China's Pending Credit Crisis

China's Pending Credit Crisis

The Chinese GDP growth story is by no means news at this point. For 2013 to 2015, growth estimates remain high at a CAGR of 8.77%. But the former isolationist nation has, without doubt, already experienced its fastest growth for this cycle. This is troubling in light of the fact that Chinese credit expansion is running sky-high. Some say China's pending credit crisis resembles the U.S. circa 2007, but it may actually trump the U.S. credit bubble by a shocking magnitude. Investors around the world need to be aware of the current situation, as it has the capacity to affect the global economy (and your investments).

The U.S. is no stranger to credit. At the height of our country's own credit binge, the total credit provided by the banking sector was 244.4% of GDP. At its current rate of growth, China's credit-to-GDP ratio could easily hit 240% to 250% -- and continue ballooning from there. The World Bank has the ratio at 155.1% at year-end 2012, but with the five-year trailing CAGR of bank assets as measured by the China Banking Regulatory Commission at more than 30% (and climbing), its clear this is a runaway train. By the way, that's three times the rate of U.S. credit growth at our hungriest levels (2006 to 2007).

Now, as Kyle Bass of Hayman Capital pointed out in a recent investor letter, the credit growth has been the driver of China's amazing GDP growth, even while major economies in Europe and the Americas have stumbled. In Bass' words, "The Chinese authorities share the faith ... that sufficient expansion is the tide that will lift all boats above the threatening rocks of structural inefficiencies and accumulated macroeconomic imbalances." It's similar to U.S. economic policy, but China's is on a different level. The risks, therefore, are far greater, and the tools to buoy growth are losing efficacy.

Diminishing returns
Supporting credit expansion makes sense in times of deep economic strife, but the tactic loses its strength as time goes on. Bass notes that from the beginning of the year through March, Chinese credit expanded by 18 trillion RMB, while GDP grew just 5 trillion RMB. The money is getting sopped up by companies that have been encouraged to lever up and increase working capital, which makes their financial condition look stronger in the short term.

The risk here is most analogous to what happened on our shores: the burst of the credit bubble.

If Chinese regulators do not take action to reign in the ballooning credit situation, there is a decent chance that things will reach a breaking point, and the Chinese economy could then slip into a recession, bringing down asset prices and real-estate values. If it sounds like an old tale at this point, it is.

What it means to you
This should not be interpreted as another proselytization about the death of equities; that would be far too speculative. But investors need to be aware of their exposure to China and, more importantly, China's influence on economic health around the globe -- from domestic markets to emerging markets.

Obviously, Chinese companies are particularly exposed in this scenario, and even more so because of their relatively rich recent valuations. Now may be a good time to review these holdings and potentially take some profits.

Plenty of U.S. companies are at risk as well. For example, Yum! Brands , the owner of fast-food chains KFC, Taco Bell, and Pizza Hut, has weathered a slowdown in its formerly highflying Asian business. But a massive asset sell-off in China would hurt the company substantially -- likely more than the Doritos Locos Taco can make up for. Luxury-goods companies have enjoyed fantastic stock rises on the back of endless demand for their items in China and other Asian nations. Take Michael Kors , for example. The stock is up 160% since its IPO in late 2011. It's not Americans who are driving the growth, and it's certainly not the Europeans -- it's almost a pure play on Asian appetite for brands.

If the credit bubble isn't contained, these companies and their stockholders will undoubtedly take a bath.

If hindsight is 20/20, then individual investors should be able to see the coming credit crisis in China and protect themselves accordingly. Reducing exposure may exclude the investor from some short-term benefits, but insulating one's portfolio from a credit fallout will far outweigh those gains in the long term. You can bet that the smart money has already protected itself, and some may have even set up opportunistic shorts (not recommended!).

As Warren Buffett famously says, the first rule of investing is to not lose money. The second rule is, "Refer to rule No. 1." Everything after that is relatively easy. We can't take back what happened a half decade ago, but we should be wise enough to avoid a repeat.

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