I just read a newspaper article that suggested the “R” word is starting to be used in financial circles around the world. What’s the “R” word you may ask? Recession. If the world heads into a recession, then is this going to have a significant impact on domain investors earnings? You bet it will!

I remember reading an article posted by an industry blogger (not me) just post the Global Financial Crisis of 2008 that outlined that it was great being a domain investor because we were immune to the global meltdown. I must admit that I scratched my head and posted my own article that rebuffed this position.

The domain industry IS part of the global business community and in fact, in many respects we underpin much of it. When businesses are suffering then guess what! They spend less on advertising which depresses earnings per click rates and spend less (or not at all) as much on acquiring domains as they protect their cash.

Just this past week the German 10-year bond rate went negative. What this means is that you have to pay the government to look after your money. This sounds crazy until you realise that the recent issue was oversubscribed by 2.6 times. This suggests there is a flight of cash away from riskier higher yield paying countries (eg. Italy and Greece) as investors are more concerned about keeping their money rather than receiving earnings.

For a while now I’ve been concerned that due to China’s massive appetite for debt it was going to experience a severe correction. When you consider the debt levels in China, they absolutely dwarf the levels the USA experienced during the global financial crisis of 2008. So where is China at now and are the debt levels like an elastic band that is being stretched more and more?

It’s estimated the total Chinese debt-to-GDP ratio has risen to 317 per cent at the end of 2017. Compared to 158% at the end of 2008 means this number is continuing to rapidly increase.

In real terms this means the amount of debt in China grew to RMB 262.1tn at the end of 2017, representing a year-on-year grown of 13.5 per cent. Considering China’s nominal GDP growth was at 11.2 per cent yoy in 2017, the rate of credit grown continued to exceed the rate of nominal growth.

The International Monetary Fund (IMF) pointed out in 2016 that it took four units of debt to raise the GDP by one unit. A decade ago the ratio was 1.3 to one. It’s clear that China has a serious debt problem that could potentially drag the global economy down.

I’ve written a number of articles over the past year on the looming problem of the Chinese debt situation. It’s currently just shy of 300% of GDP and this doesn’t bode well for domain investors reliant on cheap Chinese capital to purchase their domains at hugely inflated prices. So should we really panic?

I saw the following charts in a recent Bloomberg article that puts the Chinese debt problem into perspective. What’s interesting about this chart is that China’s flatter line shows that it’s not getting as big a GDP bang for its debt buck compared to some other nations. Also notice that Germany is retiring debt even while sharply increasing its GDP per capita.

The USA is continuing to increase debt while getting a lot of GDP per capita from it.....but the debt still continues to increase. At some stage the piper has to be paid and if the current trends continue it will be more when not if.

I’ve taken a great deal of interest in the Chinese economy of late and I’ve written a number of articles that outline how everything is not so good in the dragon nation. Debt continues to skyrocket, GDP is levelling off and there appears to be stockpiles of commodities that are unused. So how is this all going to impact domain investors?

CNBC published an article, “Moody’s raises worries over China loans as Communist party paper calls debt load ‘original sin’”. Within the article, influential investors Kyle Bass and George Soros warn of a credit crisis in China, with Bass noting the presence of “ticking time bombs” in China’s banking system.

What really struck me about the article was the second video where an independent economist, Andy Xie, suggests that China’s real bad loan situation is closer to 20% and not the 1.5% being reported. He then went on to say that over half the loans relate to property and that all across the country buildings empty and that they are being traded like gambling chips. Everyone is hoping that someone else will pay more for the assets.

The Economist recently wrote an article titled, “The coming debt bust”, which outlined the fact that China’s overall debt is 280% of GDP. One scary statistic is that 16% of China’s top 1,000 firms owed more in interest than they earned before tax. Debt levels are expanding twice as fast as the economy. Market Watch recently indicated that it takes four units of credit for each unit of growth.

So will the Chinese authorities be able to manage the economy to a hard or soft landing? They have plenty of ammunition in their reserves (around $3 trillion) but more and more commentators believe that the current regime is playing catch-up to rapidly changing economic circumstances. What everyone appears to be saying is the debt piper is calling….

If there is a hard landing how will this impact domain investors? Since China is the world’s second largest economy we can draw a comparison between it and the US sub-prime fuelled crash of 2008.

For traffic portfolios, Google immediately took greater margin in a great cash grab to help support their earnings. The difference we are seeing now is that Google’s TAC (Traffic Acquisition Costs) has been pushed down to the point where they really can’t increase margins without losing market share to tier two advertising networks. This means that we are unlikely to see a collapse in earnings per click rates induced by Google.

The other factor impacting the advertising auction system is obviously the companies bidding for the traffic. In the event of a crash many companies will immediately hold onto their cash and reduce discretionary spending (which online advertising is often seen as). This will place downward pressure on EPC rates and depending upon competition for the market vertical keyword how far down the rates will fall.

Domain sales will almost certainly experience a sharp correction (especially in the ChiP domains) as debt laden Chinese buyers suddenly become sellers at any price. In many cases, off-market margin loans have underpinned domain valuations and these loans will be called as stocks collapse in value. Chinese investors will be forced to sell domain assets to meet their lenders capital requirements.

Assuming that the world doesn’t go into a global depression, what’s the good news? If you’re cashed up, then there’s going to be a heap of bargains. A good rule is most people make money on the buy not just the sell. In other words, in this type of market there will be domains available that can be snatched up for a song and later sold at an enormous profit.

Whatever happens, make sure you have some cash to ride out the crisis. Some commentators are suggesting that the GFC of 2008 was a tremor before the real financial earthquake.

I know that my wife and I are reviewing our personal financial circumstances to help ensure that we are in a position to weather a global storm. We periodically do this but right now I’m getting a sense of urgency about it. If I’m completely off the mark, then the worse that we’ve done is be financially prudent.

Remember, many people make a fortune in the bad times by being wise in the good times.

I’ve been concerned about China’s debt levels for quite some time and the impact that a Chinese economic meltdown may have on the domain industry. After returning from a week’s vacation I decided that it was time to start digging into the data and piecing together a number of anecdotal data points.

It didn’t take long to discover that just about every major investment media source is concerned about China’s debt problems. Back in October 2015, The Economist had a little chart with the title, “Still Bingeing”, that outlined China’s total debt as a % of GDP. The chart can be viewed below

On the 22^nd Feb, Bloomberg News had a headline announcing that China’s debt will peak at 283% of GDP in 2019. To put this into perspective, the USA debt to GDP ratio is 104%.

Having a debt ratio of China’s magnitude is scary to say the least and many commentators suggest that this is only sustainable as long as China is able to maintain a GDP growth of greater than 6%. The problem is that the Chinese economy has not been growing as fast as the increase in debt levels.

For example, the country’s banks extended a record $US385 billion of new loans in January. Bloomberg news stated, “The increase in debt could pressure the country’s credit rating, Standard & Poor’s said on Tuesday, less than a week after the cost to insure Chinese bonds against default rose to a four-year high.”

The first problem is the Chinese economy is slowing down and is being propped up by massive injections of capital in the form of debt. So called state-owned “zombie” companies are being constantly bailed out rather than put down. These companies can repay the interest on loans but not the principal which just exacerbates the problems.

The second problem is the Chinese fuelled real-estate bubble collapses. Beijing and Shenzhen are up by more than 700% since 2000 and this has driven Chinese investors to look at high end top coastal cities in English-speaking countries. For example, Sydney, Melbourne, Auckland, Singapore, San Francisco, LA, Vancouver, New York, London….

The Chinese real-estate market has been falling for over a year and investors looked to the stock market, driving it up by over 160% in mid-2015. Dumb money entered the market and within 2.5 months the Shanghai Composite Index fell 42%.

The Chinese government has been trying to prop up the market ever since by buying hundreds of billions of dollars in stocks. This is an artificial way to keep the stock values from collapsing but ultimately the companies will be devalued to their true worth.

Some commentators are suggesting the index should fall by as much as 80% and sit around 1,000. Just watch the fall-out in the international real-estate markets when this happens!

What’s really interesting is the “non-performing loans” have jumped by over 50% between Dec 2014 and Dec 2015. “Non-performing loans” are loans where the borrower is defaulting. It will be interesting to see if the Chinese banking sector is healthy enough to handle waves of defaults. As 2008 proved the USA banks weren’t up to the challenge.

In the next article in this series I will apply this background of information on China to the domain industry.

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Michael Gilmour has been in business for over 32 years and has both a BSC in Electronics and Computer Science and an MBA. He was the former vice-chairman of the Internet Industry Association in Australia and is in demand as a speaker at Internet conferences the world over. He has also recently published his first science fiction book, Battleframe.

Michael is passionate about working with online entrepreneurs to help them navigate their new ventures around the many pitfalls that all businesses face. Due to demands on his time, Michael may be contacted by clicking here for limited consulting assignments.