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19 February 2014

What Goes Up Must Come Down...

In the last thirty-odd years, China’s economic growth has been the fastest sustained improvement the world has ever seen. To be honest, I’m not entirely sure how the statisticians can measure that, but I guess we can all agree that it’s been an astonishing performance to go from the closed, somewhat ramshackle product of war and revolution to today’s gleaming economic superpower. The key change was probably brought about by the partial introduction of so-called ‘free-market’ reforms during the 1980s, but the huge increase in credit in the wake of the 2008 crisis has also had a major effect in shaping what we can see today, most obviously on the eastern seaboard but also in the glittering expansion of some of the other old industrial cities.

Everybody connected to the metals business is for sure aware that the appetite this growth created for raw materials has been the most significant driving force of the boom in commodity prices. Miners and traders enjoyed a golden period, which, with little more than a hiccup, continued despite the crisis in western economies caused by the credit crunch. It’s been good for us all, but are the fault-lines becoming just a little more obvious?

Credit-Driven Boom

What’s been achieved, particularly post-2008, has been built on the back of a soaring amount of credit. Seeing the crisis posed by western bank problems and failures, the Chinese Government’s reaction was to use its large state-owned banking sector to make loans to stimulate growth through infrastructure and property development. That’s resulted in the construction of lots of airports, lots of metros, lots of apartment blocks. Anybody who has been there – in fact, anybody who has watched TV – has seen them. While the credit taps remain open, it’s all systems go. Problems arise, though – at least potentially, so far – because those taps actually can’t remain permanently open. If the growth of credit year-on-year exceeds the growth of GDP, basic economic logic would suggest that the position becomes untenable. And that’s what has been happening. Despite seeming conspicuous consumption by Chinese visitors to Europe and the US (think London property purchases), the domestic Chinese economy remains still seemingly tied to its export-driven base; without domestic consumption driving GDP to grow faster than credit, the lack of balance remains. Credit has fuelled property speculation but that in itself does not increase consumption in the economy. Neither is it by co-incidence that so much gold has been sucked into China – gold is a solid store of value, and its attractions are not lost on Chinese investors.

'Shadow' Finance

During 2013, the Government – who one has to believe do understand what is happening – have several times tightened credit, with the result that short-term interbank rates shot up. That’s a sign of fragility, mitigated to an extent by the growth of the so-called ‘shadow’ banking sector. That sector is now responsible for a growing share of the credit market in China, facilitating some quite strange operations. We know there is a glut of steel production in China, and yet iron ore imports do not seem to be suffering commensurately. One reason is the use of iron ore as collateral. The trade is to buy iron ore with a term letter of credit, sell the ore spot and invest the proceeds in the property market in the expectation that rising property prices will produce an attractive return before the original loan (via the L/C) has to be repaid. Now, I’m very cautious of criticising other peoples’ dealing strategies, but I don’t think that’s a particularly smart trade. You begin by buying a raw material whose end-product market is in over-supply, and you use the money you generate from the loan to invest in a sector which is also suffering oversupply. Not only is the property market showing signs of over supply, but anecdotal evidence suggests that a disturbingly large proportion of the loans originally taken against property are ‘non-performing’ – i.e., bad.


To me, this has all the signs of a fairly well-developed bubble; the bit I’m not clever enough to see (sadly) is the time-scale over which it will play out. It’s all there, though; huge indebtedness which a Government tries to reign in, with credit nevertheless growing faster than GDP, a shadow finance sector facilitating somewhat irrational investments (it’s not only iron ore, that’s just my example), newly-built properties standing empty, and conceivably not worth the loans outstanding on them, and a voracious appetite for gold. 

In the words of Blood, Sweat and Tears (‘Spinning Wheel’, 1969) "What goes up, must come down". And yes, I do know they were neither the first nor the last to say that.



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