Both the Canadian economy and the domestic equity market were pulled from the 2008 crisis fire by an unprecedented expansion of credit in China. Now, with evidence of a Chinese financial crisis piling up, Canadian investors must protect thier portfolios from the potential fallout.
Credit stress in China stems from debt-laden companies unable to repay their obligations. The trend threatens the viability of the country's monstrous $1.7-trillion (U.S.) wealth management product (WMP) industry.
Concerns about WMPs are not new, but defaults are. In early January, the $500-million Credit Equals Gold #1 Trust barely avoided default when authorities stepped in to guarantee investor principal.
Ominously, Bank of America Merrill Lynch rates strategist Bin Gao compared the fund's near-collapse to the onset of the U.S. financial crisis, noting that "the bailout looks very much like the Bear Stearns moment."
More signs of financial stress have appeared since the Credit Equals Gold bailout. On Wednesday, Reuters reported that Jilin Province Trust Co Ltd. would be unable to repay investor principal on a $48 million WMP backed by loans to coal company Shanzi Liansheng Co. Ltd.
This is only the latest in a series of defaults on Jilin trust products. The company failed to repay $75-million on matured products in late 2013 and investors are not hopeful that $34-million in trust products maturing in the next few weeks will be paid in full.
Standard & Poor's believes that industrial overcapacity will see credit stress spread throughout the Chinese financial system.
In "China Banking Outlook 2014: A Turbulent Flight Ahead," analyst Qiang Liao writes, "We believe Chinese banks' loan quality will deteriorate noticeably in 2014. Banks remain heavily exposed to debt-laden local government financing platforms and manufacturers (such as steel and cement producers) saddled with overcapacity because China's decade-long construction boom is cooling… We believe government-engineered consolidation in these segments will reduce production capacity and could lead to a rise in [non-performing loans] for Chinese banks over the next two years."
Mr. Liao believes the government will step in with enough financial support to prevent a 2008-style financial meltdown. Nonetheless, the rampant credit growth that has driven China's economic expansion – and global resource demand – will inevitably slow as debt defaults rise.
Canadian investors can no longer depend on China's credit and infrastructure boom to support global commodity prices and, by extension, profits for the 35 per cent of the S&P/TSX Composite made up of resource stocks.
Scott Barlow