June 28, 2013

3 Bearish Factors That Could Set China on Fire

Chinese business leaders and officials may try to spread the blame for their diminishing fortunes, but they have become their own worst enemies

Woman in front of a Shanghai stock board (Photo: AP) Woman in front of a Shanghai stock board (Photo: AP)

A quick glance at our global equity map shows one key consistency; emerging market stocks are badly lagging developed market stock.

Leading the way down is the BRIC complex (Brazil, Russia, India, and China) and China is in the thick of the selloff. 

Since the beginning of the year, popular ETFs like the iShares FTSE China 25 Index ETF (FXI) and the SPDR S&P China ETF (GXC) have declined 17.55% and 12% respectively.

Let’s examine three factors that may lead to more downside for the Chinese stock market.

Credit Crunch, Credit Bust

In case you missed it, Chinese banks are in the midst of a minor crisis.

The average overnight Shanghai Interbank Offered Rate (SHIBOR) rose to 13.4% last week, while the one-week repo rate in China's money market climbed to 11.2%, the highest in 10 years, reports Reuters. The SHIBOR is the average interbank lending rate offered by 18 Chinese commercial banks.

Meanwhile, the number of nonperforming loans is rising.

Data from the China Banking Regulatory Commission shows outstanding non-performing loans at Chinese commercial banks rose 20% to $86 billion at the end of the first quarter compared to a year earlier. Yet, those figures don’t really reflect the real amount of bad debt. That’s because China’s banks camouflage losses from bad loans by packaging and selling them as “wealth-management products” that are pawned off to unsuspecting victims. 

On June 23, the official Xinhua News Agency acknowledged that risk is increasing in China’s financial system as the shadow banking sector grows along with highly leveraged investments.

This latest episode seems to be following the path of other banking crises; a spike in borrowing costs, panic, liquidity freeze, and cardiac arrest.

Gold Bust

There is a very important and close connection between China and the Great Gold Crash of 2013. Six years ago, China overtook South Africa to become the world’s largest gold producer.

As the globe’s largest gold producer, China created 109.6 tons of gold in the first four months of 2013, up 6.3 tons or 6.13% year on year. Instead of cutting gold production, like others are doing, China’s output is rising. And therein lays the rub: Chinese gold producers are pretending like gold is still in a raging bull market.

Le Yukun, head of metals and mining research at BOC International China in Shanghai, told Bloomberg on 6/24, “We haven’t heard of any Chinese miners opting to lower production because of the gold rout.” Apparently, China didn’t get the memo about gold’s bear market. Or maybe they did, but they’re deeply buried deep in a mine, they haven’t had a chance to check gold’s chart.  

Crony Capitalism

In a wonderful Bloomberg piece "Why Did Chinese ATMs Stop Working?" by Adam Minter, he points out another big problem for China; crony capitalism.

"The lack of credibility that China’s state-owned banks have with the Chinese public has everything to do with their interconnectedness with the Communist Party and what is often perceived to be their self-serving agenda and self-acknowledged corruption. That’s a point that was made, in a brief Monday dialogue on Sina Weibo, started by Wang Mudi, a well-known financial news talking head and producer. “The banks made so much money and yet they have a ‘cash shortage,’” he tweeted. “What’s the most likely reason?”

Although Chinese business leaders and officials may try to blame slowing exports, Europe’s sovereign debt crisis, or other events on their diminishing fortunes, they have become their own worst enemies.

For investors who seek clarity and transparency, China is not your kind of place.

ETFs that aim for inverse or opposite performance to Chinese stocks are the -2x ProShares UltraShort China (FXP) and the -3x Direxion Shares Daily Bear Shares (YANG).

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