Economic worlds collide in China

YOU don’t need to read Michael Lewis’s book The Big Short: Inside the Doomsday Machine to realise the conditions that led to the 2007 US sub-prime mortgage crash are emerging today.

The common threads of sky-high property prices, overstretched homebuyers and greedy bankers can be found in almost every country today, as central banks raise interest rates to crush the inflation they helped cause.

What might come as a surprise is that the next sub-prime crash, which might lead to a rerun of the GFC, appears to have already started in one of the least likely places: China.

Homebuyers in an estimated 80 Chinese cities are refusing to make debt repayments on more than 200 incomplete housing projects.

Their position is understandable because they’re being asked to pay for a home they can’t yet occupy as the developer has run out of cash to finish construction.

Those unserviced loans are said to have a total value of $US290 billion, an amount considered manageable in the Chinese banking system.

But what becomes more interesting is that other homebuyers who have moved into their finished properties are being egged on to join the mortgage strike because the value of their purchase is falling as interest rates rise.

That is essentially what happened in the US when homebuyers labouring under rising mortgage repayments simply walked away, mailing the keys to their bank, which became owner of an unwanted (overvalued) property they then had to sell in a falling market, forcing a government bailout of the entire banking system.

Something similar appears to be happening in China, where a potentially disastrous clash of two economic systems is developing: capitalism, built on property ownership as known in the Western world, is clashing with China’s communist system, which is built on a belief in communal ownership of property.

The mortgage strike is an example of the scope for conflict between two economic systems in the one country, potentially creating financial chaos that may eventually require government intervention to protect the banking system.

China will solve its trouble with these property buyers either by squeezing the banks, which could cause more problems in the financial system, or by squeezing the property buyers, which could cause social unrest (something the authorities consider to be even worse).

Of those solutions, the banks are most likely to be forced to bear the greatest pain of what is a deflating property bubble, because they are a politically softer target than individual homebuyers.

However, if that happens, China will compound a growing belief it is becoming a business risk.

There are multiple reasons for China’s problems, with private ownership of property (alien to the core beliefs of the communist government), overstimulation of the property development sector and easy bank loans for buyers with poor credit ratings all causal factors.

A property crisis is the last thing China needs today, and while it is likely to be fixed by pumping more money into the economy, that is just another version of what the US has been doing.

It’s called kicking the can down the road, hoping for a future fix.

But, just as the US has failed to find a fix for its problem of excess money creation (which started after the 1987 stock market crash and was compounded by even faster printing of money after the 2007 sub-prime crisis), so will China struggle to rein in its cash creation to paper over a deep-seated problem of trying to bolt a capitalist business system into a communist government.

If that sounds an extreme view of what’s happening in China today then you need to look closer, because what’s evolving under the dictatorship of president-for-life Xi Jinping is not good news for Australia, especially its most trade-exposed state of Western Australia.

Global fund managers are starting to steer clear of China, declining new investment opportunities and selling out of existing positions because of increasingly unpredictable government regulations and intervention in the private sector.

Those early warning signs, detectable in the flow of capital out of China, are a modern version of the moves made by contrarian investors who are the heroes in Lewis’s exposé of the US sub-prime crisis.

They saw what was coming and took investment positions designed to benefit from a financial crisis: they sold short in the hope of buying back later, which they did, trousering billions of dollars in profits.

Short sellers are not yet obvious in China but as one fund manager said in a recent Bloomberg News report, several of his European pension fund clients no longer want Chinese assets in their portfolios because of rising geopolitical and governance risks.

A new $US8.5 billion Asia-focused fund created by Carlyle Group has minimal Chinese content and greater exposure to South Korea, Australia and India.

Funds might not be outright sellers of Chinese assets but they’re certainly becoming reluctant buyers.

Head-honcho, top dog

THERE is not yet a competition between WA’s two richest people–Gina Rinehart and Andrew Forrest–for the title of ‘the big cheese’, but if either decided to add financially-stressed Bega Cheese to the dairy component of their extensive portfolios it could be an appropriate description.

Mrs Rinehart’s best-known exposure to the dairy industry is through her support for the Northcliffe-based Bannister Downs Dairy, home to one of Australia’s biggest herds of dairy cattle.

Mr Forrest’s exposure is through a direct investment in Bega Cheese, with his last reported position being a 10 per cent stake held by Tattarang AgriFood Investments.

Bega, which is based in its namesake town in southern NSW, has run into trouble over a deal to increase payments for milk bought from Victorian and NSW dairy farmers, followed by claims some fund managers got an early warning that encouraged them to quit some of their shares.

The net result is a storm in a milk bottle that has damaged the company’s reputation and wiped about $100 million off the value of Bega, which has seen its share price fall from $5.20 before the crisis broke to $3.25.

At Bega’s latest price, Mrs Rinehart or Mr Forrest could swoop for about $1 billion, almost petty cash for the iron ore billionaires if they want to make a big impression on the dairy industry and are interested in the title of Australia’s ‘big cheese’.