Will the Dragon’s Failure be the Elephants gain?

This is a guest post written by my colleague, Rachit Channana. Rachit is a professional consultant and has interests in global economy, investing and risk management. His articles are widely published both within the corporate network & knowledge center and in various publications, both online and in print.

In accordance to the famous investment analyst and entrepreneur Marc Faber, the Chinese economy is set to crash in the next 9 – 12 months. I cannot but agree with him fully.

With 60% of the country’s GDP pegged at Construction, it already looks under pressure with the fall of commodity prices. The government has already banned loans for purchase of third homes in China and has raised the mortgage rates and down payment requirements for second homes, thereby reducing the speculation in the real estate sector.

The negativity is being felt by the fact that though the property prices have spiraled to an unparalleled growth of 11.8% since March 2010 (the highest since 2005, which was the golden boom period) and the economy grew by almost 12% in the first quarter of 2010, however, the banking stocks of the major banks in China like ICBC, BoC and CCB are at their lowest valuation figures as the investors despite the rising profits are vary of bad loans.

Under a stress test conducted by the Shanghai branch of the China Banking Regulatory Commission in February, local banks’ ratio of delinquent mortgages would triple should home prices in the country’s commercial center decline by 10%. Citigroup warned in March that in a “worst case scenario”, the non-performing loans of local-government investment vehicles, used to channel money to stimulus projects, could swell to 2.4 trillion yuan by 2011. (Source: Economic Times)

The Chinese composite index has declined by almost 12% since the starting of the year, and the stock market as slated by the investors is almost fully sold or fully priced, thereby leaving no scope of further investment for good valuations. Hence, Chinese investors are speculated to become active Gold Traders.

Investment Activity of China:

Also, there is yet another source which is slowly and silently investing in other avenues, which are deemed important from the future perspective.

The China Investment Corporation is discreetly buying out stakes in majority of companies, especially in the US. The giant sovereign fund with fund size of about $300 billion invested $9.6 billion in US stocks alone last year. This is apart from the US bond debt, of which China is expected to be a major stakeholder.

The two largest holdings as of Dec. 31 included $1.77 billion in Morgan Stanley (NYSE: MS) and holdings valued at $3.54 billion in Canada's Teck Resources Ltd. (NYSE: TCK). CIC rescued MS, who was seeking to raise cash for the pay back of money borrowed during the TARP (Troubled asset relief program of US during the crisis).

Other investments include big names like Citigroup, Visa, Bank of America Corp., Coca Cola, Apple Inc., etc.

What if…?

Known to be a discreet investor and opaque in the functioning, China might be at a brink of collapse. What if Chinese “bubble” bursts, the series of consequences might be deterring and might set off crisis of a scale that the world is yet to witness. The Red Dragon is not only deep rooted in terms of investment in the Major world economy such as the US, but in growing economies too, who will not be able to honor their commitments if China seeks to pull back. Leave aside financial ramifications, it might set off a streak of Political actions which mankind has been avoiding since The Great Depression.

Known to be the back bone of the US consumer economy by financing them in order to keep its own export economy ticking, China will be in a fix if its own market defaults.

If we see the Chinese market defaulting on its loans, which is highly likely in the wake of rising concerns over its asset bubble and aforementioned facts, the investors will surely run for cover thereby liquidating their positions leading to a catastrophic crash. As the assets will see a fall in value, it will lead to an increase in default rates of banks, which might force Chinese government to restructure loans and bail out in a similar manner that their US counterparts did. However, it will also run to liquidate its US treasury (Gilt securities and Bonds), thereby leading to devaluation on US treasury bonds in the international markets. This will in-turn lead to emptying its US $ reserves, thereby sending the US currency spiraling downwards. The direct impact will also be on Crude oil, whose biggest consumer is China. Thereby leading to crash of Crude oil prices and affecting the balance sheet of rich Middle Eastern companies.

The Investments of CIC (China Investment Corporation) in the major companies of US and others worldwide might see liquidation, leading to another crash in the US and international bourses. This might lead to high Inflation in the US suddenly high influx of Dollar in the market and the US. The only solution in this can be that the US in turn helps in resurrection of China, and the money that was to finance its own economy spending, goes back to where it came from (China).

However, can India, benefit from this crash? I still am divided on this issue, as on one hand, the consumption linked mostly internal and the manufacturing sector growing by a healthy pace, India is likely to get less affected. However, if the crash comes in as early as within 12 months, the Indian industry is also set to lose.

Firstly, the exports will become less lucrative as Indian rupee would be stable as compared to the US $. And it would be very difficult to absorb large amount of devaluing currency. However, with Crude oil prices coming under pressure, India will be able to contain its Inflation numbers of which Crude holds a trump card, thereby making the industries more competitive.

The cash rich Indian companies with stable currency, can or will be in a position to increase their cross border takeovers of the capital hungry companies’ at cheap rates, thereby expanding their portfolio and reach.

However, still its to be seen if the crash really happens or not, and if or not India gets an opportunity again with its ‘Smart’ economic policies to overtake China as the next Superpower.