Why shipping investors must acknowledge financial risks

Market Realist

Will China's financial crisis crash the dry bulk shipping party? (Part 7 of 7)

(Continued from Part 6)

Imperfect financial data

Critics are quick to point towards China’s manipulation of data. But it’s also important to consider that China’s economy is changing quickly, which makes activity hard to track. Add to this the fact China is a country with a population almost four times as large as the United States’, and you realize quality data is hard to come by. If quality data is hard to come by, we can borrow from what the market knows.

Credit default swap

The credit default swap is an instrument used by investors and speculators to hedge against or bet on a default. When China’s economic activity was expected to slow substantially and default rates were predicted to climb, prices of a credit default swap (the cost of insuring against a bond default) have historically risen. Since those who trade the credit default swaps are professionals, they tend to be more knowledgeable, which makes the cost of insurance a valuable indicator.

Risk is higher than pre-2008

The current cost of insurance ($50 to $100) suggests higher expected loss in the event that the Chinese government defaults on its loan, compared to pre-2008. This reflects overcapacity in the manufacturing sector, increased financial risk spurred by cheap credit, and an economy that can’t rely on exports as much as before. If cost starts to shoot above $100, they could spell trouble. This happened once in mid-2013, and the Chinese stock markets fell (see below). On January 13, 2014, the cost of insurance stood at $90.99, following the recent run-up in interbank lending rates.

ShenZheng outperformance

As soon as the interbank lending rate rose to a multi-year high (see the previous articles in this series), the central bank injected funds into banks. Since then, the Shanghai stock exchange, largely comprised of financial stocks, has moved sideways, while the ShenZheng stock market, an index that contains smaller and private enterprises, climbed.

Acknowledge risk

So far, however, China has been successful at engineering a soft landing—maintaining low credit growth while keeping its financial sector and economy afloat. Low inflation means the government has tools to stem a financial crisis. The chance that the government will allow one of its major banks to default is unlikely, because this would look like it were casting its own child out of the family—not sure how the public will perceive this, since family plays an important role in Chinese culture.

But if a default were to occur, emerging markets and the Guggenheim Shipping ETF (SEA) would be negatively affected. While a default isn’t a key driver until it happens, it is a risk that dry bulk shipping investors must acknowledge because crises are a part of life.

To learn how China’s economic activity is performing, visit this new Market Realist series: The must-know economic currents that affect dry bulk shippers.

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