Time to Panic: Today's China Looks Scarily Like 2006 America


The latest development out of China was a classic case of good news/bad news. On Thursday their central bank, the People's Bank of China (PBoC), unexpectedly cut interest rates for the first time since 2008. The good news is that the PBoC is reacting aggressively to their slowdown. The bad news is that their slowdown warrants such an aggressive reaction by the PBoC.

Actually, it might warrant far more. Or it might not. China is so opaque, it's almost impossible to say. You might be wondering how a country that announced 8.1 percent GDP growth in the first quarter of 2012 might be in such trouble. The answer: Those numbers are reported year-over-year, not quarter-over-quarter. In other words, even if we can trust them -- which is far from certain -- high growth figures don't necessarily mean that China has high growth right now.


When the financial crisis hit in 2008, China responded with a massive stimulus program. Except it wasn't "stimulus" in the way we usually think about it. The Chinese government didn't cut taxes or spend more. Instead, the Chinese government told their state-owned banks to lend more. A lot more. The chart below shows the percentage growth of China's high-powered (red) and broader (blue) money supply since 2005. Notice the post-Lehman surge in 2009.


This lending boom fueled an investment boom that made up for lost exports. But it also fueled a frothy housing sector. China's officials certainly noticed. Over the past year they have introduced a number of measures to rein in rising prices. Careful what you wish for. China in 2012 is starting to look a bit like the U.S. in 2006.

Something strange is happening now. It looks like a combination of too loose credit and too tight credit at the same time. Credit might be too loose for big state-owned enterprises (SOEs), but too tight for small-and-medium enterprises (SMEs). We can get an inkling of that in the chart above. Bank money (red) is barely growing recently, but broader money (blue) is accelerating. China's state-owned banks have said they might miss their 2012 lending targets, so this broader money growth is likely a story about China's shadow banks -- unregulated lenders who are banks in all but name. Shadow banks are happy to lend SOEs that enjoy explicit government backing, but less so for SMEs.


What are big companies doing with shadow bank money?

When prices are falling, developers don't want to develop, and steel companies don't want to sell steel. They'd rather wait until the economy turns up and their scarce resources -- land or metal -- will make them more money. In the meantime, they're happy to play the role of hedge funds. Rather than borrow money to invest in their own businesses, many of them are borrowing money to speculate.

We have a word for this. It starts with a "p" and ends with "onzi".

Steel companies have been particularly bad (so much so that China's banking regulator recently issued a warning). They have taken out multiple loans with the same collateral, and then thrown this borrowed money into land and stocks. Even with housing prices retreating.

Then there's Zoomlion, a construction machinery company that just happens to be the most shorted company in Hong Kong. Zoomlion has managed this thanks to supercharging its sales by lending customers the money to buy their products.

Smaller companies are missing out on this credit boom. They're left asking banks if they can spare a dime. Well, maybe not anymore. Now they're turning to another U.S.-in-2006 standby: collateralized debt obligations (CDOs). In plainish English, a handful of small companies with bad credit ratings get together, issue debt, and then put all of their bond payments into a security. The idea is that pooling the risk reduces risk for investors -- and lets banks get the risk off their balance sheets. It can work out. But the very fact that it's happening should concern you. Also worrying: Local governments are guaranteeing these debts.


But maybe things aren't that bad. It's easy to fall into the trap of availability bias. When you've just been slapped by a housing bubble, every bad piece of evidence starts to look like a housing bubble. Still, it's undeniable that both credit and housing prices increased substantially since 2009 -- and that the latter are now falling. It's also undeniable that the behavior of China's shadow banks and big companies are reminiscent of our own circa 2006. And it's certainly undeniable that China's government is worried about growth if they're slashing interest rates for the first time in four years.

Maybe China's leaders will engineer a so-called "soft landing". They certainly have room to cut interest rates and reserve requirements. Or the government can spend money on infrastructure itself. But with Europe teetering and the U.S. slowing down itself, the last thing the world economy needs is for its biggest engine to break down too. Let's hope this is just a hiccup.