The bursting of China’s credit bubble

By Alasdair Macleod

Posted 14 March 2014

According to Garet Garrett in his book “A Bubble that Broke the World” Cheops employed 100,000 men for twenty years to build his great pyramid, “and all he had for 600,000,000 days of human labour was a frozen asset.” Cheops’s distortion of the Nilotic economy was nothing compared with the economy warped by the Chinese government today, which has overseen the construction of empty cities, unused airports, carless highways and bridges to nowhere.

A notable difference between ancient Egypt and modern China is the ability to direct economic activity through the use of credit. The result today is a far larger scale of economically useless projects than the pharaohs could possibly entertain. Government-directed bank lending in China has financed misallocated economic resources to an extraordinary degree, artificially inflating the economy and leaving a legacy of useless property and infrastructure assets, incapable of generating income to service the debt incurred.

The delusion is only sustained for as long as increasing quantities of money and credit are available to insolvent borrowers. That is now ending, because China’s government is trying to restrict credit growth, which is impossible to do without setting off wide-spread debt liquidation. Instead of managing a hoped-for retreat towards order, tighter monetary conditions will almost certainly bankrupt owners of unproductive property assets, piling up bad debts at lending banks. Unlike the Lehman crisis, this time the major banks are government-owned, so China’s currency is at considerable risk, and it is already displaying initial weakness.

There can hardly be a stronger signal that China’s credit bubble is on the edge. Furthermore, China has more than its fair share of financial entrepreneurs who have devised myriad ways to use assets to raise money many times over. In the Chinese version of shadow banking, an asset such as a few thousand tonnes of copper in conjunction with letters of credit is used to raise cash over and over again to spend on property speculation and elsewhere. All sorts of shady deals, some of them downright fraudulent, can be expected to come unstuck, and China seems set to provide an extreme example of this empirical truth.

China’s rich have an estimated equivalent of $3 trillion in personal assets to protect from a credit and currency maelstrom. Inevitably this will lead to huge shifts in asset allocation, and gold bullion is likely to be the outstanding beneficiary. In common with all other Asians the Chinese regard gold as true money, a safe-haven from government currency. And only five per cent of $3 trillion at current prices is 68,000 tonnes of gold, which gives an idea of how dramatic the effect of even a small flight to gold would have on the price.

This is likely to catch Western capital markets on the hop, given the common misconception that gold is little more than a demonetarised commodity. With a credit crisis appearing to be developing in China, this view could face its ultimate test at a time when the West is systemically short of physical gold and silver, and its institutions even short of paper gold as well.
Today’s troubles over Ukraine can come and go, but for gold China is the bigger story by far. So much so, that this could turn out to be a very bad time to own claims on gold instead of physical gold itself.