Another Piece On China Bubble

Edward Chancellor is a member of the asset allocation team for Boston-based GMO, is a financial historian and bubble expert.

His 1999 book, Devil Take the Hindmost: A History of Financial Speculation, examined past speculative manias. Perhaps you've read articles comparing the tech boom and 1990s' bull market to tulipmania in 1630s' Holland.

The difference is that Chancellor was making that comparison before the tech bubble burst, some years before Alan Greenspan claimed it was futile trying to predict bubbles at all.

Chancellor's timing may have been fortuitous. To accurately predict something once might mean little. To repeat the feat perhaps means something more.

His next major piece - Crunch time for credit: An enquiry into the state of the credit system in the United States and Great Britain - included this prescient paragraph:

''The growth of credit has created an illusory prosperity while producing profound imbalances in the British and American economies...When credit ceases to grow, the weakened state of these economies will become apparent.''

That report was written in 2005, years before the credit bubble burst. Chalk two up to Chancellor.

Third time lucky?

He's now turned his attention to China, a fertile ground for his fertile mind. Released last week on the GMO website, China's Red Flags is split into two parts.

Crisis checklist

Section one identifies speculative manias and financial crises, offering a checklist for those trying to identify bubbles in advance of their bursting. Chancellor offers 10 criteria for what he calls ''great investment debacles'' over the past 300 years (the report explains each in far more detail);
1. A compelling growth story;
2. A blind faith in the competence of authorities;
3. A general increase in investment;
4. A surge in corruption;
5. Strong growth in money supply;
6. Fixed currency regimes, often producing inappropriately low interest rates;
7. Rampant credit growth;
8. Moral hazard;
9. Precarious financial structures;
10. Rapidly rising property prices;

Although all these criteria need not be present in order for a bubble to be present, you can see where Chancellor's heading: not-so-subtly steering readers towards his own conclusion. In section two he takes each factor and applies it to the case of China.

Ponzi scheme

His conclusion is alarming; The very factors that have allowed China to grow so rapidly over the past few years despite the global slowdown - an investment boom, a credit boom, massive increases in money supply, moral hazard and risky lending practices - are all factors that investors and the mainstream press feel they can safely ignore because China is growing so rapidly.

After the past few years, we should all understand the potential negative implications of such major imbalances. But there seems to be general agreement that a ``build it and they will come'' approach is warranted in China because it keeps growing rapidly. There's a Ponzi-like element to the circularity.

Chancellor is concerned that China's high GDP growth is no longer a function of impressive natural growth. Instead, growth is being engineered to achieve high GDP numbers. It's producing a system that's unsustainable and prone to collapse.

This, in essence, is Chancellor's argument:
- Investors are adopting an uncritical attitude to China's growth forecasts;
- Because of the way local officials are incentivised, it's likely that migration of the population from country to city is much further along than the official numbers suggest. So when you hear of another 350 million internal migrants arriving in cities by 2025, many of them are actually already there;
- Hence, future productivity growth will be much more reliant on efficiency gains than urbanisation. China's record in this area isn't at all strong;
- Beijing imposes GDP growth targets on local governments. Thus, ``GDP growth is no longer the outcome of an economic process, it has become the object''. `When the allocation of resources, whether at the corporate or national level, becomes all about ``making the numbers'' then poor outcomes are to be expected';
- In 2009, Chinese fixed asset investment contributed 90% of total economic growth (an incredible statistic and a natural consequence of the previous point);
- Significant over investment is present in many areas. For example, capital spending in the cement industry increased by two-thirds despite capacity utilisation running at an estimated 78%;
- The efficiency of investment (incremental GDP growth for each additional unit of investment) is trending downwards towards wasteful levels;
- Interest rates have been kept way too low for decades, sparking economic growth but also imbalances and bubbles;
- China's enormous foreign exchange reserves are not necessarily a plus. As Michael Pettis pointed out recently, only two countries have previously accumulated such large foreign reserves relative to global GDP - the United States in 1929 and Japan in 1989. Oh dear;
- The Chinese stockmarket is in bubble territory. Last October, a new Nasdaq-style exchange opened in Shenzhen with 28 new listings. The minimum price rise (the laggard of the 28) rose 76% on the first day. Price/earnings ratios averaged 150;
- The residential property market also appears to be in a bubble. In Beijing, the house price to income ratio has climbed to more than 15 times, versus 9 times in Tokyo in 1990;

My main reason for saying China is not headed for a big implosion is that the Chinese economy is still a relatively closed economy. The liquidity swishing around is still controlled by Beijing, with the exception of some hot money into property. We cannot regard China like normal more open economies - e.g. Malaysia or Indonesia, where we can be on the receiving end of a lot of hot money, and will feel the gravity of it when these funds exit. You do not have such a keen issue in China.

Beijing knows the unbalanced lending to state firms and municipal councils, and is trying to redress the problem, albeit a tad late. Yes, China has been building a lot more infra than is necessary. Yes, there will be some white elephants for a while. Yes, there is a property bubble. No, I don't think there is a stock market bubble (refer to previous posting on China bubble).

Owing to the fact that its a relatively closed economy, it can sustain gaps in supply and demand much better than other more open economies. Of course, Beijing will have to rein in their excessive capital stimulus one day, nobody wants to stare at massive highways which nobody uses, or townships that is half filled. China has a window whereby it can still do what it is doing without much drastic repercussions - the caveat being that the global economy must be back to normal growth by 2012 or earlier. Past that, China really cannot keep up with the GDP growth numbers. As there are few safety nets, unemployment and social unrest could get dirty if Beijing even halves their annual stimulus package.

One more point to note is that most of the bears assume Beijing will be sitting around doing nothing. Please note that bank lending by Chinese banks fell 43 per cent in the first quarter from a year earlier as the government winds down its stimulus and tries to cool a credit boom while keeping its recovery on track, central bank data showed on Monday.

Banks lent 2.6 trillion yuan (S$529.7 billion) in the January-March quarter, the People's Bank of China said on its Web site. That compared with 4.6 trillion yuan in loans in the first quarter of 2009 as banks ramped up loans for construction and other projects as part of a 4 trillion yuan stimulus. The figures indicated the central bank's efforts to prevent runaway lending and restore financial discipline in China's state-owned banking industry might finally be taking hold, lessening the need to raise interest rates to curb inflation.

The tightening on lending reflects worries that many of the loans issued in the past year or more may go sour and that easy credit is fueling wasteful investments. On Sunday, the chairman of the China Banking Regulatory Commission, Liu Mingkang, announced an aggressive plan to assess the safety of loans made to financing entities set up by local governments to invest in real estate, infrastructure and other projects.