- Bubbles always last longer than you expect
- Warning signs are coming out of China
- The truth about my analysis of China’s bubble economy
If you’ve read this far, you’ll know that the final paragraphs of today’s edition will reveal a surprise about my analysis. You might already be suspecting it. But let’s consider when China’s bubble might burst…
What’s to say China’s vast misallocations of capital cannot go on uncorrected for quite some time yet? The Soviets managed to plod along for a while. The PIGS property boom and the sub-prime bubble lasted many years too.
Well, as was mentioned above, debt is what is bringing much of the Western world to its knees. China, it is thought, maintains a comparatively low debt-to-GDP ratio. But you have been lied to. And just as debt brought Greece, Ireland and many American States to their knees in 2008, so too will China struggle to maintain “political stability”. The anti-austerity riots of Athens, London, Wisconsin and Spain will feature in China when the borrowing can’t be maintained.
Chinese government officials were directed to engineer a certain level of GDP growth (regardless of the value of that growth to individuals) in response to the spreading economic crisis of 2008. The most bureaucratically convenient method to do this was to borrow and build houses. And so that’s what they did. On a staggering scale. We’ve looked at the construction side of things above. But that’s done and dusted. It’s the debt that Chinese governments racked up in the process of construction that should have you worried.
Northwestern University’s Professor Victor Shih estimates the extent of the government’s borrowings:
“If you take a very broad view of the Chinese government’s contingent liabilities rather than explicit debt on the books then the number comes to well over 150 per cent of China’s GDP in 2010.”
In the same article, Time Magazine blogger Roya Wolverson points out that Professor Shih’s figures are “a good deal more than the government’s official debt load of less than 20% of GDP.” And 150% is well beyond what academics Reinhart and Rogoff identified as the point of no return for public debt levels in their book This Time is Different. (The title offers a further clue to the nature of the issue.)
Chances are that this build-up of debt is not quite what the high-level Communist party planners had in mind when they instructed local governments to generate growth. In fact, it seems that local governments became rogue borrowers in their attempts to meet growth targets.
Realising their mistake, senior Chinese officials ordered an investigation. The first Chinese government audit of local government debt found a total of 10.7 trillion yuan in debt, with 8 billion yuan already overdue. Debt ratings agency Standard & Poor’s estimates 30% of these bank loans to “turn sour”.
When the higher levels of government first realised what kind of leverage was being pumped into the economy, local governments were prohibited from more borrowing. But they still had their growth targets to meet. (Coming up short could end a glowing bureaucratic career in “the Party”.)
So, following the lead of Wall Street Banks, local governments set up 6,576 “financing vehicles” according to a government audit. This is essentially the same practice that the likes of Enron, Bear Stearns, Lehman Brothers and Greece used to hide their debt and continue racking it up.
The financing vehicles went on to borrow 4.97 trillion yuan, with approximately 60% of that effectively owed by the government, according to the government audit. Other figures, from the Chinese central bank, suggest a problem of slightly larger proportions. By its count, ten thousand financing vehicles had been set up, coming to 7.7 trillion yuan.
“It seems the government doesn’t have a concrete idea what is a local government financing vehicle and what isn’t,’ a Credit Suisse analyst told Bloomberg. “The biggest problem is it’s very difficult to define in China what is private and what is public.”
Again, this is very familiar. In the US, the companies that treaded this line of “public or private?” ended up costing the US taxpayer billions in bailouts.
Fannie Mae and Freddie Mac, to name two, were linked to the housing market and the debt racked up in the boom. The bailouts of General Motors and Chrysler reek of political motivation in the same way that Chinese planners target “political stability”. (Auto workers fared significantly better than they would have under ordinary bankruptcy proceedings.)
It seems China selected the worst parts of American crony capitalism and claimed them as its own.
Bloomberg sums up how Wall Street sees the Chinese problem playing out:
UBS AG estimated in a June 7 report that local government debt could be 30 percent of gross domestic product and may generate around 2 to 3 trillion yuan of non-performing loans. Credit Suisse AG economist Tao Dong said it was the biggest “time bomb” for China’s economy.
Now that the construction bubble is bursting, with demand nowhere near supply, the governments’ profitability to cover the cost of past borrowing is falling short. Increasingly, more borrowing is taking place to pay off old loans – a debt financed Ponzi scheme that would make even EU bureaucrats blush.
The government’s representatives are surprisingly open about the issue. “Some local government financing platforms’ management is irregular, and their profitability and ability to pay their debt is quite weak,” said Liu Jiayi, the country’s auditor-general and former ANZ bank economist. A translation of this is that much of the debt cannot be repaid without assistance and the amount of debt is obscured in dodgy dealings.
Remembering that further borrowing by local governments is prohibited, and that the construction undertaking isn’t reaping income for those local governments, auditor Liu outlines the immediate concern over the situation:
“Many financing vehicles will have to pay interest and principal by year-end. If the local governments can’t issue debt in the next three years, they would have to cut their combined fiscal spending by 5 percent to 7 percent of GDP to meet obligations.”
This implies a dramatic reduction in further construction.
Nothing about the Chinese property boom was genuine. The demand was nothing more than a reaction to suppressed interest rates, as Chinese investors fled cash and bank accounts. The supply was a government-managed jobs programme for unskilled labour, with unsustainable debt financing to pay for the bubble. Much of borrowed money flowed right here, to Australian shores. But that cannot continue and now may be the beginning of the end.
One intriguing difference between China and many of the nations it shares the housing bubble story with is that China’s boom was primarily about construction (as Societe Generale points out in the quote above). The Western world featured primarily price booms. Of course, property prices in China skyrocketed and house construction in many Western markets boomed, but the focus was different. Debt is what unifies the two versions of a housing bubble. And it signals how these bubbles end.
But this is why the distinction between a price boom and a construction boom matters: while falling prices in the Western world unleashed what was primarily a financial crisis, the popping of the China bubble will unleash what will primarily be an economic crisis. In the US and Europe, it was banks that fell first. This time around, it will be the resource industry that gets shellacked.
Warning signs abound
Things have been stumbling along in the Middle Kingdom for years now. But now China’s bubble is giving warning signs. In the US, the trigger for the housing bubble’s collapse was slowing house price appreciation. Similar signs are emerging in China now. In fact, China shares many of the same symptoms as the Western housing bubble was having in 2007.
If you’ll recall, the beginning of the Global Financial Crisis was marked with a long overdue tightening of monetary policy in response to inflation. But China has gone well beyond that in its attempt to reign in the bubble it inflated in the first place. Price ceilings, requiring higher deposits, limiting second home purchases and transaction tax surcharges have all been applied. The effects are finally being felt.
Financial news website Bloomberg reports: “Asia Housing Boom Stalls as Tightening Puts Brake on Prices”. The Wall Street Journal has the headline “The Great Property Bubble of China May Be Popping”. As you will know from 2008, by the time these news organisations are on the case, things have developed much further. Heck, even the credit ratings agencies are in on the act this time. They have busily been downgrading the outlook for Chinese property developers.
The problem is that overvalued assets tend to correct, not just remain stable, after reaching highs. A boom that relies on a vicious circle of capital gains justifying more leverage, which creates more gains, cannot stabilise at the artificially high level. Prices need to return to where fundamentals justify them.
The China bear camp grows and grows louder
So what do the gurus think about all the discussion of China’s (temporary) demise?
Economist Nouriel Roubini – China faces a “meaningful probability” of a hard economic landing
Blogger Mish Shedlock – “China is in the midst of gigantic property bubbles that will soon pop”
Billionaire investor George Soros – “China is “losing control” of its economy” … “bit of a bubble”
Famed China bear Jim Chanos in May – “I am not bearish enough on China.”
Societe Generale report – “Early signs of weakness in China”
In a June interview, Gordon Chang, the author of The Coming Collapse of China was asked about the timeline for his predictions: “… matter of months, not years. All the signs of stress are there…”
The rest of the issue delved into what investors should do about the bursting China bubble.
But here’s the remarkable fact I promised to reveal when we began this three-part series – the information you promised to read on to discover.
This work was written in 2011. It is more than ten years old!
I’ve only made very minor changes to the content, such as removing dates, to mask the year I published the research and all the facts in it. And yet, this report could’ve been written today!
The point being that these problems have persisted in China for a remarkably long time. And so too have predictions of an imminent economic crisis in China.
Now, many of the predictions I made in the report did indeed play out. It was written for my Australian subscribers at the time and warned of the risk to the Australian dollar, which subsequently lost a third of its value. More importantly, the commodities sector which dominates the Australian economy and stock market began a severe and prolonged crash.
But China hardly had the meltdown I predicted. And so the recent media furore may be wrong, again.
In this month’s issue of The Fleet Street Letter we explain why the never-ending predictions of doom and gloom for China’s economy may finally come true this time. And we explore what that would cause.
But the point is that all bubbles can grow ever more absurd, even ones as obvious and long-winded as China’s. Today, we are only seeing the latest iteration of China’s inevitable but rather long-winded bubble bursting… eventually.
Until next time,
Editor, Fortune & Freedom