warning sign when China reported its exports to Hong Kong were significantly higher than Hong Kong reported its imports from China.

On top of that, Goldman Sachs recently warned that Australia might be heading into a recession. Given the close trade ties between Australia and China, it doesn't make much sense for one country to be nearing recession levels while the other is growing more than 7 percent a year.

Frankly, I'm even skeptical of 3 to 4 percent. I think Chinese economic growth could easily be negative at this point. The HSBC Purchasing Managers Index (PMI) for China in June was a disappointing 48.3. This was a drop from May's reading of 49.2 — any number below 50 represents contraction in factory activity. Even before that, an economist in China's own Development Research Center was quoted as saying, "The foundation for China's economic recovery is still not solid." Add to that China's export numbers in June were down more than 3 percent from a year earlier — and that's for a country heavily dependent on exports.

How does this compute with the Chinese economy showing any significant growth?

But the fact that a mainstream voice like Morgan Stanley is saying 3 to 4 percent indicates that more and more people are growing skeptical of Chinese growth claims. This and the fact that we're seeing a strong liquidity crunch in the Chinese banking system is bring China again to the forefront of issues to focus on.

The media may underplay China's problems because they simply assume that since the Chinese banking system is controlled by the government, everything will be fine.

Ha!

Let's not kid ourselves. This is a situation we need keep an eye on, as a real crisis in China may be on the horizon.

About the Author: Robert Wiedemer
Robert Wiedemer is a managing director of Absolute Investment Management, an investment-advisory firm for individuals with more than $300 million under management. He is a regular contributor to the Financial Intelligence Report, the flagship investment newsletter of Newsmax Media. Click Here to read more of his articles. Discover more about his latest book, "Aftershock," by Clicking Here Now.

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