China: After The Credit Crisis Comes The Economic Crisis

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China is now experiencing a monumental credit crisis. Loans are basically not available because confidence in repayment has vanished.

This is how the last global crisis started in 2007. I warned about it in my 2007 book, Prelude to Meltdown. The warnings were ignored in 2007, and my observations in this article will probably also be ignored by most people. “Denial” is always a defense mechanism, but not very useful.

China has already seen a significant decline in export growth these past two years because of the deepening European recession. Now the country is also being confronted with the effects of Japan’s massive stimulus programs. Japan has orchestrated a record decline in the value of the yen, with the purpose of making its goods relatively cheaper in the global market. In addition to being of better quality, Japanese goods are now getting price competitive with Chinese goods.

The negative repercussions are already being felt. In June, China reported that both its exports and imports had fallen, a phenomenon that hasn’t happened since October 2009, in the midst of the global recession.

The decline of 3.1% in exports shocked analysts, as they had been expecting a 3.7% gain. Amazingly, they still reported a GDP growth of 7.5%. Anyone who believes that number is likely to also believe in the Easter bunny. I predict that the decline in export growth will now accelerate downward. Only a sharp economic recovery in Europe and the U.S. could stop that.

Normally, in order to compete with Japanese goods, China would likely follow Japan’s lead and devalue its currency. In the 1990s it did just this, with a one-time, 50% devaluation. However, such action is not possible under current circumstances. Now, just the hint that a devaluation was being planned would cause a massive outflow of foreign capital from China and deepen the credit crisis.

Thus China is now between a rock and a hard place, as they say. On the one hand, not devaluing will cause a deeper decline in exports, worsening the current private sector recession. On the other, devaluing will cause a greater outflow of capital than the People’s Bank of China might be able to handle.

The worst is still ahead. As economic opportunities turn to high risk, foreign capital no longer flows in, and in fact flows out. The China Securities Journal, which is published by the governmental securities regulator, had a front page article that warned of a reversal of foreign capital inflows. (By the way, that’s exactly what I predicted one year ago in my e-book, The Coming China Crisis.) When foreign capital flows out, it has many repercussions.

The China regulator warned: “China will face large-scale capital outflows if there is an exit from quantitative easing and the dollar strengthens.”  The Journal referred to the U.S. Federal Reserve’s quantitative easing. Here we can see that Federal Reserve policy has important international repercussions.

Outflows from Chinese equity funds in early June were the highest since early 2008.  Total credit in China’s financial system has reached epic proportions. The world has never seen such debt acceleration. It has increased eight-fold the past 10 years and is now 220% of GDP.

According to the government, Chinese firms will have to pay $1 trillion in interest this year. Therefore, corporate cash flow is primarily used for debt service, not for growth. When economic growth turns to contraction, the bankruptcy avalanche starts. And that is happening now. The largest China shipyard is already in severe financial trouble. It can’t borrow money, so the latest word is that it will sell bonds. Who will buy them?

Some large shipyards and other large firms lend their excess operating cash out in the “shadow banking system” in order to get a higher return. Now those loans are defaulting. So, the operating cash goes up in smoke.

Western economists are sure that the communist dictatorship can resolve all these problems, including the estimated $10 trillion of shaky loans in the ‘shadow banking’ system. How naïve! Is there any example in history where a command economy can stop the collapse of a debt pyramid? Ignoring reality cannot make it vanish.

Bert Dohmen, Founder
Dohmen Capital Research, Inc.

Posted on Forbes.com