I think investors are worried about the wrong kind of crisis in China.
Worry seems to focus on the possibility of an asset bubble and the change that it will burst sometime in the next two to three months.
I’m more concerned about a slide into a crisis that will be an extension of the current Great Recession. That slide could begin, I estimate, sometime in the next 12 to 18 months.
I certainly understand the worry about the possibility of an asset bubble in China. After all, we’ve just been through two horrible asset bubbles—and busts—in the U.S. and global financial markets. And it’s only natural to fear a replay now that the market has rebounded so sharply
But China’s economy and political system is so different from that in the United States and the rest of the developed world—and its relationship to the global financial market so unique—that I don’t think we’re headed to any kind of replay of March 2000 or October 2007.
A Chinese bubble is a distinct possibility and one worth worrying about. And the possibility of a bubble should certainly figure into your investing strategy.
But for reasons that I’ll explain in this column, the bursting of an asset bubble in China wouldn’t to be anywhere near as serious as the bursting of asset bubbles in 2000 or 2007.
A bigger worry is a long-term slide into a lower or no growth world where nations strive to beggar their neighbors and all portfolios slump. As crises go, it’s very different but ultimately just as painful for investors as the asset bubbles that draw all our attention now.
To paraphrase Leo Tolstoy in Anna Karenina “Happy bull markets are all alike; every unhappy bear market is unhappy in its own way.”
Most China bubble or crisis analysis starts, rightly, with the river of money flowing into the Chinese economy.
How deep is that river?
Start with the $585 billion in official stimulus spending. Add in bank lending that doubled in the first 11 months of 2009 to $1.4 trillion from $615 billion in all of 2008. And finally factor in continued run away lending of $88 billion in the first week of January. If that rate were to continue, China’s banks would wind up lending 50% more in January 2010 than they did in 2009.
All this has led to an explosion in the country’s money supply. Money supply as measured by M1 was up 35% in December 2009 from December 2008.
All that money has to go somewhere. Some of it has gone into productive loans or government-financed capital projects. But clearly huge amounts have been siphoned off, in ways that China’s politically connected capitalists know how to do so well, into speculation in real estate and the stock market.
This has led to the enormous price increases for those assets that have stoked fears of another 2007 style financial asset bust.
At its 2007 peak the Shanghai A-share index (A-shares are priced in renminbi and can be purchased only by domestic investors) traded at seven times book value. At its high in the 1990s Japan’s Nikkei only traded at five times book value. Right now the U.S. Standard & Poor’s 500 stock index trades at 3.5 times book value.
The global financial crisis cut the price of Chinese stocks in half but the subsequent recovery has taken them back into bubble territory. Using an average of earnings over the last ten years to take out some of the volatility, Chinese stocks now trade at 50 times the average 10-year earnings per share. The comparable figure for U.S. stocks is 15. (Even that’s not cheap by historical standards.)
The bubble is even more apparent in real estate. According to figures in a Financial Times column by Peter Tasker, a Tokyo-based analyst for Arcus Research, the Tokyo real estate bubble peaked with apartment prices at 12 to 15 times average household income. In major Chinese cities now the comparable price for an apartment is 15 to 20 times average household income.
When real estate speculation exceeds that in the Japanese real estate bubble, investors are right to worry. And that’s why even some minor saber-rattling like the increase in reserve requirements by the People’s Bank of China on January 12 is enough to rattle China’s stock markets. And developing markets around the world.
If you own Chinese stocks or Chinese real estate, you should worry about the bursting of this bubble. It could easily take prices of Chinese stocks down 20% or more. After all the Shanghai market fell 21% in just the month from July 31 to August 31 of 2009. That was in the middle of the huge rally in global markets off the March 2009 bottom.
This is why I’m hesitant to buy into the Chinese stock market now. For my strategy on how to buy emerging market stocks now see my post http://jubakpicks.com/2010/01/07/how-to-buy-into-emerging-market-stocks-now/
But… I don’t think you need to worry about the bursting of the Chinese financial asset bubble producing either a replay of the Great Recession that followed the collapse of U.S. and other developed world financial markets in 2007 or another great global stock market bust.
For three reasons.
First, the Chinese financial markets are still only partially integrated with the global financial system. Even a huge collapse in the prices of Chinese stocks and real estate isn’t likely to spread beyond China’s borders to a degree that would endanger major global financial institutions. It was the contagious nature of the problems at American International Group (AIG) and Lehman Brothers that turned a crisis in the U.S. financial markets into a crisis for international financial institutions such as ING (ING), and the Royal Bank of Scotland (RBS), and then in to a crisis for governments in the United States, the United Kingdom, Ireland, Spain, and beyond. Because the renminbi isn‘t a freely exchangeable currency, because international banks don’t have a lot of tricky to price and hard to trade derivative products structured with Chinese banks at the other end of the deal, because international institutions don’t, despite their wishes, have very much exposure to Chinese financial assets, it’s unlikely that a collapse of asset values in China would trigger a collapse of asset values around the world.
Second, the Chinese government is committed to growth come global recession or high water. Beijing’s reaction to the global financial and economic crisis proves that. China’s economic growth slows to 6.1% in the first quarter of 2009 and what does the government’s do? Panic. Beijing threw money at the economy. Almost $2 trillion in spending and loans. And it continues to pour cash into the economy even as growth climbs back toward 10%. I think that reaction should put an end as well to worries that a Chinese financial asset or property bust would lead to a collapse in the global commodity markets. Or at least not one that lasts very long. One of the advantages of running a centrally planned economy is that you can throw cash at the economy (without opponents carping about the size of the deficit) so that companies can build up stock piles of raw materials that they won’t need for quarters–if you are so inclined. China’s reaction to the global financial crisis should have removed all doubts that its government is so inclined.
Third, in China the government keeps the books. As the 1997 Asian currency crisis shows no bank in China is bankrupt if the government says it isn’t. And huge debts can be shuttled to newly created financial institutions where they linger for decades until they simple fall from memory. I’m willing to bet that if all the bad loans of 2009 and 2010 were finally added up, more than a few Chinese banks would be bankrupt. But I am also willing to bet that nobody will ever see those tallies and no more than a few “demonstration” banks will be allowed to go broke.
So if the bursting of any Chinese financial asset bubbles won’t be contagious will be quickly reversed with a river of government cash, and aren’t likely to be allowed to take down any significant financial institutions, what (other than a 20% or worse short-term correction) am I worried about?
I’m worried because over the long-term a system like this can’t efficiently allocate capital and in the long-run massive mis-allocations of capital in China will lead to another global supply/demand crisis—just like the one that we’re now trying to end but worse. (We tried to solve the last one by turning houses in the United States, Spain, the United Kingdom, Ireland, and elsewhere into ATMs so consumers in developed economies could buy stuff they really couldn’t afford. See how well that worked out.)
Take a look at any global industry where China is a major player. I wrote about cars on January 13 (http://jubakpicks.com/2010/01/13/fords-dilemma-it-has-to-sell-more-cars-in-places-like-india-to-survive-but-can-it-make-a-profit-there/ ) and aluminum on January 12 http://jubakpicks.com/2010/01/12/alcoa-delivers-bad-news-for-global-profits/ ). Either would serve as an example of the big problem.
China has 117 car makers. The China Association of Automobile Manufacturers calls 17 of those major manufacturers. All 117 can raise capital if they’ve got the right political connections. So is it surprising that automobile manufacturing capacity in China grew by 30% in 2009 to 20 million units? That compares to record demand in China of 13.6 million units in 2009, a year when Beijing cut taxes on sales of many cars and implemented its own cash for clunkers stimulus program.
I haven’t been able to find any figures for how many of those 117 companies were actually profitable in all of 2009. But in the first half of the year profits at the 17 major manufacturers were up just 1.5% from the depressed first five months of 2008. Half of the 17 saw their profits fall in the period and three actually suffered losses.
Will supply and demand or the workings of the capital markets force any of those 117 companies out of business? Not if it means putting local workers on the streets.
The effects on the global economy spill out from China. Since profit and loss don’t count if a loss-making company can just keep raising capital, excess capacity in China results in low priced exports that depress prices at competitors around the world. Countries looking at the example of China—or who don’t want to lose the jobs, prestige, and technology that go with having a domestic car industry–decide to go China’s route and bail out unprofitable car makers.
Multiply the effects from this to industries from aluminum to wireless phones (Sorry, I can’t think of global industries that start with X, Y (yak butter, I’m pretty sure is a regional business) or Z) and you get
- First, rising global trade tensions. Developed and other developing economies have a limited tolerance for seeing jobs shipped to China especially when there’s growing feeling that China doesn’t play fair. See the tariffs the United States put on Chinese tires in 2009 as an example of what happens when these tensions start to escalate. This trend doesn’t end anywhere good, especially because it plays right into a widespread belief in China that the developed West wants to see China reduced to the powerless status it had in the nineteenth century.
- And second, increasing inefficiencies in the Chinese economy. In the first nine years of the 00s, it took $1.50 in new credit to add a dollar of output to the Chinese economy, estimates hedge fund Pivot Capital. In 2009 that figure jumped to $7 in new credit for $1 in additional output. Even factoring in the delays in turning 2009’s big surge in credit into actual output, the number is worrying.
There is a way out for China and the world—it’s called domestic consumption in China. In contrast to the United States where domestic consumption makes up some 60% to 70% of GDP, domestic consumption is around 30% to 40% in China. That low share is intentional, the result of policies like an undervalued renminbi that depress the purchasing power of Chinese consumers (especially when it comes to imports.)
In 2009 the Chinese government made lots of noise about raising domestic consumption and took some concrete steps such as improving health care and paying school fees for more people that were intended to make Chinese savers feel they could spend more and save less.
But the jury is still out on whether these changes are enough to change the composition of the economy or whether the return to export growth will put China back on the same ol’ track. I’d say China and the world have about 12 to 18 months to show convincing progress on fixing the intertwined problems of global excess capacity and under-consumption by Chinese consumers before we start to lay the foundation for a new crisis.
It won’t be signaled by the bursting of a new bubble. We’ll simply and gently slide back toward crisis. And that will simply show that we never really fixed the underlying economic problems that caused the current crisis, the one we’re still struggling to fix.