China could become the rating agencies’ next subprime. This is the view of a small but growing number of investors and analysts who warn of the perils of ignoring Chinese financial risk at a time when popular wisdom casts emerging markets, including China, as largely immune to the effects of Western credit woes.
For Ralph Suppel, chief economist and strategist at hedge fund Bluecrest, the question is simple: why isn’t China subject to the same kind of scrutiny accorded other investment destinations? The problem, he says, is that credible information is hard to come by; macroeconomic data are widely distrusted and public and corporate balance sheets lack transparency. But at the same time “people don’t pay attention to Chinese financial risk.”
James McCormack, head of Asia at Fitch, admitted this week that there is a great deal ratings agencies and investors don’t know about China. “Transparency is an issue in China, as it is in many other emerging market countries. There is no question about that,” he said. “At the sovereign level, there are things we don’t know, such as how much debt is held at the provincial government level.” he said.
Though McCormack won’t say thing are worse in China than other emerging regions, there’s nevertheless enough reason to worry about the numbers and what they imply.
Inflation, which has been rising since mid-2006 and is now at an 11 year high, is China’s most pressing problem. Higher inflation could hit international competitiveness, undermine macroeconomic stability and contribute to social unrest.
A shortage in pork has been widely blamed for the problem and while food comprises 33% of China’s Consumer Price Index basket, upward trends in equity markets and consumer prices are evidence inflation is more widespread. The problem is that, as foreign currency reserves continue to pile up, the Chinese authorities have been flooding the economy with renminbi, putting upward pressure on prices. Fitch forecasts an average inflation of 5.2% in 2008, up from 4.8% last year.
So far, the authorities have dealt with inflation through price controls but this is little more than a band-aid solution and is a marked step backwards in terms of reform.
Allowing the renminbi to appreciate more quickly could rein in inflation but would have a damaging effect on China’s export industry. There are already signs that inflation may hit China’s international competitiveness - in the US, the average price of imports from China increased for the first time in July 2007.
Until now, investors have been taking heart from the belief that the Chinese authorities will intervene to ensure the country’s growth remains above 8%. But, Sueppel warns: “Ultimately intervention by the state will only aggravate the structural problems.”
“The biggest concern is serious financial dislocation,” adds Sueppel. He paints a bleak but not unfamiliar picture: financial mismanagement at a large corporate or bank could trigger a default that sparks an explosion of mistrust and panic among China’s retail equity investors.
A liquidity pressure-cooker has forced piles of retail cash into Chinese A-shares, pushing valuations dangerously high – price/earnings ratios in the Chinese stock market are, on average, in the 40s, compared with Brazil, where they earnings ratios average in the 20s.
Amid the unbridled optimism, the few voices warning on China sound like Cassandra. But talk of China “decoupling” is little more than collective amnesia. Complacency on the part of investors and ratings agencies over Chinese financial and transparency risk will ensure that, far from providing investors with a “safe haven” from global slowdown, China may prove to have been an accident waiting to happen.