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Why China s Credit System Looks Vulnerable

'Why China s Credit System Looks Vulnerable '
GMO White PaPer January 2013 Feeding the Dragon: Why China’s Credit System Looks Vulnerable Edward Chancellor and Mike Monnelly* Prologue For GMO’s asset allocation team, valuations are our first protection against losses. We generally believe that cheaper assets are more resilient against bad economic and financial events, and that if we focus on avoiding the overvalued assets, we should not only achieve higher returns over time, but more often than not do less badly when markets encounter difficulty. From a valuation perspective, Chinese equities do not, at first glance, look to be a likely candidate for trouble. The PE ratios are either 12 or 15 times on MSCI China, depending on whether you include financials or not, and the market has underperformed MSCI Emerging by about 10% over the last three years (ending December 31, 2012). Neither of these characteristics screams “bubble.” And yet, China has been a source of worry for us over the past three years and continues to be one, affecting not merely our behavior with regards to stocks domiciled in China but the entire emerging world, as well as some specific developed market stocks, which we believe are particularly vulnerable should things in China go down the road we fear it might. China scares us because it looks like a bubble economy. Understanding these kinds of bubbles is important because they represent a situation in which standard valuation methodologies may fail. Just as financial stocks gave a false signal of cheapness before the GFC because the credit bubble pushed their earnings well above sustainable levels and masked the risks they were taking, so some valuation models may fail in the face of the credit, real estate, and general fixed asset investment boom in China, since it has gone on long enough to warp the models’ estimation of what “normal” is. Our fears have not stopped us from buying emerging stocks, or indeed some Chinese stocks, but they have tempered our positions relative to what they would be if we were not concerned about the bubbly aspects of China. Because this view has a real effect on our portfolios, it is important for us to continue to update our work to make sure we aren’t missing something important. The recent apparent strengthening of the Chinese economy is a potential challenge to our thesis, and as a result, Edward and others at the firm have been working hard to understand what is driving the rebound and understand whether it is sustainable or not. “Feeding the Dragon” looks at the utterly crucial issue of funding in China’s very credit-dependent economy. Ben Inker, January 22, 2013 Introduction – The Credit Tsunami Until the summer of 2011, China’s economic juggernaut seemed unstoppable. In September of that year, however, an acute credit crunch appeared in the city of Wenzhou on China’s eastern coast. Stories suddenly appeared of defaulting property developers, loan sharks disappearing in the middle of the night, work halted on half-completed apartme
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