Watch out for China’s ‘freak’ economy Commentary: This is the real danger to the global economy

BOSTON (MarketWatch) — Forget Greece. Forget Italy. Forget “Occupy Wall Street.”

The really ominous news right now?

China.

It’s been the juggernaut carrying us all year. But Albert Edwards at SG Securities says the world’s second biggest economy is a “freak” and it’s starting to go berzerk.

Bad news.

What’s going wrong? How? Here are some troubling signs:

The housing bubble is finally bursting.

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Overhauling refinancing program

Details of a plan to overhaul a mortgage-refinance program that would remove hurdles for homeowners. Photo: Brandon Sullivan for The Wall Street Journal

And we know how that story ends. Think: America, Ireland and half the West since about 2005. Think of Japan after 1990. Think of…well, every housing bubble in history.

The aftermath of a burst bubble is unmitigated disaster. That’s because housing affects everybody — middle-class families, developers, banks, local government. It’s the Spanish flu epidemic of real estate bubbles. There’s no containing it.

Take a look at the Chinese situation. The bubble has been as big as any we’ve seen.

Massive high-rise real estate projects have erupted across the country in recent years. Visitors tell stories of giant, empty condo buildings — “ghost” cities. Prices in the major cities have skyrocketed. And newly middle-class investors have piled in.They’ve never seen a housing bust. They assumed it will go on forever.

Ten years ago, homes in Shanghai sold for about six times an average family’s income. Today that’s 13 times. Shenzhen has gone from five times to 14 times. These are off-the-charts absurd ratios. This is a bona fide mania.

And it works fine until the music stops.

Where are we now?

Prices have started falling. Now, fewer than 46 of 70 major cities saw prices stall or decline in September, reports the National Statistical Bureau. As recently as January the number was just 10.

Analysts at DBS Vickers Securities say developers are now slashing prices to move unsold inventory, and they see a lot more to come in the next few months.

Reuters

A laborer works at a construction site for new houses in Huaxi village, Jiangsu Province in China earlier this month.

The cuts are already so deep, says DBS Vickers, they are already provoking protests and attacks on sales offices from those who bought at earlier, higher prices!

You can see a proxy for the Chinese housing bust in the performance on Wall Street of E-House (China) Holdings EJ +11.27%  , a real estate broker with a U.S. listing. The stock has collapsed in a year from $17 to less than $7, and the company recently reported it swung to a second-quarter loss thanks to “tough market conditions.”

The credit bubble is imploding.

What would a housing bust be without a credit bust? This will be the mother of all implosions, too.

In the past two and a half years, China has witnessed a staggering credit bubble. Total lending has come to about $7.8 trillion.

To put this in context, that is twice the entire net government debts of the European so-called “PIIGS” — the troubled countries of Portugal, Ireland, Italy, Greece and Spain — put together.

What sort of accountability has there been to all this lending in a single party, Communist-run, Third World economy with little previous experience of credit?

Um…

An alarming report from Schroders said Chinese banking operates in a “twilight zone” of phony accounting and shadow money and it’s all coming apart. “Almost half of all credit creation in China is off balance sheet,” wrote the team at Schroders.

They think this situation could unravel “over the next three to six months,” producing a huge crisis with international implications. Most Chinese banks, they predict, will end up as “zombie banks.”

The canary in the coal mine might be the boom city of Wenzhou in the south. On a single day last month, nine company bosses all suddenly went on the lam to avoid bankruptcy. Nine on one day.

Reports put the figure in the town at 29 since April. One boss committed suicide.

The stock market is signaling trouble.

It’s a mistake to assume the stock market is always correct, but generally speaking when it signals a downturn it does so pretty clearly.

And what it’s saying about China is alarming.

Chinese stock prices have slumped by 22% since July, says FactSet. They are, on average, down to nine times forecast earnings, valuations last seen during the depths of the financial crisis in 2008-2009. Prices of property developers have collapsed, in many cases below book value.

And you can see in the prices of mining and other resources stocks elsewhere. They have in many cases slumped by a third or more. In London, mining giant Vedanta Resources   has halved in price since early last year.

In most cases, the stocks of resource companies have fared much worse, so far, than the prices of the underlying resources themselves. Maybe that makes them a buy. Or maybe the forward-looking equity market is seeing something sooner than the commodities markets — as was the case for gold mining stocks six weeks ago.

Albert Edwards at SG Securities warned that China’s long-running investment boom has no precedent and is bound to burst. “China is a ‘freak’ economy,” he wrote. “To my knowledge no other economy in history has experienced such high investment/GDP ratios and seen so many sequential years of strong investment growth.” The Asian tigers in the 1990s? Japan? Nothing comes close, says Edwards.

That boom has helped carry the world economy through the troubles of the past five years. What happens if it, too, ends?

Don’t ask. 

Citi raises gold, silver forecasts for 2012, 2013

LONDON (MarketWatch) -- Citigroup Inc. C -0.10% Monday raised its gold and silver forecasts for 2012 and 2013, citing expectations of increased resilience in both metals amid a "high probability" that the macroeconomic and financial factors that have propelled prices over the past three years will continue for the next 12-18 months.

The bank now sees gold averaging at $1,950 a troy ounce in 2012, compared with $1,650/oz previously forecast, and sees a 2013 gold price of $1,745/oz, up from $1,500/oz.

Citi expects an average silver price of $32.90/oz in 2012, compared with its earlier forecast of $26/oz, and a 2013 price of $27/oz, up from $22.40/oz.

"Increased global risk, U.S. dollar weakness, growing inflationary fears, the U.S. debt downgrade and continuing sovereign debt risks in Europe have increased investor appetite for gold," Citi's Jon H Bergtheil said in a research note.

"This has been supported by central banks reversing activities from being sellers for most of the past 15 years to net buyers more recently and is supported by the Fed's stated desire to keep interest rates at super-low levels in the medium term," he said.

As Eurozone Steers Silver and Gold, Watch the US Dollar

If Greece defaults and the European situation begins to spin out of control, where will money flow? It would not make sense for market participants to buy euros during a default regardless of whether the default is structured or not. In fact, it is more likely that European central banks and businesses would be looking to either hedge their euro exposure or convert their cash positions to another currency altogether.

Some market pundits would argue that gold and silver would likely benefit, and I would not necessarily argue with that logic. However, the physical gold and silver markets are not that large, and depending on the breadth of the situation, vast sums of money would be looking for a home. The two most logical places for hot money to target in search of safety would be the U.S. dollar and U.S. Treasurys.

The U.S. dollar and U.S. Treasury obligations are both large, liquid markets that could facilitate the kind of demand that would be fostered by an economic event taking place in the eurozone. My contention is that the U.S. dollar would rally sharply along with U.S. Treasurys and risk assets would likely sell off as the flight to safety would be in full swing.

To illustrate the point that the U.S. dollar will likely rally on a European crisis, the chart below illustrates the price performance of the euro compared to the U.S. dollar Index. The chart speaks for itself:



Clearly the chart above supports my thesis that if the euro begins to falter, the U.S. dollar Index will rally sharply. In the long run I am not bullish on the U.S. dollar, however in the case of a major event coming out of the Eurozone the dollar will be one of the prettiest assets, among the ugly fiat currencies.

The first leg of the rally in the U.S. dollar occurred back in late August. I alerted members and we took a call ratio spread on UUP that produced an 81% return based on risk. I am starting to see a similar type of situation setting up that could be an early indication that the U.S. dollar is setting up to rally sharply higher in the weeks ahead. The daily chart of the U.S. dollar Index is shown below:



As can be seen from the chart above, the U.S. dollar Index has tested the key support level where the rally that began in late August transpired. When an underlying asset has a huge breakout it is quite common to see price come back and test the key breakout level in following weeks or months. We are seeing that situation play out during intraday trade on Friday.

We are coming into one of the most important weeks of the year. Several cycle analysts are mentioning the importance of the October 26^th – 28^th time frame as a possible turning point. I am not a cycle expert, but what I do know is that we should know more about Europe’s situation during that time frame. It would not shock me to see the U.S. dollar come under pressure and risk assets rally into the October 26th – 28^th time frame. However, as long as the U.S. dollar Index can hold above the key breakout area the bulls will not be in complete control.

If I am right about the U.S. dollar rallying higher, the impact the rally would have on gold and silver could be extreme. While I think gold would show relative strength during that type of economic scenario, I think both metals would be under pressure if the U.S. dollar started to surge. In fact, if the dollar really took off to the upside I think both gold and silver could potentially selloff sharply.

As I am keenly aware, anytime I write something negative about gold and silver my inbox fills up with hate mail. However, if my expectations play out there will be some short term pain in the metals, but the selloff may offer the last buying opportunity before gold goes into its final parabolic stage of this bull market. The weekly chart of gold below illustrates the key support levels that may get tested should the dollar rally.



For quite some time silver has been showing relative weakness to gold. It is important to consider that should the U.S. dollar rally, silver will likely underperform gold considerably. The weekly chart of silver is illustrated below with key support areas that may get tested should the dollar rally:



Clearly there is a significant amount of uncertainty surrounding the future of the eurozone and the euro currency. While I do not know for sure when the situation in Europe will come to a head, I think the U.S. dollar will be a great proxy for traders and investors to monitor regarding the ongoing European debacle.

If the dollar breaks down below the key support level discussed above, gold and silver will likely start the next leg of the precious metals bull market. However, as long as the U.S. dollar can hold that key level, it is quite possible for gold and silver to probe below recent lows.

Both gold and silver have been rallying for quite some time, but the recent pullback is the most severe drawdown so far. It should not be that difficult to surmise that gold and silver may have more downside ahead of them as a function of working off the long-term overbought conditions that occurred during the recent precious metals bull market.

Make no mistake: If the dollar does rally in coming months, risk assets will be under significant selling pressure. While the price action will be painful, those prepared and flush with cash will have an amazing buying opportunity in gold, silver, and the mining complex. Right now, risk remains excruciatingly high as the European bureaucrats wag the market’s dog.

EU Summit: Not Enough Progress Made – Pressure Remains on EUR/USD

The leaders of the European Union have made some progress in the first summit on Sunday, and it seems that some kind of watered down compromise will be reached on Wednesday.

It looks far from comprehensive and is likely to weigh on the euro. Here are the main points, and what’s missing to make it a real deal.

1) Greek haircut

The progress: Germany managed to get some concessions from France and especially from bondholders, the banks. The banksare now ready  to up their offer to a 40% haircut, from 21% agreed on July 21.

This is still short of the 50% to 60% demanded by the IMF and Germany. So nothing is agreed yet. This will wait for Wednesday, and the IMF threatens to close the tap for Greece if a big haircut isn’t agreed upon.

Note that this debt cut doesn’t provide a full relief for Greece as it applies only to the private sector, not the Official Sector: the EU, ECB and IMF.

Possible serious solution: A 60% haircut for the private sector AND a similar cut for the ECB will be more in the direction of a comprehensive solution.

2) EFSF Leveraging

In order to ring fence Italy and Spain, some kind of enhancement is necessary for the current bailout fund – the EFSF. France wants to turn it into a bank that can borrow money using leverage from the European Central Bank. Germany strictly opposes it.

Progress made: France has gathered backing from many other countries and the pressure on Germany and the ECB is growing, especially as the president of the ECB, Jean-Claude Trichet, a great hawk, is stepping down in about one week.

Possible serious solution: Germany should give up this demand in return for a bigger haircut and perhaps some other concessions from France. Using the ECB is a swift solution that can also have a side effect of printing money, weakening the euro and boosting growth that is so necessary in Europe, on the brink of recession.

The chances of this happening seem low, but there’s always hope.

3) Bank recapitalization

This is one area that an agreement seems closer. Banks will be required to raise between €100 to €110 billion.

This is far from €200 billion (IMF estimates) to €372 billion by other estimates. Unfortunately this deal seems to be closed, but it isn’t comprehensive.

4) Growth

This was on the agenda on July 21 and is still missing from the agenda. This is what can make a deal very comprehensive indeed.

All in all, the deadlock around the EFSF, the small progress around the Greek haircut and the small deal for the banks are not enough to boost the euro. On the other hand, expectations were already lowered towards the summit.

A small slide in EUR/USD is likely with tension remaining high towards Wednesday.

The European Financial Crisis In One Graphic: The Dominoes Of Debt

The European Financial Crisis in One Graphic: The Dominoes of Debt

The dominoes of debt are toppling in Europe, and there is no way to stop the forces of financial gravity.

After 19 months of denial, propaganda and phony fixes, the political and finance leaders of the European Union are claiming a "comprehensive solution" will be presented by Wednesday, October 26-- or maybe by the G20 meeting on November 3, or maybe on Christmas, when Santa Claus delivers the gift global markets are demanding: a "solution" that actually pencils out and that forces monumental writeoffs of debt and thus equally monumental losses on European banks and bondholders.

There have been any number of insightful descriptions of what's going on beneath the artifice, spin and lies, for example:

Four Facts that PROVE the EFSF (rescue fund) Doesn’t Matter At All (Zero Hedge)

Revised Troika Forecast Sees Total Greek Debt-To-GDP Peaking At 186%: Here Is What Happens Next (Zero Hedge)

There Is No Bailout Spoon: The Math Behind The €2 Trillion EFSF Reveals A "Pea Shooter" Not A "Bazooka" (Zero Hedge)

Citi Expects A 76% Haircut On Greek Debt (Zero Hedge)

EU Bank Stress Test: When No. 1 Financial-Strength Ranking Spells Doom (Bloomberg)

I have summarized the fundamentals in this one graphic: the European dominoes of debt. Simply put, there is no way the EU authorities can stop the first domino--Greek default or equivalent writedown of its impossible debt load--from toppling the over-leveraged banks which will be rendered insolvent when forced to recognize their losses.

That leaves each nation with the politically unsavory option of bailing out its premier banks with taxpayer money, and squeezing the money out of its citizenry via higher taxes and austerity. That assumption of bank debt will in turn trigger downgrades of heavily indebted sovereign nations such as France, moves that will raise rates and make the bailout even more costly to taxpayers, who will also be suffering from reductions of income due to global recession.

Once the banks and bondholders accept a 50%-75% writedown in Greek debt, then the other debtor nations will be justified in demanding the same writedown in their crushing debts. This dynamic leads to estimates that 3 trillion euros will be needed to bail all the players out. Alternatively, total losses will equal 3 trillion euros, wiping out banks and bondholders of sovereign debt.

The German economy is simply not big enough to fund a 3 trillion-euro bailout. Germany has 81 million people and its GDP is $3.3 trillion; the EU GDP is roughly $16 trillion. Compare those with the U.S., with 315 million people and a GDP of around $14.6 trillion.

As an act of self-preservation, Germany will be forced to either exit the euro outright or cloak its withdrawal with a "euro 1 and euro 2" scheme, a scenario I first laid out in March 2010: Why the Euro Might Devolve into Euro1 and Euro2 (March 2, 2010). (Other recent entries on the end-state of the European debt crisis:)
The Eurozone's Three Fatal Flaws (September 21, 2011)
The Dynamics of Doom: Why the Eurozone Fix Will Fail (July 25, 2011)
Why The European Union Is Doomed (March 28, 2011)

In any event, the last domino, the artifice of a single currency, will fall one way or another.

It's important to understand that the supposedly "prudent" economies of France, Germany, South Korea and Canada are just as heavily indebted as the U.S. or "drowning in debt" nations such as Italy. In the long view, is Germany's load of 284% of GDP really that different from Italy's 313%? Yes, the mix of debt is different, but the point is that all of Europe, and indeed the developed world, is overloaded with debt: state, bank and private.

The idea that leveraging more debt can resolve this gargantuan over-indebtedness is beyond absurd. (Source:BusinessWeek)

It has recently come to light that in the worst-case scenario (i.e. reality), "solving" Greece's debt crisis would absorb the entire EFSF Rescue Fund's 400 billion euros. By all accounts, every estimate of Greek tax revenue is overstated, and every estimate of its expenses understated; Greek GDP is collapsing. In all probability, the reality is worse than anyone is willing to confess, which means this chart is already outdated and hopelessly rosy:

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Way back in August, the euro was reckoned to be 20% above fair value of 1.15 to the U.S. dollar; once the dominoes start toppling in earnest, what will the euro's fair value be? Parity, or perhaps even lower? Why hold euros when the end-game is already visible?

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Central Bank Buying Means Gold to Rally to $2,000

Oct. 14 (Bloomberg) -- Gold may surpass $2,000 per ounce for the first time by early next year, as central banks in emerging markets add the precious metal to reserves to diversify away from the dollar, according to Mine Life Pty.

The CHART OF THE DAY shows the proportion of gold in the international reserves of India, Russia, China and Mexico is lower than the rates in the U.S., Germany and France, based on data compiled from the World Gold Council. The lower panel tracks central bank holdings in metric tons and the bullion price since March 2008. Central banks last year were net gold purchasers for the first time in two decades.

“I certainly expect international central bank gold buying to continue, especially in emerging economies where foreign reserves are growing,” said Gavin Wendt, founder and senior analyst at Sydney-based Mine Life, which publishes reports on the metals industry. “It’s the safest option for them.”

Immediate-delivery bullion has dropped 13 percent since setting a record $1,921.15 on Sept. 6. The metal is still up 18 percent this year, having outperformed equities and Treasury bonds because investors sought alternatives amid low interest rates and economic-slowdown concerns. The dollar, which mostly moves inversely to gold, was down 2.2 percent this year against a basket of currencies of six major U.S. trading partners by 6:22 p.m. in Shanghai yesterday. Bullion was at $1,671.99 an ounce at the same time.

Central banks, the biggest gold holders, have expanded reserves as bullion is headed for an 11th straight annual gain. Central bank and government-institution buying totaled 192.3 metric tons in the first half of 2011, World Gold Council data show. Gold accounts for 75.4 percent of the U.S.’s reserves and 72.7 percent of Germany’s. The ratio is 1.6 percent for China and 8.2 percent for Russia, WGC data show.

“Governments in many places like Asia and South America are rapidly embracing gold as a security mechanism,” said Wendt, who expects gold at $2,500 in 2013. “The value of their U.S. dollar foreign reserves has drastically fallen over the past decade.” Thailand, Bolivia and Tajikistan raised reserves in August, according to the International Monetary Fund.

Is the global economy facing a global banking crisis?

Posted by MICHAEL SCHUMAN Tuesday, October 11, 2011 at 6:31 am

6 Comments • Related Topics: bailouts, banks, china, europe, greece, politics, sovereign debt, wall street 

(Photo: Michel Gangne / AFP / Getty Images)

So it's official. The French-Belgian specialty bank Dexia is the first financial institution to fall victim to Europe's debt crisis. In a deal hammered out by the governments of France, Belgium and Luxembourg, Dexia will be dismantled, with the Belgian government nationalizing the local operations of the bank. Taxpayers are also on the hook for $120 billion in credit guarantees. I can't imagine that Dexia will be the only bank in Europe to meet this fate as the euro crisis continues to boil. Banks across the region hold festering compost heaps of rotting sovereign debt, spoiling the strength of their balance sheets. Some have holdings bigger than their capital. Greek banks are so exposed to their faltering government that I can't see how they dodge a bailout. French banks have been under pressure as financing has dried up. And with talk of a do-over for the proposed second bailout of Greece, as that nation's financial position continues to deteriorate, banks across Europe could be facing larger losses on their holdings of Greece's sovereign bonds.

And why stop there? Banks all over the world seem to be stumbling. Not only is the global economic recovery faltering under the weight of persistent unemployment, high commodity prices and debt crisis-induced austerity measures, but the global financial system, on which the global economy is built, is also too sick to help us out. And, even worse, the world's banks could need a whole new round of repair.

Of course, ground zero of this renewed banking crisis is Europe. But the shakiness of European banks has raised fears that problems on the continent could spread around the world, much like the Wall Street subprime fiasco of 2008 tanked global markets and ushered in the Great Recession. Eyebrows have been raised over the possible exposure Morgan Stanley has to European banks, for example. And then banks in the U.S. still have troubles of their own, leftover from the housing bust. Our own banking guru Stephen Gandel recently asked if Bank of America has turned into the walking dead.

And something worrying happened in my part of the world on Tuesday as well. Mighty China dipped into its sovereign wealth fund to buy up shares of major Chinese banks, which had been taking a serious beating. Banking experts at Fitch and elsewhere have warned that Chinese banks could be highly vulnerable, despite the nation's lofty economic performance – or should I say, because of it. Few believe the massive credit expansion China undertook to combat the Great Recession will leave banks unscathed. It seems impossible that they, too, could experience a spike in bad loans as a chunk of the debt built up sours.

The Dexia disaster and the problems of France's major banks have woken policymakers to the dangers they face if the world's banks aren't fixed up. At their weekend summit, German Chancellor Angela Merkel and French President Nicolas Sarkozy pledged a euro zone-wide effort to support the region's banks. As usual, we got lots of vague statements and no details, let alone action – this was a meeting of European leaders, after all -- but the bank repair plan is now supposed to be part of yet another grand scheme to finally quell the euro zone debt crisis, to be finalized over the next two weeks. I'll believe it when I see it. But the fact that Merkel and Sarkozy are talking banks at all is encouraging. Europe's policymakers had been in la-la land on the severity of their banking problem, despite warnings from, well, just about everybody.

How costly could a European bank bailout be? That depends on how much worse the European debt crisis gets. If we can stop at merely a Greek default, the burden probably won't be too heavy. But if the euro crisis spirals further downward, undercutting the value of Italian and Spanish bonds even more, then we enter the danger zone. A big bank bailout in Europe could then spread to a big bank bailout in the U.S. That's just one reason why acting sooner rather than later on fixing Europe's banks is so crucial. Look at what happened in Japan. After its property-and-stock bubble burst in the early 1990s, Tokyo refused to admit the country's banks were broken for half a decade. The failure to act quickly is one reason why Japan's post-crash downturn has lasted for two decades.

Will Europe's leaders do enough to fix its banking sector? That remains to be seen. Based on their previous attempts to contain contagion, my guess is that we'll all be disappointed. But to be fair to Merkel & Co., bailing out the banks in 2011 won't prove as easy as in 2008. The world has changed too much since then.

First of all, we have to ask if the governments of the West have the money to undertake a big bank bailout. Well, OK, they have the money, if they are able to use it. With austerity and budget cutting the priorities these days, there is a lot less room for governments to intervene and support banks as they did so aggressively after the 2008 crisis. So we're looking at a possible Catch 22 here. Governments need to shore up banks to protect them from the sovereign debt crisis and rebuild investor confidence. But the process of doing so places an extra financial burden onto governments, which could then intensify the sovereign debt crisis. Remember, Ireland ended up in a bailout mainly due to the costs heaved upon the government by its banking crisis. Belgium will likely see its government debt to GDP ratio increase simply because of the Dexia mess.

Secondly, the political situation in the West isn't as conducive to bank bailouts as it was in 2008. Bailing out Wall Street was less than a popular idea three years ago. Now, with angry protestors cramming Wall Street and the furor over banks escalating, any politician brave enough to spend yet more taxpayer money supporting bankers is taking a serious risk come election time.

So the best hope for everyone involved is that we avert a banking crisis entirely. That again puts all of the pressure on the leaders of the euro zone and their next great bargain. Let's hope it's just that. A bargain, but one that works.