7 Signs That China’s ‘Bubble Economy” Is About to Burst
— and What That Means for the Rest of Us
If you follow the mainstream financial media, you’re probably under the impression that all the problems threatening the U.S. economy today are homegrown — and that China is about to “eat our lunch.”
Don’t believe it. The reality is, despite its very real progress over the last three decades, China in recent years has been pursuing policies that in many ways duplicate the very same mistakes that led to the U.S. financial crisis — and will lead to a very similar outcome.
Only this time, the broader effects on the global economy — and on the U.S. in particular — could be worse. Much worse.
Don’t get me wrong. I’m not saying that China will never be the global economic superpower many are predicting. What I am saying is that there will be some big bumps in that road — and that one of the biggest is about to knock the wheels off the Chinese juggernaut.
Again, this is not my opinion alone. Nor is it the opinion of some Ivy League ideologue with no actual experience in the financial markets.
Exhibit A: Edward Chancellor, who, as author of the recent bestseller, Devil Take the Hindmost: A History of Financial Speculation, is not only THE leading expert on speculative bubbles, but is also an active asset allocation expert for GMO, the global investment management firm.
It was for GMO and its clients, in fact, that Chancellor recently wrote an 8,500-word internal “white paper” in which he argued:
“China is showing many of the classic symptoms of a great speculative mania alongside several of the leading indicators of financial fragility.”
He also warned that “China’s current situation is reminiscent of the late stages of the dotcom bubble.”
You read that right: the late stages. In other words, the “China Bubble” is about to burst.
To support his contention, Chancellor first analyzes the “classic signs” of speculative bubbles — and then shows how China currently fulfills each and every one. Here are the key ones, summarized and supplemented by my own analysis and that of other economists:
Classic “Bubble” Sign #1: A compelling but exaggerated growth story.
Every speculative bubble has one. Railroads in the 19th century. Radio in the 1920s. The Internet in the 1990s. Not that these things aren’t real; it’s just that their growth prospects become wildly exaggerated and extrapolated into the far-distant future.
China’s “growth story” is its own massive population. 1.3 billion people emerging from the slavery and poverty of communism into the freedom and prosperity of capitalism! 300 million country-dwellers — roughly equivalent to the entire U.S. population — moving into the towns and cities over the next decade alone — driving up demand for industrial commodities and consumer goods exponentially!
Compelling indeed — but there are worms in this apple. For instance, many new urban dwellers are essentially migrant workers who come when there is work, leave when jobs vanish, are poorly paid, and have seen little real wage growth over the last decade. “Equating the expansion of the urban population with the growth of the middle class is simplistic,” writes one expert on Chinese demography.
More important, thanks to decades of its brutally-enforced “one child” population policy, China’s population is actually set to decline in 2015, and its worker participation rate will peak this year — after which the numbers of people joining the workforce will fall off rapidly. If you would look at the real future of China, look at Japan, whose own aging population is the hidden cause of its continuing decline.
Classic “Bubble” Sign #2: Blind faith in the competence of authorities.
“One of the wonders of modern China,” writes Chancellor, “is that it has turned some of the world’s most ardent capitalists into fervent admirers of an economy managed by communists.”
But it is only the closed nature of Chinese society that allows this illusion to flourish. To the extent we can see what’s really going on behind the Great Wall of Secrecy, we find that China’s central planners are making the usual sorts of mistakes typical of their kind.
Such as:
A focus on “trophy investments projects” that leads to misallocation of capital
An over-reliance on exports, causing a growing trade surplus with the West – which cannot continue without inviting protectionism
Favoritism for state-owned enterprises (SOEs) that stifles innovation and private enterprise
GDP growth targets that the central authorities impose on local governments – which are liable to being gamed, and often lead to costly boondoggles
There's also a presumption that nothing bad can happen to Chinese banks because they’re a key instrument of Beijing's economic policy — and despite their long and proven record of bad lending practices.
“Too big to fail,” anyone?
Classic “Bubble” Sign #3: A government-fueled investment boom.
In a free-market economy, investments fall during periods of uncertainty. Yet in 2009, Chinese investments in fixed assets jumped by 30%, rising to a record 58% of GDP. Roughly a quarter of this investment was state-directed, with many projects serving solely to meet local GDP growth targets.
One commentator says China is following the “Asian growth model on steroids” — i.e., the pattern of the Asian Tiger economies, boosting growth through ever-increasing investment, which led to the Asian Crisis of 1997-98.
The difference? China's investment share of GDP is higher than any Asian economy in history — so its problems are potentially greater.
Classic “Bubble” Sign #4: “In Real Estate We Trust”.
You’d think China would have learned something from the U.S. housing crash. But despite our cautionary example, Chinese authorities are pursuing massive commercial and residential real estate construction despite lack of perceptible demand.
Among the results: the newly constructed “ghost town” of Ordos in Inner Mongolia — with housing for a million, and virtually no residents.
“Build it and they will come” — or maybe they won’t.
In addition, for Chinese households, artificially low rates of interest on their savings are also driving them into speculating in real estate — just as Americans did in the years leading up to the 2008 crash.
As a result, in China today, residential real estate is averaging between 20 and 40 times average household income — compared to roughly 10 to 12 times household income at the height of the U.S. housing bubble in the most overvalued neighborhoods.
“This has to qualify as the most dramatically overvalued real-estate bubble in world history,” writes Steven Jon Kaplan of TrueContrarian.com.
Why isn’t this all over the financial media? Explains Kaplan: “While there is no way to know for certain, it is possible that the Chinese government has forbid any discussion in their local media of the possibility of a real-estate collapse in that country, so as to prevent widespread public panic..”
But that can change rapidly. “As soon as the psychology among the average Chinese person switches from ‘real estate only goes up’ to ‘I’d better sell before my neighbor does,’ an accelerated pullback is likely—as anyone in Tokyo, Dublin, or Phoenix can attest.”
Classic “Bubble” Sign #5: A surge in corruption.
“All great speculative manias have been accompanied by rising levels of fraud,” observes Edwin Chancellor — and it’s only after the bubble bursts that the Madoffs and Enrons come to light.
Here, of course, is where the closed nature of Chinese society is especially worrisome: China recently earned a dismal 3.5 (out of 10, for “very clean”) in Transparency International’s 2010 Corruption Perceptions Index, giving it a rank of 78... just below Tobago.
More worrisome: the real estate boom and infrastructure spending that are driving Chinese growth areespecially susceptible to corruption. As evidence, the New York Times reports that while China is the fastest-growing market for luxury goods, half of all those luxury sales are estimated to be bribes.
“Endemic corruption,” writes China expert Professor Minxin Pei, “steadily increases a country’s systemic risks. As a result, its financial system is fragile, its environment degraded and vulnerable, its law enforcement establishment tainted and ineffective, its infrastructure insecure, its public health service unresponsive, and its regulatory system creaky.”
Classic “Bubble” Sign #6: Easy money and risky lending.
From the Tulip Mania of the 1630s — which was funded with IOUs — to the U.S. housing bubble, all great speculative manias have been inflated by easy money.
Likewise, China today is keeping interest rates artificially low to promote investment and subsidize state-owned companies.
Consider: For the past 40 years, the interest rate that major U.S. companies have borrowed at has been, on average, 1 percentage point higher than the rate of GDP growth. In contrast, the Chinese prime borrowing rate has been on average 9 percentage points below GDP growth over the past two decades.
What's more, Beijing responded to the 2008 financial crisis and the resulting collapse in its exports by ordering its banks to lend. In 2009, new bank lending grew by nearly 10 trillion renminbi ($1.5 trillion), or around 29% of the country's GDP.
“The size of this credit expansion is worrying in itself,” observes Chancellor. “It beggars belief that lending could have expanded so rapidly without some decline in underwriting standards..”
Indeed, much recent bank lending in China resembles the lowered underwriting standards that led to America’s subprime-mortgage meltdown of 2007-8. For instance, up to half of 2009’s bank loans went to local government funding vehicles that appear to have little or no current cash flows. Instead, local governments are now depending on asset prices for revenue — much as they did in places like California during America’s housing bubble.
Classic “Bubble” Sign #7: A fixed currency.
“Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts,” cautions Chancellor.
China’s currency, the renminbi, is “pegged” (fixed) to the U.S. dollar — leading to an undervalued exchange rate that boosts exports, keeps interest rates low, and encourages massive inflows of foreign capital.
But anyone who thinks that China’s enormous foreign exchange reserves render its economy invincible is delusional. As Professor Michael Pettis of Peking University’s Guanghua School of Management has pointed out, the only two countries which have previously accumulated such large foreign exchange reserves relative to global GDP were Japan in 1989 — and the United States in 1929.
And get this: The Bank of China is printing as much as $2 billion worth of renminbi per day in order to buy dollars and maintain the currency peg. The money supply skyrocketed 26% last year in China, creating an artificially booming economy that cannot last and will eventually cause a collapse.
Savvy investors agree. In a recent Bloomberg poll, a majority (53 percent) of professional investors, traders and analysts said that they consider the Chinese economy to be in a bubble fueled by speculation.
As one currency strategist put it, “There is no doubt that China is in the midst of a speculative, credit-driven bubble.”
He then likened the expected fallout to the aftermath of the U.S. subprime-mortgage meltdown.
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