New reports that the Chinese government is developing a large scale strategy to avert financial system catastrophe provide clear indication that the Chinese investment story – one that has enriched so many Canadian resource investors – is in its late innings. The pattern is following the same boom bust pattern most recently endured during the technology bubble.
On Monday, Australia's The Age reported, "China is drawing up a blueprint for sweeping reforms aimed at .…. revitalizing the world's second-largest economy amid deepening fears about a trend of rising corruption, wasteful investment and local government debt."
China's government is now fully realizing the excesses caused by the country's remarkable economic expansion. These excesses will be alarmingly familiar to Canadians old enough to remember the technology bubble. In both cases, a compelling, long term growth story with seemingly limitless potential attracts trillions of dollars in investment, leading to over-capacity and huge portfolio losses.
Modern China's ghost cities and new airports working at a mere fraction of peak capacity (Time magazine reports that 80 per cent of Chinese airports are not reaching traffic targets) are very much analogous to the massive, ill-fated buildout of telecommunications networks in the late 1990s. In that case, the eventual realization that too much had been built too quickly saw $2-trillion (U.S.) wiped out from the Dow Jones Communications Technology Index by 2002. Twenty three 23 telecom companies – including Nortel – file for bankruptcy.
There are also signs that segments of the Chinese financial system are using a desperate form of accounting reminiscent of the technology bubble. While there is no evidence of the outright fraud that brought down Worldcom, official non-performing loan ratio statistics at Chinese banks are generally considered laughably low, according to News China Magazine:
"[O]fficial statistics show less than a 1 per cent non-performing loan rate at China's banks... Industry insiders have revealed that in the first half of 2012 alone, China's 16 listed banks saw an almost 126 billion yuan ($20-billion U.S.) increase in the value of overdue loans, indicating an estimated non-performing loan rate of more than 5 per cent. The questionable figures are believed to be due to falsified statistics from local banks, for whom non-performing loans can result in official sanctions."
Investors will remember that the end of the technology investment bubble was not the end of the technology industry. Portfolio losses were severe between 2000 and 2003, but this did not stop Apple Inc., flat panel televisions, social media and online shopping from increasingly dominating our daily lives. In the same way, the end of the China bubble will not be the end of Chinese economic development. It is not a contradiction to predict severe economic upheaval in China – and global commodities markets – in the short term, and also that China will become the world's largest economy by 2025.
For Canadian investors, reports of major economic reform are only the latest sign that there are too many similarities between China now and the technology sectors in 1998 or 1999. Investing lessons learned in 2000 and 2001 in the technology sector – not buying the dips on Nortel, for instance – should be revisited. Portfolio positions, notably in the mining sector, that are dependent on the "China economic tree growing to the sky" need to be reduced in the coming months.
Scott Barlow