How To Profit From the Coming Burst of the Chinese Credit Bubble

China has quickly become one of the most important parts of the global economy, as its GDP exploded in the past decades, and today a huge portion of the global growth is attributed to the country. This means that a crisis in the country would have a much larger effect on the global markets and economies than any time before. In the aftermath of the US credit crisis, China restarted its struggling economy with an enormous stimulus program that was fueled by cheap credit and central infrastructural projects.

The corporate sector was also flooded with capital, in partly through the infamous shadow banking system, to maintain the rate of growth. This expansion fueled bubbles everywhere from the stock market to the housing market. To put the increase in outstanding debt into perspective here is a comparison with the other countries that experienced credit crisis before and the effect on the local housing market.

The problem is that the recent growth in economic output has been far from efficient and the projects that have been financed are highly unlikely to be sufficient for the debt service, let alone “real” profitability. For an investor, the most important thing is that the Chinese banking system will face a huge solvency problem that one way or another will be solved by the government. This restructuring will be very painful, and it will require a large portion of the reserves of the country.

Debt growth fails to boost the GDP anymore, but housing prices surge (source: Barron’s)

How will this affect your portfolio?

In the 2015-2016 period, the Chinese market decline caused a deep correction in international stock markets as well, while the main industrial commodities also fell sharply. The same dynamic is expected to continue, as the crazy level of construction activity declines. A Chinese “hard landing” could very well cause a global bear market, especially given the lofty valuations in the US and other developed countries.

On another note, history tells us that if a country can heal the wounds of a banking crisis by devaluing its currency than most likely it will. Also, the Chinese leadership has already used the “competitive currency” tool before, as a foundation of its cheap labor based growth model that transformed the country to the modern China that we know.

That model is now in a seismic shift towards a consumption based economy, but there are serious bumps in the road ahead, with the current credit excess being the first major one. The Chinese Yuan already declined by around 15% against the USD, as the Chinese interest rate fell, and it’s almost granted that it will fall much further before the restructuring concludes.

How to play China in a smart way?

As profiting on the decline of the Yuan is not easy, investors could look for other, less direct ways to profit from the inevitable burst. Gold is an obvious choice in the case of a credit crunch, as the masses will further lose their faith in central banks and fiat currencies, while the central banks will once again try to print their way out of the problem. Bitcoin and cryptocurrencies are also already profiting from the Chinese situation, as Asian demand for them is skyrocketing. This will likely accelerate, as the situation in China deteriorates, and the debasing of the Yuan gathers steam.

Another way to play the crunch is to go short the assets that will be affected the most, like industrial commodities (copper, iron ore, aluminum etc.) and the related companies, stock markets, and currencies like the Australian Dollar and the Canadian Dollar. Chinese stocks will also likely decline in value, but shorting them is not easy for an average investor. Most importantly, reducing your exposure to risk assets, mainly stocks, is a good idea, as bonds are a much better bet in the times of credit deflation.

With most markets still trending higher, gradually selling into strength is still possible and easy. It’s also highly likely that in the coming years there will be great opportunities to get back into risk assets. That said, exactly timing the end of a bull market is impossible, and it could be frustrating to sit through several months of gains, but market declines are usually quick and devastating and staying calm in those times is even harder.

Trader and financial analyst, with 10 years of experience in the field. An expert in technical analysis and risk management, but also an avid practitioner of value investment and passive strategies, with a passion towards anything that is connected to the market.