Assume China Will Have a Financial Crises, What’s Next?

September 26, 2011

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While polls show a slight majority now realize China has large challenges in the pipe, not enough have been thinking about the ramifications. Most operate under the false premise that China’s government has an iron fist control over the people and the economy. This is a faulty and dangerous premise from which to draw conclusions. A Davos poll showed only 1% saw the odds of a political crises, implying a 1 in 100 years probability. Tiananmen Square was only 22 years ago. The Chinese Civil War was only 52 years ago.  The Chinese revolution was 100 years ago. This implies a large mispricing of risk remains.

Lessons from The 1997-1998 Asian Financial Crises suggest the next stage of the crises will be missed debt payments by a major Chinese firm. This will trigger a crises of confidence about other firms. The debt and corruption is systemic, so it could be a property developer, SOE, financial institution, or industrial company.

What happens then? The central government is displeased at the corruption and abuse at the local level. They could let them fail. We can assume bailouts of SOE, Banks, and corporations, putting their sovereign rating at risk. It’ll be interesting to see if these banks are able to fleece foreign investors one more time and raise capital. Or rather, at what price they will be able to do so.

Then there is the currency. One scenario is a currency devaluation to boost exports, whom many in the inner circle are financially connected. Even if a strong currency is pursued to boost the consumer sector is a choice, which is unlikely, it’s hard to see the government taking a large haircut on their $3 trillion short Yuan position and simultaneously reduce the control they exercise over their people through financial repression. Options on forwards are starting to hint at the bearish direction with the puts trading at three times the value of equivalent calls.

“The Party” may be lucky to escape with just a financial crises. The situation meets all of the factors associated with violent uprisings, according the “Predictive Societal Indicators of Radicalism Model of Domestic Political Violence Forecast.” The model accounts for food prices, various measures of oppression, corruption, and soon bailouts of non-government entities. It has an 80% accuracy rating forecasting an uprising in sample, and is 100% out of sample. The model ranks China as the 11th most likely to have a violent uprising by 2014, without a financial crises as a factor. To put this in perspective, Egypt made the list, but it was only 36th. For all their growth, the wealth creation has been highly concentrated, limited to those with connections. Two thirds of the people still earn less than $6 a day. They have benefitted from a little national pride and are suffering amid high inflation. Meanwhile, if there is unrest, they will be met with a new political regime who come from families that were abused during the Mao reign. Like an abused child that grows up to be a violent adult, the crackdowns have the potential to be brutal.

On the other hand, nationalism, a yearn for a return to Maoism, and anti West sentiment is on the rise. The next leader, Xi Jinping, is said to be redder than red. And while support for corrupt local government officials is quite poor, the central government sports a mid 90s approval rating (if you believe the numbers). Certainly this will fall amid a financial crises and deep recession. But one cannot dismiss  the degree of economic repression the people are willing to tolerate. The new regime could implement the “rally around the flag” political campaign to deflect attention for their own blunders and turn their attention their neighbors in the South Sea and/or the West.

The best case scenario is they have an awful recession and they eventually grow into the ridiculous overbuilding of roads, bridges, airports, residential, and commercial real estate. Bubbles and their busts often lay the foundation for the next boom.  Following the Dot com bust, fiber optic cables went dark and companies went bankrupt. Now with the consumption of video and cloud computing taking hold, the cable is being used. But that will not happen if what they have built falls apart, as is already happening.

Reading the stories of corruption and shoddy workmanship within the rail system led to me to forecast a major train wreck within the next 5 years that would then force a bankruptcy. It took 5 months. Interest rates on Ministry of Railways have since tripled. Expect more of the same and the tremendous foreign inflows to shift to equally large outflows, at a minimum.

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