The China Credit Crisis

TheStreet.com

NEW YORK (TheStreet) -- China has the largest credit bubble in the world.

We have tracked the private sector credit in China for the past several years. It's a parabolic curve, and as market observers know, parabolic moves eventually collapse.

My e-book, "The Coming China Crisis" (150 pages), one year ago predicted a crisis. It was greeted with great disbelief, similar to our book written in 2007, "Prelude to Meltdown," which predicted that 2008 would see a potential meltdown in the U.S. system. Very few people believed it and the financial media ignored it. But now it has surfaced.

This month, on June 20, the global markets were shaken by the big overnight surge in short-term interest rates in China. The Shibor rate (similar to the short-term Libor interest rate in the western world) soared to over 11% overnight. The overnight repo rate soared over 25%.

The Chinese news media said this is intentional action by the government to crush the out-of-control shadow banking system. I don't believe that. It seems more like things have gone out of control and they don't want to acknowledge it. So they say, "We did it on purpose."

The global stock and commodity markets tumbled. Analysts in the U.S. quickly blamed Federal Reserve Chairman Ben Bernanke's statements on May 22, although he said nothing new. In fact, he even said that there is no time limit on the current stimulus of $85 billion and, if conditions require it, it would continue. Most analysts are looking in the wrong direction. Interestingly, the president of the Fed of Minneapolis, confirmed on June 28 on CNBC that "the markets had it wrong."

Our work says that the highly leveraged trading outfits like hedge funds were caught by surprise with the events out of China. On that day, the DJI plunged around 350 points, gold lost around $100, closing below the critical 1300 support level, and bonds plunged as well. The highly leveraged trading operations were selling anything that had a bid in order to raise cash.

My view is that a China crisis would infect the entire globe. And that is what we have been writing for the past 18 months. No one will be immune.

According to Fitch Ratings, total credit in China has grown from $9 trillion in 2008 to $23 trillion. That's bigger than the entire U.S. banking system. The "shadow banking system," which is largely unregulated and partially illegal, is over $10 trillion. That's enormous.

The China credit markets are virtually shut down. Small to mid-sized firms are unable to get credit anywhere. Credit is the lifeblood of the economy, which is the basis for the "Theory of Liquidity & Credit" that we developed in the 1970s. According to our theory, when credit tightens like this, a recession, or worse, is inevitable. In 1990, this allowed us to predict the bursting of the Japanese bubble. Now, we see the same happening in China.

Chinese companies have tremendous corporate debt burdens, requiring them to pay US$1 trillion in interest this year. Much of current liquidity is being used to repay debt rather than finance output.

After a great party, the hangover is proportionate to the amount of fun you had. The stimulus-induced party In China has come to an end. However, because the central government owns the big banks, you won't see a banking crisis like that in the west in 2008. The government can bail them out. However, a total seizure of private sector credit creation will cause a deep recession. And that is likely to infect the global markets, first the emerging countries, and then the rest.

The effects of an imploding private credit system will cause an avalanche of bankruptcies amongst the smaller to mid-sized firms. That will cause a lot of social pain, spreading the unrest we've seen in recent years to Asia and China. Expect riots in the streets, similar to what we saw in Greece, Turkey, Spain and other countries.

Much of China's problem is out of the realm of control of the communist government. The export market has had a big decline in growth due to the European recession. This year, Japan's huge devaluation of its currency has given Japanese goods a big advantage in the world's markets.

China needs a Gorbachev. It needs to get rid of communism, introduce free markets, give people a voice, fire the 100,000 people who censure the Internet and let entrepreneurship flourish. Otherwise, China will go the path of all communist nations: an eventual demise of the system.

Written by Bert Dohmen.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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