Wow! What a roller coaster ride the markets had yesterday! Right from the S&P’s open at 2056.55 it dove straight off a cliff, falling to 2037 within the first 5 minutes of trading for a drop of nearly 20 points or some 0.95%.
After a sharp bounce up, it again fell to the previous floor, actually breeching it a bit to reach a low of 2,034.17, slightly more than 1 full percentage point off its open by the time the first hour of trading was through.
But the market’s remarkable resilience pulled through once again, lifting the index slowly up the next hill to an intraday high of 2,060.60 by the end of the day, more than four points above its opening level, ultimately finishing the day a mere 0.02% below Monday’s close. All which was lost during the opening hour was ultimately reclaimed.
What in the world caused all that commotion? News out of China that its government is going to crack-down on its corporations for taking on too much debt. While Americans were still sleeping early Tuesday morning, China’s Shanghai Composite index fell a staggering 8.25% from 3090 to 2835 within its last two hours of trading.
Ultimately, then, the reaction in the West was simply a knee jerk where most investors just play along without really thinking about what they’re doing. They simply became caught up in the panic and sold, sold, sold.
After an hour or so, when U.S. markets finally had a moment to stop and catch their breath, people began realizing that maybe the news out of China really wasn’t so bad after all.
I’ll now present two reasons why indeed that news really is nothing for investors to worry about, neither in America nor in China.
Cracking Down on Too Much Debt
“The broad selloff was triggered when China’s securities clearing house said late Monday [U.S. time] it raised the threshold for corporate bonds qualifying as collateral for repurchase agreements, or repos, short-term loans with maturities spanning from overnight to 182 days,” reported the Wall Street Journal.
“The new rule is to prevent risks from building up further as a result of high leverage in the market,” Xu Hanfei, analyst at Guotai Jun’an Securities explained. Economists estimate corporate and local-government debt has surpassed 250% of gross domestic product this year.
The national government’s fear is that China’s economy isn’t going to grow fast enough to enable corporations and municipalities to generate enough revenue to finance their massive debt loads. China’s GDP grew at only 7.3% in the third quarter. While that still makes eyes in the west pop open, it none-the-less represents the slowest growth in more than five years.
“Investment, industrial production, retail sales and industrial profit all posted weaker growth in October,” reported WSJ, “and new-home sales in November declined for the seventh consecutive month.” “We haven’t seen any significant pickup in any indicator recently,” ANZ economist Zhou Hao revealed.
Fearful that the nation will not be able to support its massive collective debt load, economists believe Chinese officials will “set a stable monetary and credit policy stance for next year” and “discuss key structural reform plans, such as interest-rate liberalization, reform of state-owned companies and land policy”, WSJ adds.
Ultimately, then, it is like Mom and Dad seizing their child’s credit card and chopping it up. Or perhaps, reducing its credit limit.
Yet while this is clearly the right thing to do to prevent a debt disaster later, it is feared that tighter lending policies and tougher qualifying criteria on what can be used as collateral will bring about a different problem more immediately… slower growth.
“Policies aimed at cutting down on debt… could hold back growth in the short term if they choke off credit to industries such as steel and cement, where problems with overcapacity are widespread,” WSJ cautioned.
The Communist Party’s principal newspaper, the People’s Daily, ran with a headline calling “an end to high growth” as the “new normal”.
But are these fears founded? And more importantly, should they really scare off investors?
A Little Pain Now Spares More Pain Later
There are two main reasons why neither China nor the west should be worried about the Chinese government’s annual plan when it is revealed in a few months’ time.
Firstly, as Liu Shijin, vice president of the State Council’s Development Research Center, was quoted by the People’s Daily as saying in reaction to the news of the government’s expected tightening of lending rules, “The important objectives are to adjust the economic structure and boost its quality.”
Now let’s stop and think about what all of this means. Money is cheap now all over the world, including China compared to the recent past. But at some point in the near future, money will not be so cheap anymore. Interest rates are falling now, but they will be rising in two or three years’ time around the globe.
Too much debt now will turn into too much interest later, so the Chinese government is going to reign it in before it becomes too burdensome. By some reports, in some municipalities it already has become too burdensome even at these easy rates.
So Shinjin’s comment about improving the “quality” of debt is very much the smart thing to do. In so doing, the government is ensuring that loans are properly collateralized with truly valuable assets, instead of permitting so much debt to be issued on such low quality assets as is happening currently. That means a more stable debt market later.
Secondly, while growth has been slowing to the low 7% area and will likely flirt with a possible breech of 7% as a result of tighter borrowing rules, we must see it for what it really is.
“A lower GDP target for 2015 is almost certain,” Societe Generale Group warned in a research note. “The new target is likely to be either ‘around 7%’ or ‘a desired range of 7%-7.5%’.”
Nations in the west would go to war if they could secure growth rates that high. Yes, it is slower than the 8 to 12% GDP annual growth rate China was enjoying from 2007 to 2012. But it’s still 7%. Better even.
“Industrial output, the most closely watched indicator of the economy’s performance, is expected to slip to 7.5% year-on-year growth in November, from 7.7% the month before, according to a median forecast of 16 economists surveyed by The Wall Street Journal,” the WSJ informed.
Investors Needn’t Panic
Investors aught to note that the Chinese government is very forward-looking, more so than almost any other government on Earth. Even if tighter lending rules and stricter collateral qualifications end up shaving half a percentage point off of China’s GDP growth in 2015, it will ultimately reap more bountiful returns down the road when China’s corporations and municipalities are spared bankruptcy for being unable to support growing interest payments on their massive debts.
This means stocks in China will have a much more solid future ahead of them after these lending reforms than they would if the Chinese government simply let things continue as they are.
And that means Chinese and American investors’ portfolios – whether they hold Chinese stocks or American stocks which depend on a strong Chinese economy – will also enjoy a much more solid future ahead of them.
Yesterday’s news out of China was not all that bad, but was quite good indeed. That is, if we have what China’s government has… a very long-term view.
Joseph Cafariello
