The trouble with valuing China

By Elite Wealth ManagementCovestor

As the timetable for a US Federal Reserve rate hike gets pushed out and interest rates remain steady at 0% – 0.25%, the market is once again looking at the first major indicator that the global economy could be in trouble…China.                   

Wall Street has been operating the majority of 2015 under the assumption that the global and domestic economy were continuing to gain strength and that the Fed would therefore raise interest rates.

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Holding Fire

Investors believed that as rates began to climb, it would reflect a strong, healthy economy going forward.

While recent events did much to make investors reassess the current state of the global economy ahead of the Fed meeting, the decision to keep rates low was still a blow to investor confidence.                   

The S&P 500 fell 1.61% on Friday, September 18, following the Fed’s decision to keep rates unchanged while volatility jumped 5.39% to 22.28.

China Matters

Now with one question answered, all eyes are back on China as its economic woes will dictate the overall direction of the global economy going forward.                                   

The Chinese economy has been a global powerhouse for the past decade.

With annual GDP growth in excess of 10% and low labor costs, China became a manufacturing giant with a vast industrial network that supplied goods to countries around the world – exports in 2014 topped $2.34 trillion.

Slowdown

That growth finally peaked though, and has been falling for a while. Annual GDP growth for 2015 is estimated at 7% while 2014′s figures were revised down from 7.4% to 7.3%, indicating a slowdown that could continue on at an accelerated pace.   The buildup in the Chinese economy was also a huge boon to commodity prices as demand for industrial products soared.

Commodities Rout

With demand easing for the foreseeable future, commodities have all but collapsed and I believe could remain there well into 2016 or even further out.                   

Investment in Chinese stocks accelerated this year thanks to the encouragement of state-run media companies and massive leveraging to buy more shares of stock.

From June 12, 2014 to June 12, 2015, the Shanghai Composite Index rose an astonishing 151.81%, creating a massive equity bubble.

Stock Swoon

After June 12, 2015, the cracks in the Chinese stock market finally broke, sending stocks tumbling down sharply while more than half of listed companies filed for a trading halt to try and stem their losses.

Since its June 12, 2014 high, the Shanghai Index has shed nearly 40% of its value as of September 21, 2015.

Considering that the Chinese indices are still up quite a bit for the year, the fear of further weakness in the stock market is still very real.

Wealth Destruction

The core problem with China’s economy isn’t over though. The Chinese government has significant sway and influence over the economy and stock exchanges which has led to a number of problems with unintended consequences.    The initial rise in Chinese equity values came on the back of a fundamental change in Chinese exchange rules and a massive push for local investment into the stock market.

Lax requirements for opening up margin accounts and borrowing money to invest led to the opening of over 40 million new brokerage accounts between 2014 and 2015.

Now with more than $3 trillion worth of wealth destroyed, the government has cut interest rates and devalued the yuan multiple times in an attempt to stave off the growing anxiety.                   

Black Mist

Investors are hoping for some clarity from Chinese President Xi Jinping when he visits the U.S. this week.

Global economic concern, particularly in China, was the main talking point in Janet Yellen’s speech during which the Fed kept interest rates unchanged.

Uncertainty in China’s future will impact the global economy, but the question remains exactly how much damage could be caused?

Global Impact

Economists at JPMorgan recently estimated that a 1% change in China’s GDP could have as much as a 0.2% hit on growth in developed markets like the U.S.

As the U.S. economy fights to keep inflation from becoming deflation, the drastic depression in commodities prices will be a difficult challenge to overcome.                   

The U.S. and Chinese trade makes up less than 2% of GDP, but it’s the widespread impact that could come back and harm the economy.

Domino Effect

Commodities are the main casualty of China’s slowdown. Without that demand, other countries like Canada and Brazil that have relied heavily on commodity demand overseas have begun to suffer.

It’s a domino effect that has the entire global economy on edge.                   

The unrealistic expectations of unending double digit GDP growth in China has fed into a long lasting global bull market that’s now struggling to find a branch to latch onto in order to survive.

Understanding where China is heading is critical to anticipating how healthy the U.S. economy is and what to expect. But that might not be as easy as it might look.

Managing Expectations                   

Now that we’ve established how and why China’s future is critical to the global economy going forward, we face another problem: how to interpret the data and manage expectations.                   

Unlike the U.S. economy, China’s approach to solving economic woes is heavy-handed with government interference.

While the U.S. stock market might be influenced by the Fed, the Chinese government has more far-reaching powers that it uses.

Hybrid Economy

China’s economy is ostensibly capitalist, but the government is still heavily influenced by Communism and doesn’t have as much experience managing a free economic system. Transparency isn’t a priority which makes it hard to ascertain the true state of the Chinese economy. The government’s encouragement for local investors to invest in the Chinese stock market in an attempt to keep the economy appearing strong and to lift stock values is a sign of economic inexperience.                  

Investors will be watching for President Xi to address policy changes regarding accounting standards and other reforms that will allow the Chinese economy to have more of a soft landing rather than a hard landing that could trip up the global economic bull.

Contagion Risk

The Chinese stock market may be a concern to investors but it’s the financial system that could further weaken the economy.                   

The total number of bank assets has risen dramatically in the past decade.

In 2005, assets in the Chinese banking sector equaled roughly $5.9 trillion but rose to more than $27 trillion by the end of 2014.

Now, total assets number around $31 trillion while China’s GDP is just $10.3 trillion – around three times the size of GDP. That means a 10% loss in banking assets would equate to a $3 trillion loss in the economy or 30% of annual GDP.

Bond Sell-Off

If that happened, China would likely initiate a massive bond sell-off in an attempt to inject liquidity back into the banking system.

Combined with China’s yuan devaluation policy that it’s currently engaged in, and you have a recipe for a global crisis.                   

Exacerbating the problem is China’s extremely high corporate debt-to-GDP ratio which stood at a record 207% at the end of June 2015, well above what’s considered a safe level.

The use of high leverage and state-run accountability programs has allowed the Chinese banking system to issue loans with very little oversight in order to help grow the economy and present to the world a high annual GDP.

Deleveraging

The lowered 7% GDP growth for 2015 could easily drop several hundred basis points quite rapidly if there is any kind of deleveraging and continued use of extreme leverage will almost certainly do to the banking system what it did to the stock market.                   

China’s shadow banking sector has been the subject of much criticism but won’t change unless there are significant policy overhauls.

Shadow Banks

According to a U.S. News & World Report, the Chinese government owns 65% of commercial banking assets and “de facto” control of 95%.

This combination of government owned banking institutions and regulatory agencies basically gives the financial sector free reign to lend money and leverage assets without having to worry about moral hazards.   

Risky loans that are deemed unsuitable for a banking institution’s books are simply packed and repackaged in a similar manner that the now infamous collateralized mortgage obligations (CMOs) that were responsible for the U.S.-led financial crisis in 2008 were done.

Risk Multiples

The government loans are re-purposed as wealth management products and sold to the Chinese investor class which makes the banks’ balance sheets look healthy.    As financial leverage and margin continues to increase in the Chinese banking system, the risk multiplies.

State-run programs and risky assets that are collateralized and sold off make evaluating the banking system difficult.

If the building tension in the Chinese economy isn’t dealt with, the global economy could suffer for several years.

However, I believe a soft landing is still possible if the waters are carefully navigated.

                 Photo Credit: Jonathan Brennan via Flickr Creative Commons //

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