Chinese Turbulence A Wakeup Call for Investors

The latest convulsions in the markets do not bode well for China, writes the chief of Handelsblatt's finance section.
Beijing is to blame for mistakes that are causing increased investor concern about the world market.

The message sounds dramatic: The turbulence in global markets emanating from China "reminds me of the crisis we experienced in 2008," the doyen of financial markets, George Soros, said recently.

But Mr. Soros is a legendary speculator, right? Does the loss of more than $2.5 trillion (€2.31 trillion) in a few days mark the beginning of a financial crisis like the one we experienced only seven years ago?

It's just wrong to foment anxiety with prophecies of doom. Though we can't rule out the possibility of a financial system meltdown, it seems unlikely.

Nevertheless, it would be negligent to deliberately ignore the signals coming from the markets – and they do not bode well for the next one to two years.

The good news is that in contrast to Western countries, Chinese debt is concentrated in the government. Still, the growth of credit in state-owned enterprises, the real estate sector and municipalities is alarming.

The causes of the sharp decline in stock prices do not lie solely in the inept actions of Chinese authorities, as some stakeholders with interests of their own would have us believe.

Of course, the notorious decision to suspend trading, the planned lifting of selling restrictions for wholesale investors and the erratic devaluations of the yuan triggered the worst start to a year for global markets in many decades. But these are merely symptoms, while the causes are more deeply rooted.

First, investors are concerned about economic problems that have been building up in China for some time. Second, the power of central banks worldwide is reaching its limits.

It's true that China's stock markets are primarily driven by private investors, so what happens in those markets is a poor reflection of the condition of the economy. But share prices are also merely symptoms of underlying problems.

The Chinese market bubble is nothing but a failed attempt by Beijing to keep the economy afloat in the last two years with an artificial bull market, and to use the market to recapitalize its troubled state-owned enterprises.

And the market is only a sideshow. China's true problems lie in the exorbitant expansion of credit, with which the government has maintained its economic growth since the beginning of the financial crisis.

The numbers are staggering. According to McKinsey, China's total debt lies at $28 trillion, which surpasses that of the United States. And according to figures by Nomura, the country's debt has grown by 61 percent in five years – a much faster rate than its economic output.

The good news is that in contrast to Western countries, Chinese debt is concentrated in the government. Still, the growth of credit in state-owned enterprises, the real estate sector and municipalities is alarming. The volume of loans by major banks at risk for default is already growing rapidly.

The Chinese government and central bank could certainly react with further monetary stimuli. But that would only ignite yet another straw fire, which would be unlikely to last, especially as the government faces the growing problem of capital flight, with foreign currency reserves declining by $512 billion last year. If this trend accelerates, even the enormous mountain of foreign currency reserves in China, currently valued at $3.5 trillion, will eventually disappear.

There is also another reason behind investor concerns, one that can be found in the Western world: flagging confidence in the alchemy of central banks. This is reflected in the credit markets, where investors are once again starting to differentiate between high-risk and lower-risk borrowers. This risk assessment threatens to become a self-fulfilling prophecy, so that some borrowers will be unable to afford the higher cost of credit in the long term.

If all of these factors continue to dampen the dynamics of the global economy, price valuations in the United States and Europe will quickly take a much bigger turn for the worse than many professional optimists believe today.

While we shouldn't panic, investors must prepare themselves for more turbulent times ahead.

The deceased market guru André Kostolany, who attended the same school in Budapest as Mr. Soros, said decades ago: "In terms of crowd psychology, reactions in the market are the same as in the theater: One person yawns, and before long everyone is yawning. One person coughs, and immediately the entire room is coughing."

But sometimes observed warning signs are not psychological phenomena, but rather a sign of an impending epidemic.


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