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Will China's Credit Squeeze Burst the Mother of All Bubbles?

Things are getting tough for small, private businesses in China. As the WSJ reported yesterday,

Many smaller private companies, unable to obtain bank loans because of the government’s tightening of credit to fight inflation, have turned to so-called shadow lenders for funding. Such lenders often charge exorbitant interest rates, and many smaller enterprises, struggling to repay the debt, have gone under…

Since April, nearly 100 factory owners in Wenzhou alone have fled the city after failing to repay high-interest debt, according to state media reports. Such distress, economists warn, could spell bigger problems for China’s vast banking sector and the economy at large, potentially leading to defaults even on bank loans at normal rates. That could cause banks to cut credit lines to sound businesses and their suppliers.

These small companies face a growing profitability problem: high-interest debt, increasingly expensive labor, widespread power outages, and a more competitive global market are forcing small-time manufacturing companies, of which there are many, to the wall. Efforts by the central government to control inflation by tightening access to credit have hit small companies hardest. Shadow-lending has typically eased access to credit for these small companies and banks, but the price of this credit is ruinously high and the opportunities are coming under increasing scrutiny from the central government: “Analysts say there is now a risk that this source of credit could dry up, bringing down even thriving companies, with ripple effects on the formal banking system”.

Best case, this is just another phase of the business cycle, and China moves on.  Worst case?  This could be the Big Squeeze at work: the nightmare scenario in which the profitability of Chinese manufacturing falls, creating credit, unemployment and social problems on a large scale.

I’ve argued before that the Mother of All Bubbles may be excess manufacturing capacity in Asia.  Decades of above average returns on investment, compounded by a range of state policies aimed at encouraging the development of this kind of enterprise, have led to a massive overcapacity: the world can’t consume as many widgets as manufacturers need to sell.

What would set that off would be a contraction in demand from the developing world, much as we’ve seen in the recession and slow growth that has dogged Europe and the US since 2008.  Watch China, and especially watch its small manufacturing sector.  If tight profit margins persist for this sector, bad things could be in store.

Very bad things.

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  • Kenny

    The Mother of All Bubbles might be U.S. Treasury bond market.

  • Luke Lea

    Why investors (or economists) ever thought they could trust data coming out of China — one of the most corrupt societies on earth — is beyond me.

  • Jim.

    So why in the world aren’t the Chinese more interested in cultivating a domestic consumer market? It seems to me that (as long as our raw materials and energy production keep expanding) that would be the solution for everyone.

  • JLK

    Dr Mead

    This kind of warning about China needs to be repeated over and over. Too many people including “shrewd” industrial managers and investors think of China as one great never-ending oppportunity, ignoring the many head winds facing their economy.(Sound familiar like the US in 2005-06?)

    Currently 50% of investment capital has gone to manufacturing and only 35% to personal consumption. As you have said when the demand for Chinese widgets slacks off or hits the wall because of recession and/or oversupply what happens then? The Chinese consumer, bound by thousands of years of tradition AND a lousy social welfare system ain’t gonna lower his savings rate as quickly as would be needed to save the day by rebalancing the economy.

    Combine reduced sales and profitability and tightening credit can shake the whole economy at its roots. Their strategy of bailing the “Big Four” banks out of periodic zombie loan crises by transferring the losers to “bad banks” then funding those banks with their huge capital reserves won’t work forever.

    If the size of the zombies, especially in housing, (65 mil empties according to Fitch and that number is not a typo) overwhelms their reserves, then what happens? Do they print Renminbi? Call in bond holdings from the US and other places?

    And most dangerous for the government, if growth slows,stops or goes in reverse (I mean the real numbers not the Greek Trojan Horses) then civil unrest could move to chaos.

    China is a great dynamic country but they still have a lot to learn about running an economy for the long term.

  • Mrs. Davis

    Why we let Red China in the WTO is beyond me. Well, actually not.

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