Underground credit creation by Chinese firms means that the People’s bank of China has lost control of credit growth, that a financial crisis is likely within the next two years, and investors should go underweight on Chinese securities, according to the head of one of the UK’s biggest institutional funds.
Julien Garran, head of asset allocation at insurance firm Legal and General, said that the Chinese authorities have succeeded in sterilising only half of capital inflows from the trade surplus and speculative investors. Reserves stand at $925 billion, but the rest has “found its way into the domestic economy.” The low cost of capital has funded low-return investment, building up excess capacity in Chinese firms.
More than half of all capital spending in China is funded out of the retained earnings of companies. Garran said there was anecdotal evidence of an explosion in bills of trade. Firms are using cash on their balance sheets as collateral for future payment to suppliers, and trading the bills, “Chinese firms are essentially printing their own money, turning the corporate sector into a financial sector.”
Profits at Chinese firms are likely to be squeezed over the next two years as interest rates, currently 5.56%, continue to rise and pricing power is eroded by excess capacity: “Interest repayments will get increasingly hard to make, thereby increasing the chances of a credit crunch.”
“This poses a particular risk in China as the banking sector is still weakened by… non-performing loans.” The Chinese government has re-capitalised the country’s big four banks, which account for 80% of lending activity, during previous liquidity crises.
Bank credit to the private sector will be equivalent to 140% of GDP this year, compared to 110% of GDP in Thailand when the Asian financial crisis started there in 1997. However, Garran said that unlike the Asian crisis economies in the 1990’s, “China has a substantial current account surplus, less foreign currency-denominated debt and… almost $1 trillion currency reserves.”
Garran predicted a devaluation of the Yuan within the next two years as Chinese firms go under. He recommended going underweight in Chinese and other emerging markets securities and in securities of countries that export to China, including Scandinavia and Germany. He recommended going overweight on service-oriented economies with large current account deficits, such as the United States and Britain, that would be “relatively unexposed” to a slowdown in China.