The Chinese growth engine is sputtering

This article is by  and was originally posted on Money Geek

"The major uncertainty facing the world today is … the future direction of China. The growth model responsible for its rapid rise has run out of steam." – George Soros

No one has a better reputation for predicting global economic trends, than George Soros. Known as the "Man who broke the Bank of England", he became one of the richest men in the world by betting his fortune on his predictions. In the investment world, there are many people who can talk a good tale, but there are very few who can back up their talk with actual results. Soros is one of them.

On Monday Feb 17, it came to light that Soros had purchased $1.3 billion worth of put options on the U.S. stock market. Meaning, he thinks there's a good chance that the U.S. stock market will fall. This is no Mickey mouse position for him, either. At 11% of his portfolio, it represents his biggest position.

No one but Soros knows exactly why he bought those put options, but many people are guessing that he's nervous about China.

On January 2 of this year, Soros wrote an article that contained the opening quote of this blog post. You can read the article for yourself, but I suspect that many people will find it confusing. Soros writes with financial professionals in mind, who not only understand the jargon, but who also understand the context after having followed the news in China somewhat closely.

In this blog post, I'm going to try to unpack some of what he said in layman's terms.

How China Engineered Its Growth

To understand his stance on China, you first need to understand how China achieved its growth thus far. The Chinese growth engine has primarily relied on investments – i.e. constructing malls, airports, highspeed rail, etc. In other words, building stuff. Investment as a percentage of GDP averaged over 40% between 1991 and 2011, and has only increased since.

Some of you might think, "Isn't investing a good thing?" After all, many people think the West could do with a bit more investment. However, that's not necessarily true. Investing, or building to grow the economy is only good if it helps its citizens become more economically productive. However, that hasn't been happening, which means that much of China's investments have been wasteful.

Building airports and coal mines require a lot of money, and these are normally financed through debt. For example, if an airport costs $2 billion, the developer may put down $400 million and borrow the rest of the $1.6 billion.

In order to encourage firms to take on such investment projects, China has set artificially low interest rates. The Chinese government set a maximum interest rate that banks are allowed to pay its depositors. As a result, the banks could profitably lend the Chinese depositors' money to firms undertaking investment projects at artificially low interest rates as well. Armed with cheap loans, Chinese companies built, built and built.

Shadow Banking Emerges

However, in recent years, the banks started to run out of customers' deposits to lend, while Chinese firms' desire to build remained. To scrounge up cash, Chinese firms started to turn to what's known as the 'Shadow banking system'. In other words, they started looking for loans from non-traditional places. This is what Soros means when he says "forced savings (i.e. deposits) are no longer sufficient to finance the current growth model".

One such non-traditional means of securing loans involved the use of 'Wealth Management Products' (WMPs). Think of these as mutual funds. Investors put the cash, and the fund invests money. However, unlike normal mutual funds, these wealth management products often invest in a single security, such as a bond issued by a Chinese company. Since this is a 'wealth management product' and not a bank loan, investors in these products receive higher interest rates than they would have with a bank. Of course, the company receiving the proceeds from the bond also have to pay higher interest as well.

There are eerie similarities between U.S. subprime loans and Chinese WMPs. Both were invented to satisfy investors' demand for more yield. Both are used to lend to borrowers with questionable abilities to pay back. Both exploded in popularity.

Late January, one such Chinese WMP called 'Credit Equals Gold product' made headlines in newspapers, which was partly responsible for the brief fall in stock prices during that time. The WMP in question had lent money to a coal mining company, and it had become clear that the company couldn't pay back the loan.

No Good Choices For The Government

Faced with this problem, the Chinese government had two options – let it default, or bail out the investors.

If it let it default, many feared that it would lead to contagion. Investors would stop buying WMPs for fear of more default, which would stop Chinese companies from taking on building projects. This may slow the economy, or even lead to an economic crash. If you think back to the U.S. crisis, this is essentially the approach that the U.S. took with Lehman brothers, which resulted in the biggest financial crisis in our generation.

If the government engineered a bailout, it risked sending investors the signal that it will bail out every WMP. If that happened, investors will pour ever more money into WMPs, which would spur more building by Chinese firms, and set itself up for an even bigger crash down the road. This is what Soros means when he says "restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.".

In short, the Chinese government is caught between a rock and a hard place. Discourage WMPs and other shadow banking elements, and the economy slows. Encourage them, and they set themselves up for an even bigger fall.

Nor can China delay the decision. A lion's share of WMPs are coming due this year. $1.8 trillion of it, in fact. If they decide to let some of them default, we could feel the repercussions as early as late this year.

Whichever choice they make, one thing is becoming more and more apparent. The Chinese economy will slow – if not today, then within a couple of years. A slowing China will have a big impact on all parts of the fiancial markets, sending everything down from stocks, commodities to house prices. Soros is taking precaution. It may be wise to do the same.

Bonus: I believe Ray Dalio's brilliant video is relevant here. China may be near the end of their own long term debt cycle.