China is starting to dominate overnight price action. Similar to how in 2010, ’11, and ’12, every comment from ECB and EU officials would cause a cheer or a jeer from international investors, the PBOC (China’s central bank) is starting to move markets with its every word. Here is the intraday chart of the Shanghai Composite:
It was a 6% decline in a couple hours, which quickly reversed when the PBOC said that it would keep money-market rates at a “reasonable” level and that liquidity risks were manageable.
That turnaround caused a turnaround in all risk assets, as SPX futures rallied 1%, copper rallied 2%, the Aussie dollar rallied 1% vs the USD, and so on and so forth.
So what’s the deal with China? We know the Shibor rate spike is the near-term concern, and the empty cities are likely a misallocation of investment, and companies with razor thin profit margins are struggling across the economy. But the real long-term issue is the rapid build up of credit (unfortunately, a broad theme in today’s world).
The Economist had a stellar article two weeks ago summarizing the concerns of some Chinese analysts. Here was the meat:
At the end of 2008 total credit to firms and households (and to non-profit organisations) amounted to less than 118% of GDP, according to a new measure calculated by the Bank for International Settlements (BIS). By September 2012 the total stood at over 167%.
It is natural for credit to deepen over time in a developing country. But when credit departs too far from its underlying trend, trouble often ensues. Mathias Drehmann of the BIS calculates that when the deviation exceeds 10% of GDP, it serves as a reliable early warning of a crisis within the next three years. According to our calculations, China’s credit ratio now exceeds its trend by 14 percentage points (see left-hand chart).
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The other side of China’s surging credit ratio is the surprisingly slow growth of nominal GDP. In the first quarter record amounts were added to total social financing, but growth was weak and inflation subdued. This wrongfooted both optimists (who thought lashings of credit would fuel a strong recovery) and pessimists (who expected it to fuel rapid inflation).
The surge in credit creation in China was a major, unappreciated reason for the rapid recovery of the global economy in 2009 and 2010. Commodity prices have provided a good barometer of global growth emanating from China, and they topped in the spring of 2011. Many of the large consumer surplus countries globally saw their equity markets top at the same time (a theme we’ve highlighted here, here, and here in the past 6 months).
As China struggles with the fallout from that credit growth, the global economy needs other countries to pick up the slack. Hopes are fading that the U.S. and Japan are willing to provide the stimulus to do that, and Europe is viewed as a totally lost cause. So markets are currently on edge. The global economy is actually holding relatively steady in the here and now. But markets are looking out 6-9 months, and becoming more nervous about what they see.