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China's Credit Volcano

So far, China is losing the currency war...

THE LATEST data on Chinese credit growth released this week were truly a sight to behold, writes Greg Canavan for the Daily Reckoning Australia.

We could be wrong, but we don't think there has ever been a surge, torrent, or avalanche of credit as strong as you've seen in China over the past few months, EVER.

We'll get to the details in a moment, but here's the weird thing about it: it's not doing anything for the stock market. And the economy is not particularly robust, at least not relative to what it was a few years ago. Have a look at the performance of the Shanghai Stock Exchange:

After rallying strongly from December last year through to February, it's corrected lower since then. Perhaps it will move higher from here, but the price action during the March credit boom is not encouraging.

So how about the March credit data? Well, the traditional banking sector created 1.06 trillion in new Yuan denominated loans during the month, equivalent to about US$170 billion. But when you add in credit created by the shadow banking system, 'total social financing' hit 2.54 trillion Yuan FOR THE MONTH. That's US$410 billion, or US$4.9 trillion annualized.

China's economy is around US$8.26 trillion, or US$12.4 trillion if measured on a purchasing power parity (PPP) basis. The March credit torrent then, if annualized, comes in at an astounding 60% or 40% (on a PPP basis) of GDP. Either way it's massive and bodes ill for the future of China's economic growth.

Put simply, you can't have such rapid credit growth and expect the investments made from it to be productive. What's keeping China's economy ticking over is the ongoing flow of credit. But it will need to maintain an ever greater flow to keep the economy from sinking. China, more than any other economy, can probably keep up this facade for a while longer yet.

But the question is, do they want to? Can they afford to? China's leaders must know they are on a 'treadmill to hell' (as Jim Chanos called it) and they must jump off sooner or later. They've talked the rebalancing game for a while now, but haven't been able to engineer it.

They had a go last year by tapping on the brakes. It slowed things down more than they liked so the foot went back to the accelerator. Now, credit growth is getting out of control. We get the feeling China's leadership is worried. They know they must rebalance but don't want to because it will lead to a sharp economic slowdown. But they know that letting the boom run on will only lead to bigger problems in the future.

Even Reserve Bank of Australia governor Glenn Stevens is a tad concerned. In a speech given yesterday called 'Financing the Asian Century' (what, the one where Japan blows up its currency, starts a trade war with its neighbors and ends up in a real war with China?) he commented:

'In particular, concern has been expressed about the risks that may be growing in the 'shadow banking' system in China. In recent years, an increasing share of financing in China has been provided by non-bank entities and through banks' off-balance sheet activities. In no small part, this growth in shadow banking reflects restrictions on both the quantity of bank credit, and controls on loan and deposit rates.

'Such restrictions lead to demand for credit exceeding the formal banking sector's ability to supply it, and also provide an incentive for savers to seek alternatives to low-yielding bank deposits. The Chinese authorities have introduced a number of measures to mitigate the risks, and many types of shadow banking activities in China are now subject to some regulatory oversight.

'Hopefully, this will lead to a stable outcome. But China's experience is one that others have had at various times: as long as there are incentives to by-pass the formal banking sector, the shadow banking system may keep on growing together with the risks.'

That's central banker speak for 'if you keep going down this path you'll blow your economy up'.

For the Australian economy it's a worry. It looks like we're well past receiving the benefits of China's monetary largesse. The unemployment rate is beginning to tick up. The high Australian Dollar, a direct result of global central bank liquidity, is hurting a range of industries. In another blow to the resource sector, the Financial Review reports today that Woodside is likely to shelve plans to develop its $45 billion Browse LNG project in Western Australia.

Another point to consider in all this is the effect of US and now Japanese money printing on China's economy. Along with the credit data released yesterday, we learned that China's foreign exchange (FX) reserves grew to US$3.44 trillion, a jump of US$128 billion in the first quarter, the strongest since the second quarter of 2011.

This is probably directly related to the US Fed starting up it US$85 billion per month bond purchasing program. The Fed creates the money, but it can't control where it goes. Some of it is clearly heading to China, providing fuel for China's own credit boom.

It's all to do with the US Dollar-Yuan peg. As the Dollars flow in (and add to China's FX pile) China must print Yuan to hold its currency down against the US Dollar. This money flows into the Chinese economy and creates all kinds of havoc.

And now China must contend with Japan's monetary craziness. Right now, China's looking like the real loser in this currency war. But don't think the Chinese won't retaliate. It's only a matter of time.

We're getting to a point where the three major global economies (US, China and Japan) are increasingly fragile. Two are resorting to the 'printing press' to get out of trouble. In a globalized system, this strategy creates all kinds of unintended consequences. One of those is an out of control credit boom in China.

This is all getting very dangerous...

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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