We sure have had a busy week. Geopolitical risk grew to its most alarming point with an impending missile launch from North Korea; as a result, talks were held, defense systems were engaged, and warships were deployed. Next, investors became equally frightened by the tragic bombing in Boston and the below-consensus blow of a soft Chinese GDP. Gold was the next particle to react, a frantic drop that not only dragged down base metals but renewed pessimism on China and the commodity supercycle, and prompted Goldman Sachs to switch to a short position. Finally, we arrived at a heightened alert on China’s growing credit risk. Since then, we have seen the IMF and the CIC providing some calming views on China.

Is there a strong relationship between all the events in the last week? Yes and No. These events have all more or less centered on China, (unfortunately even the Boston bombing, since a Chinese student was amongst the dead) however, finding causality between them can prove to be nonsense. Just as a security analyst may tell you, it is all about China and its growth prospect. China is steering through a much more complicated global environment now than 5-10 years ago, and China is slower, bigger and sicker this time around.

A soft China has unnerved global markets, especially in commodities. The latest movements in gold are perhaps an exaggerated picture of the structural change that is undergoing in global markets. It is perhaps a wave, created by China, sent through to the world, proclaiming that the last standing man is also sick. Many would perhaps prefer the expression ‘when China sneezes, the world catches a cold’.

Here we offer an integrated view rather than a focal study on an isolated case. The supercycle can be seen as much more a global phenomena than a commodity specific idea. The flow-on effect of weak advanced economies which have reached their debt limit, have entered into deleveraging; this dampens demand for exports from countries such as China, and China itself is faced with internal structural malaise; commodities and commodities exporters are located at the very beginning of the global supply chain, and they are also set to suffer. The supply side for certain base metals such as steel and aluminium have reached overcapacity, thanks to China; which means the end of the supercycle for these particular commodities.

China has clearly reached a turning point, where its growth is slower and its structure needs to change. In the process of all these, credit growth is both a necessary positive development and a potentially risky area, if unmanaged. The current debate around whether China is faced with an immediate credit crisis produces much greater differences in perspectives than hard-number backed forecasts. Partially, this is due to the lack of transparency in the shadow banking industry in China.

The truth of the matter is it is hard to tell, but there is definitely increasing pressure from local government debts, shadow banking, consumer credits and high yield seeking investment facilities that are all adding weights to the system.

Here are some typical things that mark impending credit crisis:

• Ponzi financing structures
• Collateralized debts that require refinancing based on a bubbly underlying asset, to roll debts and pay interest
• An ever expanding underlying asset that spirals up with debt levels
• Debt instrument innovation that lead to high risk seeking behavior, or high yield debt instruments
• Market contagion/crowd behavior that provide a self-reinforcing asset bubble
• Easy monetary environment and a lack of regulation
• Beliefs that the upside will last forever

We know that it is the need to seek higher returns that pushed many banks to innovate in the US prior to the GFC, and contributed to the eventual financial blowout. That innovation is taking place in China right now; it seems they are concentrated in consumer credit, shadow banking facilities and in capital markets to some extent. Local government debts, although in serious trouble, are arguably manageable due to their relative visibility. What is more of a concern is shadow banking and consumer credit that encourages Ponzi financing behavior.

The government has made it clear that the next stage of urbanization will depend on capital market debt financing, so it is inevitable that the next stage of growth in China will be driven by debt. It is useful to remember that leverage is a good thing if it is backed by reasonable cashflows; and vise versa.

In trying to determine the stage of China’s credit bubble, we need to ask ourselves, how much collateralized debt is in circulation and growing? How is the property market going to do? Are there increasing amounts of Ponzi financing in the system.

The answer is risk is growing because there is more Ponzi financing behavior in risky credit facilities dealt in the shadow and also by the banks. But it is hard to call for an overnight property market collapse at this stage. Local government debt and local government financing vehicles will no doubt be receiving a lot of attention from the government from now on.

Intuitively, it is perhaps useful to remember that credit bubbles are not uncommon in history, nor do they mark the end of the world. If it happens to China, it will surely deal a terrible blow to Chinese growth and to the world. However, it is perhaps inevitable at some point.