Investing in China – A Time for Caution

The Chinese economy is in a state of transition from an export driven boom that preceded the US stock market crash of 2008-09 to a consumer driven economy that draws upon its citizens’ thirst for material goods. Much like the heydays of the housing boom in the US, China has had its own real estate frenzy. There has been rapid expansion both in infrastructure and local housing growth. Like in the US, now the roosters have come home to roost. China is now faced with a similar situation that preceded the US housing bubble. Risky loans were made, some with no collateral. Banks have had to either try to sell them at a hefty discount or keep rolling them over on bank balance sheets, thus hiding the true amount of losses.

Like the US, China is now facing “bailout” time for its banks. It is difficult to obtain accurate numbers concerning bank losses. What is especially difficult is to ascertain are the amounts of Asset Backed Securities (ABS) and non-asset backed bank loans. Some estimates are that 27.25 Trillion Yuan of ABSs are hanging open. (Reuters)

China wants to use its inter-bank structure to develop a new platform to sell off these troubled assets. If you recall, in the US the problem of troubled loans was so huge that the US Federal Reserve had to step in and buy securities and mortgage backed securities to take them off the market. We’ve had QE 1,2 and infinity, with the Fed now buying $85 billion per month in government securities and mortgage- backed securities. What is little known about these transactions is that the Fed bought these worthless mortgaged backed securities at “Face” value, thus giving Fannie Mae and Freddie Mac the working capital to stay afloat. They were holding 80% of all US mortgages.

We don’t know how serious the situation is in China. China has not indicated that it will do an all out bailout on the scale of the US program. By setting up this new platform they hope to provide a market and the liquidity to trade these troubled ABSs and non- collateralized loans. The key question is who will the buyers be for this stuff and how big a discount will they demand?

Very much like the US, smaller banks and provincial governments have issued ABSs and non-collateralized bank loans.

All of this is coming at a time when China is seeing its slowest growth since 1990. In 1990, it did an all out bailout of 1.4 trillion Yuan to keep its four largest banks afloat. Whether, eventually, it will be forced to do another such bailout remains to be seen.

Since banking is at the heart of an economy, this action bears watching as a barometer of the overall state of affairs in China. For investors, keep an eye on Chinese banks. Again, drawing a comparison to the US, the state of our economy is directly related to our banking industry. US bank stocks that were sold off during the recession have regained much of their value.

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