What if China crashes?

May 9th, 2010

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Regarding the current drama in Europe, if the European authorities does nothing (or stoically refuse any thought on moral hazards), the world will get a GFC II, in which Australia may not be so lucky this time round. Our guess is that when push comes to shove, the Europeans will eventually print money and kick the can further down the road. After all, with the nightmare of the Panic of 2008 still fresh in their minds, they will not repeat the ‘mistake’ of acting too slowly. The outcome will be more moral hazards and monetary inflation, which is something we and our children will pay down the road.

Meanwhile, as the global financial markets are fixated over the current sovereign debt crisis in Europe, contrarian investors (especially Australian investors) should look at another part of the world for any potential mishaps- China. Starting from January this year, the Chinese government had been tightening the supply of credit. Measures include turning off the credit tap to increasing bank reserves requirements. Recently, unlike 2008, the Chinese government seemed to be getting really serious about cracking down on property speculation, even to the extent that it is giving the impression that it wants the property bubble to burst (see Is China’s Stock Market Crashing?).

As we wrote in Marc Faber: Beware of investing in Australia (as it follows the Chinese business cycle), with all these tightening measures, China will slow down this year. The question is, will the Chinese government accidentally over-tighten cause a crash instead? Remember, its objective is a soft-landing (which they managed to pull off in the 1990s under ex-premier Zhu Rongji). But will they end up going too far, resulting in a hard-landing?

Only time will tell.

But if it happened, you can sure that Australia will have a very ride. As we warned our readers a few months ago in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

The first effect of an economic slow-down in China will be a fall in base metal prices. Already, there are some signs that base metal prices are cooling off. For example, copper prices are approaching the lows made in January this year. If China crashes, we can expect base metal prices to crash too.

Next, given that the Australian dollar (AUD) is seen as a commodity currency, it will fall. This is to be expected as Australia’s terms of trade and business cycle is closely tied to Chinese demand for commodities, which in turn is tied to the business cycle in the Chinese economy. A crashing Chinese economy will be likely to test the AUD as it was tested in 2008. Mining companies in general will not do well in such an environment. In fact, speculators like Jim Chanos will be shorting the Australian mining stocks (see How is Jim Chanos going to short China? (Australia: take note)).

Then, with the deteriorating terms of trade (due to falling Chinese demand), the Australian economy will slow down. With that, there will be speculations (and hope) that the Reserve Bank of Australia (RBA) will be cutting interest rates.

If China’s coming slowdown is just a soft-landing, then the story may end here. But if it’s a hard-landing, then there will be more complications. In that case, Australia is very likely to have a hard landing too. This is where we are getting nervous. The critical thing to watch out for is Australia’s unemployment rate. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises. As unemployment rises, it will eventually reach a critical mass of prime debts turning sub-prime.

Given that Australia’s highly leveraged banking system is heavily concentrated on mortgages (Black Swans lurking around Australia?s banking system), there will be a tipping point in the unemployment rate that will trigger a banking crisis. That in turn may trigger a currency crisis (see Will there be an AUD currency crisis?).

How to buy and invest in physical gold and silver bullion
If there is an AUD currency crisis, the RBA will be in a quandary. Should it cut interest rates further to support the domestic economy (and condemns the AUD)? Or should it raise interest rates to defend the AUD (and condemn the domestic economy)? This was what Iceland faced in 2008- high inflation, collapsing currency and rising unemployment. The Icelandic central bank had to raise interest rates to defend its currency. Remember, a collapsing AUD implies that the price of oil imports in AUD will sky-rocket (limited to the extent that oil prices are falling due to reduced Chinese demand). As you can read in Five potential emergencies- energy crisis, this will be extremely disruptive to the Australian economy.

Of course, the scenario that we painted is extreme. But after having read and understood Nassim Nicholas Taleb’s The Black Swan, we learnt not to say “never.” Hopefully, the outcome will not be that bad. But for those who want to be prepared, we highly recommend How to buy and invest in physical gold and silver bullion.

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  • Pete

    Yep, I was explaining the RBA's quandry somewhat successfully to my partner just yesterday.

    Using such a blunt instrument such as setting interest rates, the RBA is damned either way. It will need to decide which is the lessor of two evils: raise rates and save the AUD or drop rates and kill it.

    Either way, people with mortgages will get increased interest rates:
    – if they drop rates a lower AUD means higher overseas borrowing costs, increasing the local mortgage rates
    – if they increase rates, regardless of the higher AUD, the banks will pass on those rate increases to the locals

    Other impacts for the RBA dropping rates (lower AUD) include:
    – increased import costs
    – better terms of trade for exports
    – more exposure to international fluctuations in the cost of capital
    – more expensive outsourcing
    – increased cost of energy/electricity
    – less availability of international capital (although, perhaps Chinese will take advantage of cheaper company shares to buy bigger stakes in resource companies…also to get rid of some USDs?)

    Other impacts of RBA increasing rates (higher AUD) include:
    – lower exports, due to worsening terms of trade
    – cheaper imports
    – cheaper outsourcing (killing small business here)
    – cheaper electricity/energy
    – increased volatility as foreign capital makes it way to our shores, to take advantage of carry trades

    Or of course the RBA could leave rates as they are…but that will not imply neutrality, it will still ultimately mean a higher or lower AUD. Besides, could we possibly rely on the RBA to 'not' meddle? I don't think so.

    Then we have Government intervention which will have an unknown impact at this stage. They'll probably supply us with just enough shovels to dig a hole no-one can get out of. Hooray for democracy and pandering to the whims of the uneducated! ๐Ÿ˜‰

  • Ted

    I would say the RBA is in a quandary already, as either way is ultimately tragic. The choice for us mere mortals is to guess which way they will chose – hyperinflation or massive correction. I am willing to bet on hyperinflation for two reasons, [1] historically that has been the choice with very rare exceptions, [2] it is the politically expedient choice, especially if you manage to control to an extent the timeframe of the QE (then you can explain any rough patches with 'frequency trading' or something similar ๐Ÿ˜‰

  • David M

    If the RBA doesn't 'meddle' what is their function?

  • Anon

    Fantastic post Pete, thanks.

  • Pete

    Thanks! ๐Ÿ™‚

  • Pete

    The eternal question… if our RBA is anything to go by, I would say their function is to:
    – 'control' inflation
    – manage bubbles
    – manage currency value
    – provide options for Government such as quantitative easing
    – and do all that annoying currency swap stuff with the banks ๐Ÿ˜‰

    And they get a big fat blunt stick to do it all! (cept for the QE). It doesn't help that the blunt stick has unintended consequences, such as crippling small business with high rates or putting FHB's on the street.

  • Pete

    Totally agree. Besides, we have a precedent, locally and internationally. We have international central banks in cahoots (probably all under the thumb of the Fed) and we know what the RBA did last time there was trouble… “Panic, drop rates quick!”