Don’t expect Chinese to keep underpinning property market

It’s time to check portfolios for exposure to China. And don’t expect Chinese buyers to keep underpinning property.

For Australian investors it’s time to start seriously watching China again.

You should carefully check your portfolio for direct and indirect exposure to China and China-exposed businesses and ­industries.

The Chinese government has re-established capital controls that have had a dramatic impact on the level of capital outflows. This may sound technical but it is important in two ways:

1. It is a key factor for domestic property investors, for example, who believe that Chinese buyers will keep propping up Australian real estate.

2. It is directly relevant for investors in equity (share) funds that invest in China because the capital controls could boost the stockmarket there, but then a declining currency could offset any gains made by Australian investors.

China’s foreign exchange reserves are used by the country to stem the depreciation, on the yuan, of capital outflows. These ­reserves, however, fell by a further $320 billion in 2016, to $3.011 trillion. This followed a record decline of $510bn in 2015.

It has been suggested that the $3 trillion level is important to Chinese officials, which could explain the reason they are tightening rules to keep residents and foreigners from moving money out of the country.

While $1 trillion of foreign exchange has flowed out from China over the past 18 months, in December that number fell to almost zero. That means no money was withdrawn, for example, to settle Australian residential purchases.

Chinese buyers will continue having trouble settling global real estate purchases (think Australia, New Zealand and Canada) as banks are told they must balance their FX trades, with transactions as small as $US5000 ($6550) being scrutinised and currency conversion requests rejected, according to some commentators.

This development suggests the likes of Mirvac and other large residential property developers may see increasing settlement failures, adding fuel to an already oversupplied stock of Australian apartment inventory.

The yuan has slid over the past 12 months to about 6.9 per US dollar. And as I have previously reported, investors including the hedge-fund manager Kyle Bass of Hayman Capital predict that the Chinese government will eventually have to undertake a steeper devaluation. To date, however, they are resisting and overnight interest rates in China hit 100 per cent as the government sought to punish currency shorts.

China’s credit system is coming to a halt.

Credit excesses in China have already been built up and are significantly higher than any other country in the world ahead of their respective crises.

Recent economic growth of 6.8 per cent was dominated by unsustainable state-led infrastructure spending as reflected in the recent rise in iron ore prices (which should temper now that stockpiles are at record highs).

Back in 2005, exports constituted 34 per cent of China’s GDP and investment 42 per cent. A decade later investment had grown to 46 per cent probably because exports had fallen to 23 per cent. Importantly, the investment was funded by rapid credit expansion in China’s banking system, which grew from $3 trillion in 2006 to $34 trillion in 2015. Many of these loans, however, will turn bad.

Rising bond defaults and the cancellation of bond issues are already signs of increasing pressures on banks. Funding costs are rising and the People’s Bank of China is reported to have injected liquidity and cut the reserve ratio for banks. And just as Kyle Bass warned in 2016, it appears the banks are heading towards an inevitable recapitalisation — which would cause the US dollar to appreciate against the yuan. Before concluding a credit crisis is imminent in China, keep in mind the real test will be the wall of junk bond maturities this year and next.

As an aside, in the US, junk bond maturities will hit a record in 2019 even as hedge funds gorge themselves on distressed energy company debt in the secondary market amid a narrowing of the credit spread from 8.87 per cent this time last year to just 3.96 per cent today.

Also in China, heightened trade tensions with the US — thanks to Trump’s policy to put US businesses first, including tariffs on Chinese imports — could adversely impact China’s export performance and hit growth at the same time this debt hits record highs.

Debt over the past 18 months grew by $US6.5 trillion while deposits grew just $US3 trillion. This will accelerate the move to a tipping point in China’s need to restructure its economy.

In 2017 investors should ignore the mantra that several billion people in China can do nothing but support asset prices locally.

Roger Montgomery is founder and chief investment officer of the Montgomery Fund.