The Clock is Ticking

I.C. Angles Investment Post…

While market watchers fixated on the debt ceiling in the United States, as the clock for raising the ceiling was again reset by Congress, debt issues in China likely pose a more significant threat to the global economy. It’s a risk not lost on Chinese policymakers, who are adopting new practices in order to wean their economy off dept dependence before the worst happens. But with the current levels of debt, economic imbalances and perhaps most importantly high debt inefficiency that clock is ticking. And unlike the U.S. Congress’ debt clock, this Chinese one is not going to be reset by a simple vote of politicians to borrow more. It is imbalances such as these not so easily addressed that pose the real threat to the stock market.

Bad Company

China’s debt is keeping some bad company. Private debt is above the peak levels before the credit crisis in 1989 Japan, 1997 Korea, 2007 U.S. and 2008 Spain. Total public and private debt is now more than 200 percent of GDP—an unprecedented level for a developing country. China’s budget deficit is estimated to have reached 9.7 percent of GDP last year, including regional spending and stripping out one-off land sales, putting it above levels of Southern Europe’s indebted countries. Corporate debt levels are among the highest in the world. In addition the central government doesn’t really know how much debt regional governments have actually accrued. So the central government has just commissioned an audit, in order to get a handle on the magnitude of the problem.

Commissioning an audit on some of the worst debt splurging offenders may prove to be doing too little, too late. China’s central government is concerned enough, however, to be taking other half measures, which won’t unwind excesses already created or effectively deal with a shadow banking system creating immense amounts of credit outside of official channels. Bank interest rates are still set by the government, but in a move towards market-based reforms China just launched a benchmark lending rate to guide rate setting by commercial banks. And when it comes to the government setting official borrowing rates, the seven-day Shanghai Interbank Offered rate surged to a three-month high. The central bank has also recently withdrawn liquidity through a reduction in reverse repos, and one measure of monetary liquidity shows levels near the last hard landing scare.

The Worst Kind of Inefficiency

New policies are likely being taken largely to slow a rapidly rising real estate market, which just jumped the most in three years, lest China soon join the bad company of other real estate bubbles gone bust. As my previous post on China discussed, building ghost cities is not a particularly productive investment. But China is not taking necessary, but painful structural reforms. And the economic inefficiencies are getting worse. Although as recently as 2007 just over a dollar of debt in China was estimated to create a dollar of growth, that number has plummeted as inefficiency has soared. Some estimates put a dollar of growth requiring three dollars of debt now, while Fitch Ratings estimates an extra yuan of debt only returns 0.18 yuan in growth.

These levels of inefficiency are indicative of the end of a debt bubble. At this point the debt-driven model is largely tapped out, and even piling up more debt won’t keep the economy growing. Despite all the talk about China shifting its economy towards consumer spending, increasingly inefficient industrial, infrastructure and speculative real estate continue to be the core, with investment outstripping consumption year-to-date as a driver of growth. Such inefficiencies mean the time to pay for all this bad debt is likely not far off.

Timing an Exit

This is not an unrelated dilemma to that faced around quantitative easing in the United States, where evidence shows extreme monetary policies as being exceptionally inefficient. The economic debate on quantitative easing should largely be around the lines of whether it has a very small positive impact on growth or actually has a negative effect. Either way I remain as I noted in my June post “The Party is Over” of the view that the global easy money party is coming to an end, as those policies become increasingly ineffective, and remain as bearish as I can be without technical confirmation in a big move down of stocks.

At this point it is only the absence of such technical confirmation keeping me a very reluctant and nervous bull on this stock market. Because if the global economy does roll over with monetary and fiscal policies largely exhausted at these levels of inefficiency, it is likely to get very ugly. As a result a significant move down should be treated as reason to exit or neutralize stock positions and adopt a defensive portfolio posture, rather than buy the dip. How long this clock can keep ticking until then is anyone’s guess, but complacency is not warranted even for the long-term investor.


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