The Real Chinese Risk (It's Not Dodgy Small Caps)

In early February, I asked whether China or the U.S. would kill the stock rally. Today, that remains an open question. While investors are justifiably concerned about the state of negotiations over the U.S. debt ceiling, China continues to present a different kind of debt threat. In trying to hopscotch over the global credit crisis, this rising power could well trip over one of its own, with the potential for a disruptive ripple effect on the global economy and global markets.

The great China flood
In February, I expressed my concern:

Unfortunately, one of the ways in which China fended off a slowdown was with a flood of bank lending. Just as JPMorgan Chase, Citigroup, and Wells Fargo were shrinking their balance sheets, new bank loans in China nearly doubled year-on-year in 2009. However, the Chinese "command" approach to credit, with a system of loan quotas, is inconsistent with rational lending. Expect non-performing loans down the line -- to follow the real-estate bubbles occurring in major Chinese cities. Bubbles rarely end quietly.

Because the yuan is handcuffed to the dollar, China is constrained in its ability to implement monetary policy through interest rates. Instead, officials focus on the flow of credit that is available from banks. Inevitably, when the central authority prods banks to make massive increases in their lending in an effort to preserve economic growth, this results in capital misallocation on a grand scale.

A rotten tree cannot produce good fruit
The poisonous fruit of that process looks like it is now beginning to flower. Last week, for example, credit rating agency Moody's indicated that China's local government debt could be $540 billion larger than official auditors originally estimated. Even though the situations aren't directly comparable, this reminds me of the extraordinary "peek-a-boo" moment when Greece revealed that it had effectively been fudging the numbers in its national accounts for years and that investors should no longer rely on previously published data to assess Greece's economic health and the risk associated with its sovereign debt.

An increase in the estimated amount of outstanding local government debt doesn't give the full measure of China's problem; rising loss ratio estimates are an aggravating factor. Moody's offered that "the potential scale of loan losses may be closer to its stress case than its base case." If you're wondering, the base case assumes a non-performing loan ratio of 5% to 8%, while the stress case is a step up, at 10% to 18%.

We've been here before
Admittedly, even the stress case is still well below the ratio achieved during the last Chinese banking crisis, which occurred barely more than a decade ago, in the late 1990s. Non-performing loans in the Chinese banking system were then estimated at 50% of total banking system assets. At the end of 1998, China's four large state-owned banks -- totaling nearly 70% of all banking assets -- were considered insolvent. The net loss estimate reached roughly $425 billion, or 47% of China's 1999 GDP. For reference, the $588 billion in total credit losses at U.Ss banks during 2007 to 2009 amounted to roughly 4% of 2007 GDP.

While China may not hit the same loss ratios this time around, it would be unwise to assume that because China has navigated smoothly through the global economic crisis thus far, it is immune to credit crises.

The stock sectors in the line of fire
Which companies and sectors are most exposed to a Chinese debt crisis? Chinese companies, naturally; those that belong to the financial, industrial, and materials sectors are directly in the line of fire. Take China Yuchai International (NYSE: CYD), for example, which supplies diesel and natural gas engines, as well as power generators. Outside of China, materials and commodities multinationals look particularly vulnerable:

Source: Capital IQ, a division of Standard & Poor's.

Make prudence your watchword
If you own these stocks, there is no reason to sell them indiscriminately, but you must accept that their exposure to China presents risks as well as opportunity. Shareholders should expect significant turbulence in the event of a "hard landing" of China's economy. More broadly, given China's new status as a main engine of global economic growth, its banking system represents a risk factor for all investors. It's just one more reason to adopt prudence as one's watchword in the current environment.

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