What in the World is China Smoking?

"It’s like smoking opium to look healthy."

What is?

Ohhh, just China’s efforts to meet growth expectations this year. That’s all.

So I’d say it’s time to talk about China’s debt problem … again. What’d ya think? Eh?

It must have been the beginning of this year when I watched a program with Kyle Bass — who made a lot of money shorting the subprime mortgage market — explaining how China was due for a credit event.

A credit event much like the financial crisis.

Only Bass didn’t go so far as saying China’s "credit event" would have the systemic impact as the subprime crisis did, for example.

But he did describe the event as a day of reckoning for Chinese banks, which would have to face an unavoidable pile of nonperforming loans.

He also said, at one point or another, Chinese banks could face losses more than four times the size of those suffered by U.S. banks during the financial crisis.

Perhaps that’s overstating the issue.

But it either way, it’s a big deal.

And it’s why the International Monetary Fund now estimates that China may have $1.3 trillion in loans extended to borrowers who can’t make interest payments. The IMF said potential losses could be about 7% of the country’s gross domestic product.

More recently, economists at China International Capital Corp. (CICC) have taken the insinuated impact of these claims head-on.

CICC believes the credit event will not beget a debt-deflation cycle similar to the experience of Japan in the 1990s, as Bass suggests. On their side is the alleged debt restructuring being done by swapping debt for bonds with lower cost and longer till maturity.

CICC may be right. Or not.

Goldman Sachs earlier this year slapped a 9% number on the ratio of China’s nonperforming loans, the worst level since 2003. The official level as reported by the People’s Bank of China at the end of 2015 was 1.5%.

So who’s right? Or who’s closer to being right?

Let me be clear:

I don’t care.

All I care about is that China is staring at a nagging problem that’s influencing its policymaking, its reform timelines and the expectations for its economic activity.

Aha!

Expectations.

I love that word. And I’ll speak to it again before I wrap this up. First, let me say …

China’s debt problem is not news.

And it might seem even less like news since China, in April, reported first-quarter GDP growth at 6.7% — safely within expectations.

But it will be news when it unleashes a new round of pain on the markets.

Image credit: Goldman Sachs’ "Walled in: China’s Great Dilemma" report

Since the start of the year, China has been able to distract from its problem by layering on the Band-Aids.

That is, China is concealing its wounds with the same remedies that have worsened its pain.

Investment. Stimulus. Investment. Repeat.

Indeed, since China unveiled its latest round of stimulus — what’s became an injection of 4.6 trillion yuan worth of loans from state-owned banks during the first quarter — the power hitters have stepped up to the plate once again.

Industrial output and fixed-asset investment, especially in real estate, are helping generate growth momentum in China. It figures, since the stimulus plan is to prime economic development with infrastructure projects that encourage banks to lend without hesitation.

On top of that, the PBoC stands ready for more stimulus as needed. However, no more is expected in 2016 since economic data seem to suggest a favorable reaction to current measures.

Let me step back for a moment and ask: Doesn’t the stimulus strategy just make you feel reassured?

It does?

Well, then get a load of a quote I found in the South China Morning Post …

Fudan University economics professor Li Weisen said the strategy was "like smoking opium to look healthy."

"It’s a very dangerous and irresponsible approach in the long run — existing debts are hard to repay, and new debts are piling up," Li said.

You see, many will evaluate Chinese policy decisions and blissfully point out that China’s economy no longer depends upon exports, making up 20% of GDP and down from 35% years ago.

But where has that some-odd 15% gone?

I’ll give you a hint: either to consumption or investment.

Now, I’ll give credit where credit is due. Chinese officials recognize the need for the consumption share of the pie to increase if China is to sustain its growth rates.

And it has.

But so has the investment share of the pie.

And that’s a problem since it’s just means piling on more debt.

China will increasingly need to assume the debts of state-owned enterprises. And those debts are only going to increase as they double down on their borrowings to generate economic activity.

Of course, excess capacity has been what’s plagued China for years now. Over-investment generated this excess capacity in the first place. And the merry-go-round continues thanks to Chinese stimulus plans.

Where it stops, nobody knows.

But we can speculate. And for that I like to use, you guessed it —

Expectations

Thanks to the stimulus, speculators are pouring into commodities within China and across global markets.

The last time volume for the Shanghai Aluminum futures contract was so high, the bears got their butts handed to them when the price of aluminum reversed higher.

The bulls risk the same fate.

Even more extreme, the 700 billion renminbi turnover in Chinese steel rebar futures has exceeded the market value of annual production and turnover for five top commodity futures contracts and exceeds all turnover in Chinese A-shares … by double.

Speculation has gotten so wild that China is implementing efforts to curb commodity speculation.

Even in U.S. markets, where stocks look a bit frothy and commodities have made impressive and speedy rebounds to the upside, speculators may be in for a rude awakening. Traders are more bullish on crude oil than they’ve been in a long time. And a crowded trade is usually greeted rudely by disappointment.

All of this — everything from stimulus-generated debt to Chinese commodity speculation — seems to be colliding now. The result is a lopsided blob of stimulated speculators.

I’m not sure the misplaced optimism can be sustained without some type of correction that calms down sentiment a good deal.

Expectations seem ripe for reversal. And concerns about China’s bad debt and superficial growth could be just the catalyst to do it.

You’ve been warned.

Do right,

JR Crooks

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“JR” specializes in trading commodities, currencies and options. He has spent nearly 10 years analyzing financial markets and writing about global economics. JR honed his trading techniques and global-macro worldview alongside his father, Jack Crooks, at Black Swan Capital. JR also…