How China’s Problems Affect Canada and a Potential Financial Disaster That’s Bigger Than Subprime
MacLean’s’ most recent issue gives us 99 reasons why Canada is better than America. It says we’re happier, fitter, and richer – and our kids are smarter too.
While much of it may be true, there are economic factors unraveling that might give every Canadian a reason to be scared.
While our economic numbers have been strong, we need to look at the bigger picture.
Strong Growth or Just Getting Lucky?
Last month, statistics Canada released Q1 data that shows a surprisingly strong 2.5% annualized growth between January and March.
That means growth in the first quarter outperformed every three-month period over the past year and a half. And exports – particularly shipment of oil products to the United States – made a nice 1.5% gain.
It may sound like Canada is doing great, but the numbers don’t tell the whole story.
Most of Q1 growth came from trade with the U.S., and partly due to a one-off rebound in energy exports – also to the U.S. – that are now pretty much recovered after the disruptions to production from last year.
Domestic demand was soft and outlook is weak. If it wasn’t for the contribution from government, which showed the strongest component of domestic demand, the numbers could’ve been a lot worse. Expect the weakening trend to continue as the housing market softens, and consumption spending shrinks as Canadians tackle their highly elevated debt levels
According to TransUnion, the average Canadian’s non-mortgage debt – which includes credit cards, car loans, installment loans and lines of credit – reached a whopping $26,935 in the first quarter. In BC alone, the debt per person has now reached a staggering $38,619, surpassing Alberta’s $36,223.
Factor in housing costs and we’re looking at a country that is living well beyond its means (I’ll talk about the housing situation next week).
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You know there are growth issues when government spending is one of the strongest component of domestic demand – especially when the budget balance for Canada has been negative since late 2008 and the government is trying cut back on spending.
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Budget Balance
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If consumer spending falls, business investments usually fall with it. Combine that with government cutbacks and we could be looking at a much stronger decline in domestic demand moving forward.
That means we’ll have to rely on our Canadian exports to keep moving forward.
Canadian Exports
While further oil exports to the U.S. should continue to drive strong numbers, based on U.S.’ predicted growth rate (may also not be as bright as it appears), we need to take yet another step back and look at a sector that will likely continue to decline in Canada: mining and resources.
Mining and Resources
A few weeks ago, I went over the potential effect of what losing the TSX Venture could mean for the Canadian economy. If exports are needed to drive the growth of Canada, and all signs point to this being the case, then we are in a heap of trouble.
Last year, the total value of Canadian mineral exports was $92.4 billion, accounting for a whopping 20.3 percent of Canada’s total exports.
In 2011, more than $17 billion in capital investment, $63 billion in nominal GDP and $24.7 billion in trade surplus from the mining and mineral processing industries contributed directly to Canada’s economy
The $63 billion from the mining sector accounted for 3.9 percent of total GDP, while mining and processing companies paid around $7.1 billion in corporate taxes and royalties that help support the programs and services that Canadians in every part of the country use every day, from roads and bridges to education and health care.
According to the Mining Association of Canada’s latest Facts & Figures report, Canada’s mining industry broke records in 2011 for exploration spending, production and exports. Canada remained the world’s top destination for mineral exploration in 2012, attracting 16 percent of budgeted spending.
Canada is also a world-leader in raising equity for mineral exploration and development.
Via Natural Resources Canada:
“In 2011, companies listed on Canadian stock exchanges raised almost 40 percent of the world’s equity financing for mineral exploration and mining. Canadian-headquartered mining companies accounted for nearly 37 percent of budgeted worldwide exploration expenditures in 2012. Total exploration expenditures within Canada were about $3.9 billion in 2012.
…While the United States remains Canada’s leading trading partner, the percentage of total exports to the United States has been steadily declining since 1999 while emerging countries have become important destinations for Canada’s mineral products.
In 2000, less than 2% of Canada’s total mineral exports went to China, but in 2011, 6.1% of Canada’s mineral exports – with a value in excess of $6 billion – went to China. Exports to Brazil, valued at $1.5 billion in 2011, have more than quadrupled since 2000, while mineral exports to other emerging countries, including Mexico, Indonesia, India, and Russia, have also increased over the same period.”
Clearly, much of Canada’s GDP over the last few years stemmed from strong and rising minerals exports to emerging markets, in particular Brazil and China.
But both Brazil and China are now showing strong signs of trouble. Brazil has had over two years of lackluster economic growth while experiencing high inflation.
China, while not experiencing the same levels of pressure, is once again in the spotlight on a number of factors that will likely impede world growth and commodity prices.
China – An Even Bigger Bubble?
Numbers and surveys on economic growth are often manipulated to give the grand illusion that everything is getting better, even when strong indicators point to the contrary.
Last week, the proof was in the pudding.
China’s National Bureau of Statistics has now publicly ousted a local government it says was involved in a shocking case of number fudging.
According to a statement on the statistics bureau’s website dated June 14, the economic development and technology information bureau of Henglan, a town in China’s Guangdong province, massively overstated the gross industrial output of large firms in the area, by as much as four times:
Via WSJ:
“An investigation by the state statistician into a sample of 73 out of a total 249 firms counted in the data found that 38 were too small to be counted as large firms and so shouldn’t have been included, and a further 19 had either stopped production, moved out of the town or otherwise ceased to exit.
The statement said that 71 companies surveyed by the statistics bureau had industrial output of 2.22 billion yuan ($362 million) in 2012 in total, but that the local government recorded it as being 8.51 billion, almost four times as much as the actual figure.
The data was supposed to be contributed by the firms themselves using an online platform. Instead, employees of the Henglan economic development bureau entered the figures themselves from their office, the statement said. It also said that by May or June last year the relevant government leaders in Henglan knew about the distortions but chose not to do anything about it.
The statistics bureau doesn’t say why Henglan inflated its industrial output numbers. But indications that a local economy is sagging could reflect poorly on the prospects for promotion of local officials, and China’s southern provinces have been particularly hard hit by the global slowdown in demand for the country’s exports. Factories have closed, moving inland and overseas in search of cheaper labor, denting local government revenues.
…How widespread the problem is elsewhere in the country is anyone’s guess…”
That last line says it all.
But if you wanted to make an educated guess on how widespread the problem is, you can start by looking at the health of China’s banks.
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Liquidity Crunch – Another 2008?
Chinese cash rates shot through the roof last week, reaching 25% at its peak, before dropping to just over 8% on rumours that China’s central bank, the People’s Bank of China (PBOC), has injected cash into select banks amidst the liquidity crunch.
According to Hao Hong, the chief China strategist at Bank of Communications Co., who cited unidentified industry sources, the People’s Bank of China used “targeted liquidity operations” to supply 50 billion yuan to a bank in China.
“It was only a matter of time before at least one Chinese bank (and then many more) needing to rollover overnight/short-term funding and unable to do so in an interbank market that is now completely frozen, had to be bailed out.
Hong added that more banks are in talks with PBOC to obtain funds amid a cash squeeze, as expected. The problem is that the PBOC can’t continue targeted bail outs, and will sooner or later be forced into a broad liquidity-providing move, which will unleash a repeat of the 2011 in China scenario, which did not have a very happy ending.”
Via Centralbanking:
“The tight credit conditions are a result of what Amy Yuan Zhuang, Nordea’s senior analyst for Asian economies, said is “abnormally high” demand.
Commercial banks, she explained, are preparing for their biannual balance-sheet inspections. In order to meet their capital requirements, many banks rely on issuing wealth-management products (WMPs).
This drain on liquidity is compounded by a growing “mistrust” between banks in the interbank market following the failure of the China Everbright Bank to repay a 6 billion yuan loan on time earlier this month.
When the WMPs mature, Zhuang said, the banks will look to borrow money from the interbank market to repay the WMP-holders. This process could, however, be complicated by the high and volatile money-market funds.
Fitch Ratings today observed that “persistent tight liquidity conditions in China’s financial sector could constrain the ability of some banks to meet upcoming obligations on maturing WMPs on a timely basis.”
In other words, many small to mid-sized banks in China are at a very real risk of default.
While the PBOC appears to be tightening their stance on imposing market discipline on banks that are overly reliant on short-term funding, the potential risk of over-leverage is very real.
This includes not only short-term funding, but also the overly leveraged economy of China.
According to the Taipetimes:
“…the lack of cash is a problem for smaller Chinese banks and trust companies, private businesses and even smaller state-owned enterprises that may have built up significant debt in the easy money years since recession-fighting stimulus was unleashed into the economy in 2009.
The closing of the credit spigot could have a domino effect, said Zhou Dewen, chairman of the Wenzhou SME Development Association, which represents private businesses in Wenzhou, a bastion of entrepreneurship in southeastern China
“The rate of bad loans has kept rising and liquidity is getting even tighter. This capital chain reaction could break some companies, and it will get even worse in the second half of the year,” Zhou said in a phone interview.”
One look at the Libor’s surge prior to the Lehman Brother’s bankruptcy, which led to the death spiral of events in 2008, should be a strong call to memory on a hard lesson learned.
Keep your eyes on the Shibor (Shanghai Interbank Offered Rate), the barometer of Chinese credit liquidity.
Ramp Up the Printing Press
China’s credit-to-GDP ratio is over 200% and its corporate debt bubble is the largest of any developed and developing country, and at 151% of GDP (and rising rapidly) is the biggest in the world.
Goldman Sachs shows that in 2013 the total credit outstanding in China is expected to rise to a whopping 240% of GDP, and continue rising from there at an ever faster pace.
China wants to maintain its 8% growth per year, so it will have to continue injecting massive amounts of debt to achieve that – just as the Fed, the BOE, and EU have done.
China will likely bailout more banks this year, which means more money printing.
Funny how GDP growth for the world most powerful nations are now simply a reflection of how much credit is entering (or leaving) the system.
What it Means for Canada
If China’s bubble bursts, a large part of Canada’s GDP will be wiped out.
One of Canada’s biggest GDP drivers, the mining and resource sector, continues its decline as commodity prices continue to drop and investments into the sector continue to fall dramatically.
The mining sector represents more than 460,000 jobs directly and indirectly in Canada – that’s more than 2.5% of Canadian jobs.
That means GDP will likely shrink, as exports to Brazil and China fall along with commodity prices, leading to a loss of jobs and a further decline in domestic demand.
I haven’t even begun to talk about housing prices.
If this continues, Canadians may not be so happy anymore.
Next week, I’ll talk about the Canadian housing market – you won’t like what I have to say.
An Early Look at Another Market Disaster
According to the Financial Times, the big wave of selling last week caused many exchange-traded funds to tumble below the value of their underlying assets.
There was so much selling that dealers not only struggled to keep up with the sell orders, but could no longer accept orders to redeem underlying assets from ETF issuers.
Via FT:
“One Citi trader emailed other market participants to say: “We are unable to take any more redemptions today…a very rare occurrence due to capital requirements we are maxed out on the amount of collateral we have out.”
A person familiar with the situation said it was a temporary suspension affecting only some clients, caused by the significant amount of sell orders. Citi declined to comment.
State Street said it would stop accepting cash redemption orders for municipal bond products from dealers.
Tim Coyne, global head of ETF capital markets at State Street, said his company had contacted participants “to say we were not going to do any cash redemptions today”. But he added that redemptions “in kind” were still taking place.
Market participants described the heavy volumes and losses on Thursday as a rare occurrence and said that it could translate into further selling on Friday or early next week.
“The losses for ETFs today were far beyond what the most sophisticated financial risk models could have predicated for worst-case scenarios,” said Bryce James, president of Smart Portfolio, which provides ETF asset allocation models.”
In other words, the ETF sell-off last week was worse than what the most sophisticated financial risk models could even come close to predicting.
Funny, I remember them saying the same thing about the subprime mortgage crisis…
The value of American subprime mortgages was estimated at $1.3 trillion as of March 2007. The value of the ETF industry…$2 trillion.
Food for thought.
Until next time,
Ivan Lo
The Equedia Letter
