|Easy money and hubris: China’s mega shopping mall built six years ago lays vacant (top); A Chinese coal baron pays 1.5 million for a red Tibetan Mastiff|
NEW HAVEN: China is not only a booming country, for years it has been one of the world’s fastest growing economies. Industrialization, urbanization, modernization and entrepreneurship all appear to be on steroids in the world’s most populous nation. There’s relative consensus among global investors that China will continue growing at 8 percent for the foreseeable future, providing much needed support to the global economy.
By almost any metric, economic progress in China over the past several decades has been phenomenal: GDP per capita, literacy rates, health care, infant mortality, life expectancy and national wealth have all improved remarkably.
However, as the famous disclaimer reads on most mutual fund advertisements, “past performance is no guarantee of future performance,” and this appears to be the case with respect to China’s progress. In fact, China today exhibits many of the signs that characterize the great speculative manias throughout history.
Might China slow to a more sustainable GDP growth rate, say 5 percent, in the coming years? Significant evidence suggests that such an outcome is not as outlandish as the global investment community currently believes. A Chinese slowdown of this magnitude would have material impacts upon commodity markets, emerging markets and even the S&P 500’s business and earnings mix. In short, how China goes, so goes the world economy. Given this global economic interdependence, it’s highly imprudent for policymakers and investors not to consider the possibility of such a slowdown.
“Past performance is no guarantee of future performance” – this could be the case with respect to China’s progress.
Given the highly uncertain and probabilistic nature of booms, busts and the sustainability of growth, the application of a multidisciplinary framework seems particularly apt in determining various scenarios and their relative probabilities. Consider the approach one takes to identifying animals: You stumble upon an animal and seek to determine what type it is. You might first look at it, followed by listening, and observing its behavior. So if the animal has feathers and webbed-feet, and “quacks” while waddling, the probability of it being a duck is high.
Likewise, the same method can be used to assess the Chinese economic boom, using multiple lenses to determine the relative likelihood of a forthcoming bust.
From a microeconomic perspective, one method of identifying an asset-price bubble is to spot self-fulfilling or reflexive dynamics underway. In China today, higher prices in many of its asset markets are generating demand more rapidly than supply. Such dynamics are rarely stable and create situations prone to rapid corrections.
|Figure 1. China’s critical demand role for various commodities. Enlarge Image|
Consider property markets in which willingness to lend and prices rise together in a self-fulfilling manner. Chinese bankers have been lending money against collateral, the value of which is in part rising because of the banker’s willingness to lend. As property prices rise, banks’ collateral is worth more; the bankers feel more secure and smart, so they lend more. The cycle repeats. Unfortunately for the bankers, they’ll eventuallydiscover that they themselves created the sense of safety and intelligence that they enjoyed. As happened with the subprime collapse in the West, reality eventually sets in, bankers step back and collateral values fall.
From a macroeconomic perspective, most asset bubbles are associated with “easy” or cheap money that drives overinvestment and overconsumption. Evidence of such easy money can be found in Chinese commercial real estate, where both entire cities – like Kangbashi, in Inner Mongolia – as well as gigantic malls remain virtually empty.Time magazine profiled Kangbashi as a modern “ghost town,” and foreign newspapers have referred to the South China Mall in Dongguan as the “mall of misfortune.” Despite a 95-plus percent vacancy rate six years into its opening, the solution proposed by the mall’s management is as disturbing as its existence: an expansion of approximately 200,000 square meters.
Evidence of easy money can be found in Chinese commercial real estate. Entire cities and gigantic malls remain virtually empty.
Turning to psychology, bubbles are usually associated with an “it’s different this time” mentality, along with a rising sense of national confidence and hubris. Evidence of such thinking can usually be found with world record prices. Consider the fact that Chinese buyers have been setting, and continue to set, world record prices in the art markets. Or the reality that Chinese thirst for Chateau Lafite seems insatiable, even at record prices. Another useful indicator is the world’s tallest skyscraper under construction. In this domain, five of the world’s ten largest towers under construction are in China today.
Chinese buyers have also set recent world records in the prices paid for a dog and a pigeon!
From a political perspective, we need to acknowledge the fact that the Chinese government remains communist in spirit, albeit increasingly less so. The party’s structure drives uneconomic activity as provincial leaders aspire to get noticed by producing more jobs and generating more GDP than the other provinces. Anecdotal reports are alarming: Perfectly usable infrastructure is destroyed and rebuilt to generate GDP. Likewise, job creation and economic activity are prioritized over sustainability and profitability.
Finally, employing an epidemic perspective and analogizing speculative manias with a fever or flu proves useful. In particular, a dwindling population of yet-to-be-infected participants highlights the later stages of a bubble. In this regard, that state-owned enterprises today are the dominant buyers in land auctions should, pardon the pun, raise red flags. If private developers are squeezed out by state-owned enterprises, financed by state-owned banks, in buying state land, we are far more likely to be entering the ninth inning of the ballgame rather the third inning. The end is likely not far.
Bubbles are usually associated with an “it’s different this time” mentality, along with a rising sense of national confidence and hubris.
The ramifications of a meaningful slowdown in Chinese economic activity are profound, ranging from the risk of domestic social instability to a collapse of several commodity markets.
On the global economic front, China’s voracious appetite for commodities has motivated significant expansions throughout the global commodity complex, and many industrial markets, including shipping, capital goods and more, continue to be driven by Chinese demand. Consider Figure 1, which demonstrates China’s critical demand role for various commodities, representing more than 40 percent of global demand for cotton, aluminum and crude steel.
Unfortunately, the forthcoming slowdown may arrive at a particularly inopportune time. Many Australian and Brazilian mines have undertaken massive capacity expansions. Likewise, many Norwegian and Greek dry bulk shipping companies have expanded their fleets in anticipation of rising demand. To accommodate this need for more ships, many Singaporean and Korean shipyards expanded their capacities. And so the story goes… What happens if the very foundation upon which these expansion stories are built is faulty? Might the emerging-markets tale that’s been the darling of global investors be less compelling than widely believed?
And what happens to multinational companies in a slowing world? Might the demand for US treasuries drop, resulting in higher costs for capital in the United States? Is it conceivable that the consensus belief that the renminbi will appreciate is instead met by depreciation as Beijing grasps at hopes of export-led growth? How might 25 percent depreciation affect global imbalances?
The stakes are high. Policymakers, investors and corporate boardrooms must consider the risk of a material Chinese slowdown. Despite the allure of “China is different” explanations, there is a reason well-read and seasoned investors claim the four most expensive words in the English language are “it’s different this time.”