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China Slowdown And Credit & Real Estate Bubble

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For the past few years I’ve mentioned in memos to investors and briefly in my more recent 2010 currency review / 2011 outlook article about the world’s over-dependence on China’s fast growing economy, and apprehension about their growing credit & real estate bubble.  However, it seems that many investors have been ostriches, ignoring that the Chinese economy will likely experience an inevitable slowdown, as well as face the real risk of a serious domestic financial crisis or “hard landing”.

It is no secret that the loose lending policies of the Chinese government in the past few years have allowed banks to lend like drunken sailors to states, municipalities, and the private & commercial sectors, in order to maintain stellar economic growth.  The majority of the loans have been for massive infrastructure and real estate projects.  The result has been many infrastructure improvements and rapid urbanization in many parts of China.  However, this has also left China with desolate “ghost cities”.  These surreal “ghost cities” have undergone intense urbanization, but lack the population to support the numerous highrises, malls, highways, and roads, that have been built.  Much of the residential real estate purchased, have been for investment purposes by Chinese who do not want to put their money into the volatile stock markets, but also want to protect their money from the effects of rampant inflation. In addition, as mentioned in my 2009 outlook article, greed, excess, and fraudulent activities have ballooned with China’s enormous growth. And along with them, questionable/complacent/fraudulent loans & credit practices have undoubtedly surged.

Chinese officials are well aware of the brewing credit & real estate bubble. In the last 2 years the government attempted to curtail and contain the excessive lending, mainly by increasing the bank reserve requirements and raising rates a number of times.  They have also imposed further restrictions on individuals regarding real estate investment & related borrowing. Despite their efforts, banks have managed to continue lending at very high levels.

Real estate investment & development accounts for a significant portion of China’s GDP.  If real estate was to cool & stagnate, GDP would drop quite significantly, which would still be a shock to most investors.  In early 2011, several brokerages reported that they had to close down some offices in large urban cities due to slowing demand.  The National Bureau of Statistics of China (NBS) recently reported that during the first two months of 2012, the total growth rate of investment in real estate development has slowed and that the growth rate of property sold has dropped considerably (-20.9%).  For 2011, the NBS reported that “real estate development showed a downward trend” with sales declining.

Growth based on debt works only if the debts can be repaid.  Bank earnings, are in part fueled by the profits made on loans.  However, if those loans cannot be repaid in the future, earnings will be severely impacted. Bad loans reported by Chinese banks have been for the most part less than 1%, but reported increases in the 4th quarter of 2011.  But how accurate are those numbers, and do they realistically reflect the risk of mass default?  Remember what U.S. and European banks first reported before the credit crisis in 2007?  Bad loans were a very low percentage.  Then suddenly, they weren’t!

Over the last 12 months, we have started to hear more & more of China’s economic slowdown making headline news.  We can also expect more of this (and more frequently) as we go forward.  Yet, investors still look to China for high growth & returns in their portfolio this year. According to recent bank & research firm surveys (most recent being HSBC’s in March), fund managers are still looking to China as well.  Hopefully, China can avoid a hard economic landing and also avert a crisis created by excessive lending & spending.  However, the risks continue to increase as very little has been done to actually solve the problem that has been created.  Steps have only been taken in an attempt to stop the problem from growing, as well as to stall the inevitable impact it has.  Compounding the problem is China’s most recent policy move which loosened lending, in order to sustain high growth amid more recent signs of a slowing economy. When and if, China’s problems erupt, it will likely send financial shockwaves around the globe. Its difficult to predict markets, but markets (driven by people) have historically reacted unfavorably in such financial events.  Investor disappointment is very likely on the horizon.  When might such an event take place, would be anyone’s guess. But investors should remember that during negative financial market events, there will be opportunities! Investors should be ready to capitalize on depressed values if they present themselves.

I continue to consider China a developing nation, whose has made great strides, but still has much further to go in terms of economic development (among other aspects).  Investors should be cautious and realize the associated risks of such young economies.  My perspective is that they are still very much the “wild west” of the financial, business, & investment world – and the risks are very real & high! A “hard landing” may very well be on the horizon for China. Keep in mind, this is not meant to be a prediction, but perspective to help investors to be aware of possible outcomes and not to be caught off guard by them, as well as to capitalize on opportunities that may result.

Thanks & Happy Investing! — The Investment Blogger © 2012