China’s Coming Default

800px-Shanghai_-_Nanjing_RoadLast June I pointed to four unfortunate facts in the Chinese economy.

1. Overall credit had increased to $23 trillion dollars, up from $9 trillion as recently as 2008.
2. This amount of credit was over 200 percent of GDP, an increase of 75 percentage points in just five years. (By comparison over the same period the United States’ ratio of debt-to-GDP increased by 40 percentage points.
3. The credit rating agency Fitch had downgraded the Chinese government’s debt to AA-.

Most damning if not ominous, though, was the fourth fact:

4. The cost of short-term borrowing (seven-day) on the Shanghai repo market jumped to nearly 11 percent. This was the highest rate since March 2003. (Zerohedge reported the overnight repo rate was as high as 25 percent at the time.)

In writing Deep Freeze: Iceland’s Economic Collapse, my coauthor Philipp Bagus and I observed a similar set of events with regards to Iceland. Artificially low interest rates, and especially short-term interest rates, created an environment of heavy indebtedness. Entrepreneurs borrowed money on very-short-term loans in continual need of rolling over. By financing projects with, e.g., a one-month loan at a very low interest rate, the borrower could finance a long-term project provided the credit market remained liquid and interest rates remained low. Every month he would just borrow back the amount of money to pay off the existing loan. It is somewhat akin to taking out a new credit card to pay off your old balance, which works as long as you have decent credit and the card issuer keeps interest rates low.

At the time I reported that China was on the precipice of a looming bust, the inevitable result of a credit-fueled boom. Like most things, the bigger they are, the harder they fall.

Chinese state media recently warned that investors may not be repaid by the China Credit Trust Co. when some of its wealth management products mature on January 31, the first day of the Year of the Horse.

You say you’ve never heard of the “China Credit Trust Co.”? It was recently spun off by the world’s largest bank by assets, the Industrial and Commercial Bank of China. ICBC has recently suggested that it will not compensate investors for losses and that it will not assume any responsibility.

Indeed, writing for Forbes, Gordan Chang reports that “it should be no mystery why this investment, known as “2010 China Credit-Credit Equals Gold #1 Collective Trust Product,” is on the verge of default.” China Credit Trust loaned the proceeds from sales of a half billion dollars of product to an unlisted coal mining group. The coal company is, according to Chang, probably paying upwards of 12% for the money as it was desperate for money given that it has already been declared bankrupt.

There has never been a default in a Chinese wealth management product other than some delayed payments. Besides being the first, this one could be a sign of things to come.

Of course, some observers are not worried. As Chang correctly notes: “”To have a market meltdown, you have to have a market” and China does not have one.  Instead, Beijing technocrats dictate outcomes.”

That is indeed correct, but there is the unfortunate fact that private money is on the line. People have invested in China thinking the party would never stop. The Chinese government acting as a surrogate for the market is also the reason why China is heading for the granddaddy financial collapses.

Chinese GDP has not contracted on a year-on-year basis since 1976, the year the great communist leader Mao Zedong died and optimists note that the Chinese government and central bank are flush with cash. This may be, but there are a lot of dodgy wealth funds out there. At the end of 2013 there was as much as 11 trillion yuan ($1.8 trillion) invested in wealth management products, just like the one expected to default at month´s end.

As I said, the bigger they are the larger they fall. After recently dethroning Japan as the world’s second largest economy, China is about as big as they come. Size is not substitute for stability, however, and China´s years of dependence predicated on short-term loans might just prove the point.

(Originally posted at the Ludwig von Mises Institute of Canada.)

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