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China won't let its Ponzi scheme crash... yet


China’s import and export growth likely cooled again in January according to a poll conducted by Reuters. The slowdown in China has been pressuring the entire financial food chain of the world’s second-largest economy, reminding some of the way a collapse in the U.S. housing market triggered a collapse in the financial system. Those fears have been exacerbated by rumors that China was going to allow one of its wealth management products ("WMPs") go into default; an eerily familiar sounding scenario for investors worried that China is facing its own so-called “Lehman moment.”

In the attached video Jeff Saut of Raymond James explains the product in question was being used as “sort of a Ponzi scheme.” Individual investors have been putting money into pools that are be used to buy high-risk assets like mortgage debt. When the debt comes due banks have been paying it down by raising new funds and investing whatever money is left over into yet more high-risk assets. Such schemes only work until there’s a high-risk default at which point raising new money becomes impossible.

Saut says the threat of contagion is real, which is why the Chinese are unlikely to let it happen. “The fact that they would let one go into default could cause a domino effect that could spill over. A few years ago there was only 200 WMPs now there’s over 200,000 wealth management products. I think that was one of the things that hurt world markets (in January).”

As Saut is quick to add, China is still growing at 6.5% and has ample existing reserves to keep the WMPs out of default for years. The risk of default isn’t going away but it isn’t likely to happen anytime soon. That’s hardly comforting in the big picture but if we’ve learned anything from the last decade, it’s that markets are willing to do just about anything in the name of short-term stability. According to Saut, the day of reckoning in China isn’t something investors need to be afraid of… yet.

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