Red Flags in China – Can It Prevent a Major Financial Crisis?

China's policymakers have been working to shift their economic model towards consumption, and away from excess investment spending. An explosion in lending is beginning to saddle China with the same problems that have plagued other debt-ridden nations.

Take a look at the chart below, from The Wall Street Journal, which shows the rise in China's debt levels compared with other countries before their respective financial crises. Looks strikingly similar if you ask me.

China has relied heavily on investment spending, such as construction and infrastructure projects, to boost employment and economic growth. Investment spending in China currently accounts for almost half of their gross domestic product, well above the levels of most other countries. This reliance on investment spending poses a risk to China and global markets, as that level of investment spending cannot continue forever.

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There are some indications that China may already be overbuilt. Talk about "ghost cities" has existed for some time now. Here are a couple of intriguing images. The one on the left shows Chenggong in Kunming, the capital of southwest China's Yunan province, where people and cars are rarely seen in the streets. The picture on the right shows Changzhou in east China's Jiangsu province. Only approximately 20% of the residential dwellings there have been sold.

There are many other examples of cities in China where infrastructure is not being utilized, and it makes one wonder if the loans which were created to fund these projects can or will be paid back.

Part of the dramatic increase in lending has come via shadow banks, which include the off-balance sheet lending arms of traditional banks, trust companies, insurance firms, etc. which have the ability to extend credit but aren't as heavily regulated as traditional state-run banks. On this front, China is working to pass legislation to step up regulation of the shadow-banking system. But regardless of where the debt comes from, it is starting to rear its head as a potential red flag. The question is, will China be able to take appropriate measures to rein in lending slowly, or will the deleveraging happen quickly, as it did for the US during the financial crisis?

We can already see the effects of China's central bank's efforts to rein in lending. Twice in 2013 the PBOC "engineered" liquidity crunches to drive up short-term rates and discourage lending. So far indications show that it may be working. According to Wei Yao, an economist at Societe Generale, credit has been harder to obtain since the first engineered cash crunch back in June 2013. She also notes that Chinese economic growth typically lags credit growth by three to four quarters. If this is the case, a slowdown in China could be on the horizon.

Considering the fact that markets discount future economic performance, maybe none of this should be surprising, considering that the Shanghai Composite has been having difficulties for years now. The chart below shows the performance of the Shanghai Composite over the last 10 years. After rebounding from the depths of the financial crisis in 2008, the last four-and-a-half years have seen steady declines in stock prices.

It's interesting that from a policy perspective, China's central bank is trying to do nearly the opposite of what the US Fed is doing. The Fed has promised to keep short-term rates near zero, hoping to spur lending, which will drive economic growth and overcome the deflationary forces that we have been battling since 2008. China's central bank, on the other hand, is allowing short-term rates to rise, driving longer maturity rates up to slow the vast amount of credit creation.

What may be more intriguing is that prior to the US financial crisis, Bernanke was attempting to do the same thing that China's central bank is doing now -- raise short-term rates to limit credit growth. That can be seen here in a chart of the federal funds rate. In 2004, the Fed began raising short-term rates to try to counteract the dramatic expansion in credit that was taking place. I believe that at the time, the Fed thought they could slowly rein in lending to avoid a bout of major deleveraging. History demonstrates how that ended. Before higher rates could effectively diminish credit growth, the problem had grown out of hand and collapsed on itself. This forced Bernanke and the Fed to do an about face, and bring rates down to zero. It will be interesting to watch China to see if they are better able to manage the looming problem.

The following is an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.

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