War Room 16 Nov 2011

China Hard Landing

War Room

•Monthly macro discussion

•Using tools in context

•Feature for subscribers only

•Feedback - what should it to be?

Super-Committee Update

• Deadlines 21/Nov + 23/Dec, or sequestration cuts take effect (in 2013)

• Risk of additional US credit downgrades

• Risk to defense sector not priced in ($600B in defense cuts)

• New Scenario: Super-Committee fails

China Hard Landing

•China Overview + Problems

•Euro Debt Crisis affect on China

•Potential Scenarios

China Overview

2001-10 China GDP growth: 6,000%

2001-10 China Equities growth: 90%Problems

• Housing Overheated

• Inflation + Currency Woes

China Overview – super cycle is over

Current China economic snapshot

• Exports at 8 month lows

• Car sales down 7.5% Sept to Oct

• Net exports – negative in 2011

• Increasingly anti-reform environment (dodgy companies)

Key concept velocity of deterioration

China Overview – Copper as HiddenLever

Copper has been in lockstep with Chinese markets this year.

Chinese A-Shares Index divergence from Copper told of impending doom

HOUSING OVERHEATEDChina Hard Landing

China HousingPast decade:

•Private housing development began in 1998

•Housing price index – up 70% since 2000

•RE investment + construction =12% of China GDP

•Average housing prices have tripled from 2005-09

On the ground intelligence:

•Property developers experiencing credit crunch – govt funding restrictions, property loans drying up

•64 million vacant apartments nationwide, still more vacant residential property being built

•Companies in other industries making real estate divisions, diverting investment away from core business

•Second home purchases in Beijing have been banned.

Current stats:Real estate transactions in Sept/Oct are down 40-60%

120k unsold properties in Beijing – highest number in 30 months

Ratio of home prices to annual household income:

4-5 in 1st world economies10 in China

Bad differences:•30% annual pace of loan growth, unprecedented

•Credit raised to 200% of Chinese GDP – on par with roaring 1920s USA.

•Credit in US during boom only rose 42%

Historical comparisons – USA 1996-2006

Aftermathsubprime crisis

Similarities:

•Chinese banks are reporting record profits, but MSCI China Financials index is down 21% in 2011

•Extraordinary credit boom – 700bill USD over 3 years

•RE investment + construction =12% of China GDP

Good Differences:

•Heavy down payments, not as much leverage

•Loans to homebuyers and property developers:- 17% for Chinese banks

- 56% for US banks

•US kept lowering interest rates as housing peaked, China is raising rates

Historical comparisons – Japan 1982-91

Lessons from Japan monetary policy•Japan caved into American demands to appreciate Yen..

•Japan hard landing + deflation problem often attributed to controlling currency for so long.

•China now letting currency appreciate, and Obama calling for more.

Aftermathlost decade

Similarities:

•Extraordinarily high savings rates

•Undervalued exchange rates led to export growth

•1988 talk about Japan overtaking USA same as 2010 talk of China overtaking USA

Good Differences:

•China A-shares market not inflated like 1980s Nikkei

•25% of China buyers pay cash, savings financed boom

•Average household debt:-China 2011: 35% of income. -Japan 1990: 130% of income

100% rise in 2 years

INFLATION + CURRENCY WOESChina Hard Landing

China Currency and Inflation Link

Yuan and Chinese inflation have moved in lockstep over time, opposite conventional wisdom!

Yuan/Inflation Link Implications Strong Yuan empowers Chinese

consumers, hurts exporters

Strong Yuan should lower import prices, but it's not.

China has allowed the Yuan to appreciate, but not helping curb inflation?

Weak Yuan hurts Europe/US

No easy way out of this box

EUROPE DEBT CRISIS AFFECT ON CHINAChina Hard Landing

China's Europe Exposure:Trade + Euro Holdings

25% of China's foreign reserves held in Euro instruments as of late 2010 =

$800B in Euros and Euro-denominated securities

China's 2011 Euro-zone Exports = $400B

EU is China's Largest Single Trading Partner

China's Europe Exposure:It's the Debt, not the Trade

Net exports are a small part of the China story at this point.

China's Europe Exposure:Summary

European recession won't greatly affect China's growth, since it's mostly internal now

China may buy Euros and Euro debt to protect exporters and its own holdings

Could experience big foreign reserve losses if Euro falls or PIIGS default

Question now is not how the world affects China – how does China affect the world?

Europe Exposure:

$800B in Euro + debt exposure

$400B/yr Euro zone exports