ICangles Investment Post…
The story of the Chinese economic miracle is well known. Since opening its economy in the 1980’s, China has followed an export led development model to become the world’s factory, leading exporter and second largest economy. The 2008 Olympic opening ceremonies gave China an opportunity to showcase its success to the world, including with a miraculous display of firework footprints marching across the sky. But in China all is not as it first appears. It turned out the firework footprints seen on televisions weren’t really fireworks, but rather CGI special effects. Similarly, a closer inspection of the Chinese economic miracle reveals some financial special effects at work.
Over the last decades the world has seen the Japanese economic miracle unwind and sink that country into deep debt, the South East Asian crisis similarly revealed the limits of export led development models, while the dotcom and real estate bubbles further demonstrated the consequences of cheap money flowing into overpriced assets. Of course in the case of China one hears the four words famous investor John Templeton coined as among the most dangerous, “this time is different.” However, the only way this time is likely to be different is that it will be worse than preceding occasions.
China maintains a currency peg that nearly all observers agree undervalues its own currency to allow for greater success exporting goods. When China sells exports it is forced to do something with the money earned. If it simply runs a trade surplus with a country, such as the United States, and keeps the money then a free floating currency would appreciate against the U.S. dollar. Chinese exports would become more expensive in such a scenario and fewer goods would be sold. To avoid that outcome China doesn’t simply keep the money earned. To manage its currency, keeping it an artificially low level, China buys things with the money earned abroad, including purchasing American debt in the form of Treasury bonds. The Treasury bond market is uniquely large and liquid enough to handle massive purchases.
This arrangement where America buys exports and countries, such as China and Japan, buy American debt in return, is commonly referred to as Bretton Woods II, and is the basis for the world’s monetary system. Not surprisingly for a system predicated on debt and called monetary LSD by one well known economist, it is currently unwinding. And China is economic ground zero. The exaggerated buying of U.S. debt contributed to an artificially low interest rate environment that fueled the global housing bubble. Rising home values allowed people, especially Americans, to buy a lot of items, including imported goods. After the real estate bubble finally burst and plunged the developed world into recession, central banks lowered rates further and created trillions in new money to prop up the decimated financial system.
Pegging its currency to the U.S. dollar means China imports U.S. monetary policy complete with all that cheap money and low interest rates—the same type of fuel that led to America’s real estate bubble, but at lower rates and with higher consumer inflation in China this version is even more potent. All this cheap money entering its economy leads to inflation, and China is struggling to contain both asset and consumer price inflation. After engaging in its own enormous stimulus plan to avoid recession, China’s government has since tightened lending standards and regulations, in order to lower the velocity of money and contain inflation. But the only real solution is to revalue the currency, which would make Chinese exports less competitive and risk rising unemployment.
China’s policy makers have faced difficult decisions, and in a 2005 column I wrote for Semiconductor Manufacturing Magazine “Dragon by the Tail” I predicted that would be the case for China’s export led development model, with the decisions made resulting in either a better or far worse outcome than Japan’s slump. My view is that a very negative outcome is now in the works. Although China avoided joining the world in the recession at the end of the last decade, it created growth by magnifying its own bad debt problems and creating an enormous real estate bubble.
Despite official figures showing nothing to worry about, some analysts put China’s debt to GDP ratio at 160 percent, and Fitch projects that non performing loans could reach as much as 30 percent of China’s entire loan portfolio. The erroneous view that China is in a strong position because of the amount of foreign debt it holds was addressed in my last post, so I am not going to again go over the unhealthy position of its central bank and the liabilities it holds. It is worth pointing out, however, that China’s central government cannot tap those assets to bailout a banking system and local governments that likely will badly need recapitalization. And although the exact figures of China’s debt problem and its full scope is complex, the nature of its real estate bubble is straight forward.
Businesses, local governments and individuals earn less in interest than inflation erodes if they save money in a Chinese bank. This is a powerful incentive to invest in real estate. In addition local governments count on land sales for around 40 percent of revenues, encouraging their participation in making loans to fund such sales. Lastly, there is the simple lure of a rising market and profits to entice investors into Chinese real estate. As a result of these powerful incentives, as well as tightening credit standards, a shadow market for lending has arisen in China that is centered around real estate.
In a country where statistics and financial records are falsified, as well as fireworks footage, this shadow market is aided by similar subterfuge at all levels. Local Chinese governments for instance created over 6,000 companies to avoid lending restrictions, Moody’s estimates that the exposure of banks to local governments is underestimated by half a trillion dollars and the size of the total shadow lending market is projected anywhere from hundreds of billions to a trillion dollars.
As a result of this shadow market, the cheap money keeps flowing and the central government’s efforts to cool off the real estate market have completely backfired. Some estimates link half of Chinese GDP to real estate activities, while a square meter of some property in China is estimated at 164 times per capita income versus 33 in Japan. The real estate collateral securing local government bonds is often overvalued or even non-existent. Real estate investment groups are showing rising profits by increasing the value of land already owned on their books and using those “profits” to borrow and buy more real estate. In 2010 China’s state grid reported 64.5 million apartments not using electricity for six months, and in a country that is already building unoccupied “ghost cities“, the government has plans to keep building 20 new cities each year.
China’s real estate bubble when it bursts will make America’s look insignificant for citizens in a country that lacks social safety nets. The impact on the middle class investing in real estate, supposedly non-real estate related businesses already attributing significant portions of their income to real estate, exposed local governments and China’s banking system will be horrendous. Furthermore if previous economic crisis are any indication the worst case estimates of bad debts may turn out to be too optimistic. It all adds up to an outcome China’s economic model is not equipped to handle.
UPDATE: Here is a link to a July posting on Chinese malinvestment and need for financial reform by finance professor Michael Pettis and a September article “Are Chinese Banks Hiding “The Mother of All Debt Bombs”.”