The Valor Blog.
Investment News and Views, Direct from Our Team.

A couple of great articles

by Marc Lerner

Some great articles have come out recently, both internationally and at home, reflecting our views on China and Australia. The first is by Michael Pettis, where he demolishes various arguments as to why China’s debt “doesn’t matter”. The most detailed one says that because the People’s Bank of China (PBOC), has extensive reserves which will make it easy to recapitalize banks in the event of a debt crisis. Firstly, the reserves are held in foreign currency, meaning if they were to be used to bail out banks they would the PBOC would have to stop buying US dollars and in fact sell them, leading to drastic yuan appreciation and a wipeout of China’s export sector. More importantly, however, the reserves aren’t held as ungeared savings – rather, they were purchased by the PBOC to suppress the value of the yuan with borrowed money – meaning that they are needed to repay debt, and if they are used to bail out banks the PBOC will have to borrow elsewhere, and rather than a wipeout of debt the bailout will just be a transfer of it from the banks to the PBOC. There’s no escaping Chinese debt, just like debt anywhere else.

Closer to home, Christopher Joye at the AFR has written a great article about the overvaluation of Australia’s housing and banking sectors. He points out that Sydney home values are up 13.2% since January 1, and the market capitalization of CBA and Westpac – two of the ‘big four’ banks that fund housing in the country – are worth more than massive global companies such as Mcdonalds and American Express. Measures like price-to-income ratios are expanding rapidly and unsustainably, while the bank’s earnings per share – a crucial valuation metric – have been artificially boosted by decreasing loan-loss provisions, without which profits would actually be falling.

What many don’t realize is that these two economic factors – the Chinese debt bubble and the Australian housing market – are inextricably linked. It is China’s insatiable desire for our iron ore and coal – used to build empty buildings – that has allowed the Australian economy, housing market and hence banking system to maintain its apparently invincible strength. Once China suffers its correction, if the Australian dollar falls hard and fast enough, other areas of the economy like manufacturing and tourism have a chance of taking the place of mining, at least to some degree. There is a significant risk, however, that they don’t and then the housing market will come off significantly, as miners and mining engineers lose their jobs and are unable to pay their mortgages, with flow-on effects through the whole economy and financial system.