China in a Bubble?

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Includes: FXI, PGJ
by: Ari and Arun

There's been a lot of talk lately about various Chinese asset markets being bubbles. Let's take a look.

1) Industry and Commodities
China's industrial sector is growing quickly, and many are arguing, unsustainably. Iron ore imports are up 65% year over year. Imports of most commodities and manufacturing of basic goods are far higher than one would expect given China's GDP growth. This appears to be a bubble driven by stockpiling by the government as well as by speculators. Peasants have stockpiled an estimated 50,000 tons of copper in a bet on rising commodity prices. If the world economy has a robust V-shaped recovery, global demand may catch up to China's stockpiling, but that's a big "if". While there's no obvious limit to how much more stockpiling the Chinese government and people can do, commodity imports and manufacturing are indeed in a bubble. It would probably take 3 years for world demand to catch up to the artificial Chinese demand for commodities.

2) Real Estate
China’s property values appear dramatically inflated. With a price to income ratio of over 12 in the major cities compared to a 5 to 1 ratio that the World Bank considers affordable, the Chinese people can't afford the new construction. Over the past year, completed real estate is up about 25% while sales are down about 22%. That’s a huge disparity that developers are starting to remedy – new construction is down about 1% year over year. These numbers are from the official Chinese statistics, but it's hard to know what we can trust. While China’s real estate market does appear to be in a bubble, it's no longer a growing one as you can see from the graph of real estate prices below.

The economist Andy Xie makes the point that,

China's urban living space is 28 square meters per person, quite high by international standards. China's urbanization is about 50% and could rise to 75%...so China's urban population may rise by another 300 million people. If we assume that all can afford property, Chinese cities may need an additional 8.4 billion square meters of space. China's works-in-progress covers more than 2 billion square meters...The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply - not enough people for all the buildings - could happen quite soon.

The Chinese government has started reducing the flow of easy credit which has put a lid on prices. The question is will real estate remain stable until demand can catch up, or will prices collapse violently?
Click to enlarge


3) Credit
Loans in the first 9 months of 2009 totalled 8.7 trillion Yuan vs 3.5 trillion Yuan in 2008. M2 (measure of the broad money supply) was up 29.3% over the previous year. Despite this massive money growth, the official statistics show that China is facing deflation because of tremendous overcapacity. I’ve seen estimates suggesting that China really faces inflation of around 10%; it’s not easy weeding through the competing data.

Banks were basically ordered by the government to increase loans over the last year and there's lots of anecdotal evidence that banks were throwing money at businesses with no investment prospects and even businesses that didn't want the loans. The situation is widely acknowledged - chairman of China Merchants Bank, Qin Xiao, says China must urgently tighten monetary policy to avoid inflating bubbles. China has recently moved to tighten credit, but we will likely see non-performing loans rise sharply over the next few years. Below is a graph of Chinese M2 (broad money supply).
Click to enlarge

4) Equities

Chinese equities are still 13% off their highs with GDP more than 15% higher. Simple metrics like P/E and P/B suggest that Chinese stocks aren’t cheap, but nor are they in a bubble. While many if not most Chinese companies commit accounting fraud, they are still growing quickly. No bubble here.

5) Are We The Mongolians?
The longstanding myth of the Chinese Wall was that it was built in the 3rd century BC. Most of whatever existed at that point was destroyed before the 12th century; the great wall we think of today was built by the Ming Dynasty in the 14th-17th century. The Great Wall was a great failure as the Manchu warriors entered China in 1644 and conquered Peking, establishing the Ch’ing dynasty, which reigned for three centuries. Today, China has established many economic controls to protect and preserve the pseudo-capitalist economic climate of mainland China. These new walls are likely to prove similarly ineffectual over the next few decades as western powers again impregnate China with their culture. Hopefully the modern invaders will be more beneficial to China than the Mongols were.

Conclusion:
The large current account surplus and the influx of foreign direct investment led to a bubble in real estate over the past decade. More recently, the explosion in bank lending and fiscal stimulus have produced a commodity and manufacturing bubble. However, the tremendous attention that these bubbles are receiving suggests that they are not particularly severe. In severe bubbles, the final spike occurs dramatically and with almost no one mentioning that it's a bubble. Rather, regulators, analysts, and speculators all bend over backwards to justify the rally fundamentally. With a surfeit of bubble watchers today, we're less likely to get the classic conclusion to bubbles - the violent bursting.

For this issue I drew upon insights from Michael Pettis, Victor Shih, and John Mauldin. Many thanks to them.