Bridge over ocean
1 November 2013 CFA Institute Journal Review

Where Will It End? (Digest Summary)

  1. Butt Man-Kit, CFA

China has recently been experiencing a credit bubble as a result of its financing underutilized housing construction and infrastructure projects. The author compares China’s credit growth pattern with that of the United States and Japan before those countries faced financial calamities.

What’s Inside?

Despite its appearance of strength, China has experienced slacking exports and has compensated by pumping up housing construction and infrastructure spending. Because this spending is backed by exploding credit, the situation is likely to fall apart as a result of careless analysis and misallocated resources.

How Is This Article Useful to Practitioners?

The spending in China on new infrastructure projects and housing may not help to sustain the country’s growth. Miles of mostly empty apartments, highways, shopping malls, and airports are symbols of wasteful spending. Many believe the country will soon face a potentially severe economic recession.

The credit growth in China is similar to the situation in the United States in March 2008. The increasing interbank overnight rates hint at the faded quality of debt, and the credit system may freeze up like that of the United States.

This sudden increase in the credit-to-GDP ratio has occurred since 2008. The total debt load’s growth mirrors that of the United States from 2002 to 2008 and that of Japan from 1985 to 1990.

The real estate construction boom is perhaps China’s biggest bubble. Despite the unused infrastructure, apartment prices are steady. Developers can still borrow money for new projects. People continue to believe that rural-to-urban migration will fix the housing oversupply. The author argues that a real estate market collapse would require investors to only slightly alter their thinking.

Finally, about 45% of the country’s credit creation is attributable to the enormous growth of China’s shadow banking system, which operates mostly outside the regulatory realm. Products from this system include structured investment vehicles and collateralized debt obligations (CDOs), which are poorly structured and inflated by credit ratings.

Abstractor’s Viewpoint

China’s excessive infrastructure projects of the last few years are well known. Because of the stringent credit control of the state-owned banks, many private lenders issue CDOs to the general public through the shadow banking system in China. Recently, the credit risk has spread to retail investors. All these signs echo those in the United States right before the 2008 crisis. Regulators and investors must address these risks of potential economic collapse.

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