A fresh look at China’s liquidity problem

Very interesting Table produced by Gavekal (h/t youngmoney) showing that receivables (AR) and inventories have increased significantly over the years in China,


This is means that Chinese corporate balance sheets have become less liquid although leverage has never been higher – a fragile situation. The picture is representative of an unsustainable credit expansion where money has been invested in ever more roundabout projects whose payback period lies in the distant future (and which might not materialize for most of them). Once credit stops growing exponentially, the problems surface and borrowers start defaulting.

A worsening sales/receivables relationship  usually is indicative of problems ahead. After all, sales are real only to the extent they translate into cash someday, a process that leaves something to be desired in China. Since sales are an important input in national accounting, an overstatement leads to higher GDP estimate – keep that in mind the next time someone shows you China’s debt/gdp ratio.

Lessons from History

As is well-known, the inflation with which WWI was financed did not lead to an immediate economic contraction, as had been anticipated, but instead to a “war boom” that helped make the war popular in the belligerent countries. The boom was an illusion, of course, and merely represented capital consumption – a phenomenon first described by Mises in this context.

But how did that capital consumption show on corporate balance sheets?

Well, as the governments were printing money to finance WWI, businessmen got paid in government receivables which started accumulating on balance sheets. Initially they were not worried, as decades of convertibility into gold had assured them that government promises (that had been very limited until then) were sound and could eventually be converted into money, i.e. gold. Thus, (false) profits were booked and dividends paid out. Eventually the huge supply of unbacked IOUs resulted in market FX rates deviating from their gold pegs and ultimately all were devalued against gold. Those that anticipated this made fortunes, most were wiped out in Germany and Austria. This did not happen overnight, however, but took many years.

220px-Genoa_conference_1922Participants at the Genoa conference where the gold exchange standard was officially established (source: Wikipedia)

The USD was awarded reserve currency status at the 1922 Genoa conference and devalued only in early 1933 – almost twenty years after the beginning of WW1 and after a constant increases in uncovered deposits during the roaring twenties had exhausted the liquidity of the US banking commercial banking system.

Why it will not take that long in China

I do not think (or is it hope?) that we will have to wait that long for China to give up on its peg. To be sure, since it is paramount for China’s leaders to “save face” they will hold steady as long as possible, just as central bankers bound by a code of honour established during the gold standard years did back then, but ultimately market forces will prevail. Indeed, as I have written in my last post (here), there is evidence that China’s ruling elite doesn’t think the CNY is as good as the USD anymore and has started shifting money out of China. In other words: they know those receivables are largely not going to be collected.

If my analysis is correct, this is just the beginning…

Disclosure: short CNY, short AUD


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