Why Everyone Suddenly Started Freaking Out About China This Week

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Photo: Daniel Goodman / Business Insider

It’s strange: The Shanghai Composite stock index has been one of the worst performers all year, and yet it was only this week that China-slowdown fears exploded into the consciousness of the market.You could see it in the extreme behaviour of the market: Copper got crushed. Chinese credit default swaps widened dramatically. Tertiary China “plays” like Tiffany’s and Sotheby’s, both of which have been minting a fortune selling to the growing ranks of rich Chinese got destroyed.

What caused the mass flip-out? A slew of things: Some weak economic data, end-of-the-quarter panic (investors dumping losers), and a big, negative report on China from BofA/ML.

What makes the shift in mentality particularly important is that China has been assumed to be one of the stable pillars of global growth, and in a sense—because people are so worried about debt in the US and Europe—an even safer play than the US (that goes for many emerging markets, really).

So this shift should have some pretty big implications, especially if the data ultimately bears out the notion that there’s a real slowdown coming.

China GDP expectations are tanking.

Chinese PMI (Purchasing Managers' Index) also fell this month.

HSBC's preliminary China PMI fell from 49.9 to 49.4 from August to September, suggesting a big drop-off in Chinese growth.

This was also a major concern cited in a Goldman desk note circulated Friday morning.

Chinese stock markets have fallen off since April, following drastic losses in the last 5 years.

Banking issues could be a major problem for future growth.

A huge underground banking system is emblematic of an aversion to private companies and a poor understanding of banking in general.

China has publicly admitted to a $470 billion underground banking sector, though in reality it could be much larger.

The official banking sector charges state-owned companies far lower rates than private companies, 7.2% versus 36-60% respectively. It's no surprise that private banks turn to large companies for funding at lower rates.

This underground banking system is also incredibly volatile.

Nine large business owners from Wenzhou province walked away from their underground loans when they found they didn't have the money to pay creditors. It will likely prove difficult to even locate the offenders.

Perpetrators of a Ponzi scheme kidnapped the wife of the head of a Bank of China branch after the bank noticed money missing from more than 40 savings accounts.

And lending costs are on the rise all around.

Beijing is tightening official credit, and even the underground lending rate is on the rise. This makes it more difficult for private funds to access funding cheaply.

Source: Bank of America

So some firms -- particularly private ones -- are facing a liquidity crisis.

Free cash flow (essentially, the cash companies have beyond maintaining their asset base) is hugely negative, meaning that firms have little money to spend beyond their current investments.

Hot money -- though a 'wild card' -- also looks to be dropping off significantly, reducing cash available in the short term.

Source: Bank of America

Funding problems could soon lead to a sharp correction in housing prices.

Real estate trust funds -- a last resort for borrowers -- accounted for about 50% of new loans to developers over the past year, according to a Bloomberg report. Junk bonds for Chinese home builders fell by 19% in the second quarter marked a 19.9% drop, the biggest quarterly decline since Q4 2008.

Source: Bloomberg

The Bank of China will face higher capital requirements.

The Basel Committee on Banking Supervision is about to add the BOC to its list of 'systematically important' banks. This will allow it cheaper access to funds, but also require the bank to conform to keep higher capital reserves than it currently maintains. This could further increase funding costs as the bank becomes 'too big to fail.'

Infrastructure investment bolstered China during the last recession.

In a note we reported on last week, Citi's Shuang Ding wrote, 'Investment boom during 2008-10 pushed investment/GDP to a record high -- The ratio reached 48.5% in 2010, unprecedented in recent history of China and major world economies.'

But now Infrastructure growth is levelling off.

But with nearly half of China's GDP invested, this situation is unsustainable. The marginal return on investment has gone down the tubes since the financial crisis began, suggesting that public spending needs to reined in to maintain efficiency.

According to Bank of America, infrastructure spending as a percentage of GDP was flat from 2009 to 2010, as infrastructure growth fell off sharply during the same period.

Local government debt is unsustainable, threatening solvency and infrastructure spending.

The central government extended huge loans to local governments during the recession, and China is now facing the consequences.

Local government obligations to GDP rose to 63% in 2010. The central government created financing vehicles to fund projects and alleviate local government concerns, but even these are facing problems. One such vehicle recently attempted to default in Yunnan province.

Source: Bank of America

The Justice Department, FBI, and SEC are investigating accounting irregularities at top Chinese companies.

The Justice Department revealed that it is working with the SEC and FBI to investigate accounting fraud at Chinese firms listed on U.S. exchanges, according to Reuters. The SEC has been investigating the matter for over a year.

'Not having proper accounting and reliable audit review for publicly traded companies with operations in China is just not acceptable. We have to find a path to resolution of this issue,' said Rober Khuzami, head of enforcement action at the SEC.

And a bipartisan bill in the Senate could punish China for currency manipulation and trade manipulation.

A bill in the house right now could alter trade law in order to compensate for what these Senators believe is currency manipulation on the part of the Chinese.

It would also slam them for excessive domestic subsidies, violations of labour and environmental standards, and flouting of trade regulations.

President Barack Obama, however, is against the bill.

China has a habit of disguising financial problems.

Because China is unwilling to admit to underground banking activities and prefers to cover up deficiencies in their banking sector, it's hard to make predictions about China's future financial health.

Even if the indicators are pointing to a soft landing, investors are likely to doubt professions of fiscal stability due to the opacity of Chinese government statistics.

A Goldman note circulated about China on Friday suggested that Chinese stocks could see a major sell-off over the country's uncertain economic future.

With the market already in 'attack mode,' the note's author reported seeing shortsellers targeting Chinese equities.

But a negative outlook follows decades of growth, during which forecaster after forecaster was dead wrong about the country's coming collapse.

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