More than a month ago, we were listening to a video interview with Victor Shih, of Northwestern University, and Carl Walter, co-author of Red Capitalism, on China?s banking system. It is a very interesting interview by experts who really know their stuff.

In this interview, one thing stuck in our mind. The question was put forth to Victor Shih on what he thought may be the trigger for a financial/economic crisis in China. The usual suspects of what the trigger may be usually comes in the form of an external shock (e.g. collapse of Euro-zone, global recession) that crunch China’s export industry. Surprisingly, that wasn’t his consideration. Victor Shih offered his favourite theory (though he emphasised that it is by no means a prediction) that when it comes to the point when China’s elite begin to pull its vast wealth out of China, that will be the thing that trigger a crisis. This could happen, for instance, when the elite find that the returns on/of their investments inside China is floundering.

Indeed, we notice that one of our favourite China experts, Patrick Chovanec is getting more and more nervous about China over the course of past several months. Today, we read from his latest blog post,

For the moment, I?m reminded of that song: “Something?s happening here; what it is ain?t exactly clear.” But ? and this is the real point ? something is happening, and people both inside and outside of China are right to be nervous.

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My experience, talking to numerous investors and economists, is as follows: the closer you are to running an econometric model, the better you feel about the Chinese economy; sure, there may be bumps along the road, the models tell us, but fundamentally the momentum is so strong that growth will stay on track. The more you go out and look around, and listen to your gut, the more worried you become. Something?s happening here, what it is ain?t exactly clear ? but it feels bad, very bad. The problem with models, and the reason I?m inclined to stick with my eyes and my gut, is that models work very well when prior patterns of perception and behavior remain constant, but are very poor at noticing inflection points where the way people think and act undergo a shift. In other words, they are very poor at identifying moments of crisis.

Indeed, some sort of a credit meltdown is brewing in Wenzhou. If you have friends in China, you can ask them about Wenzhou because it is in the Chinese media lately. We are heard a story that the Bank of China is offering an extremely high overnight interest rate for high net-worth investors with a big sum of cash.

There is another interesting observation that is quite unusual. China’s RMB is widely perceived to be undervalued. This can be seen by the fact that the RMB is always bumping against the upper band of the government-imposed US dollar exchange limit. But today, the RMB is bumping against the lower limit of the band. It looks like the RMB ‘wants’ to depreciate against the US dollar.

Why?

As Patrick Chovanec wrote,

Presumably because the capital account had flipped, and speculators were now rushing to turn their RMB into dollars in order to take their money out of China.

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What the new downward market pressure on the RMB does indicate, however, is that China ? for so long a no-brainer destination for investment ? has turned into a big question mark. And it suggests that at least some domestic Chinese investors who have been inclined to sock their money into empty villas and condos ? or big stockpiles of raw materials ? are now looking for a way out.

That’s exactly Victor Shih’s pet theory about a possible trigger for a financial/crisis in China. Although Patrick Chovanec reckons that this does not mean a collapse in the RMB because China’s vast hoard (US$3 trillion) of US dollar reserve can allow it to defend the RMB, we aren’t so sure.

Why?

As we wrote early last year at Is China allowed to use its US$2.4 trillion reserve to spend its way out of any potential crisis?

According to the chart provided by Pivot Capital?s report, only a little over 20% of China?s total currency (plus gross external debt) are ?backed? by their US dollar reserves, which isn?t spectacular compared to other emerging economies. In fact, South Africa is the winner in this aspect because their reserve coverage ratio is almost 160% i.e. it has $16 of reserves for every $10 of currency.

Since China had been printing copious amount of money too, the People’s Bank of China’s (PBOC) liabilities (RMB) far exceeds its asset (US dollars). If say 30% of China’s RMB wants to exit China, this could easily trigger a currency crisis for China. Is this too far fetched? We don’t know and we do not have the data to give a definitive answer. But this is something you have to watch out for.

It is no secret that Australia’s economy is highly reliant on China. In light of what’s happening in China, Australian investors better be prepared. By the way, in this Youtube video, Marc Faber advised that some sectors of China’s economy may crash.