“Nobody…nobody…knows for sure what it going on,” said he. “On the one hand, there are plenty of excesses and bad investments in China. There must be. We’ve been growing so fast. And there must be a lot of bad debt hidden in the banking system, for example.“But on the other hand, China is booming. There have never, ever been so many people working so hard to make money. It’s a bit like the US probably was a hundred years ago. Only bigger. Faster. And with more government involvement.”
~ Chinese businessman, quoted in The Daily Reckoning
Today we wrap up our 3-part series on China. So far, we’ve looked at the bear case and the bull case. Today, we’ll look at some of the basic similarities and differences between what’s happening in the Chinese economy and what’s happening in Western economies.
Today’s opening quote comes from an article by Bill Bonner of The Daily Reckoning. It was apparently taken from a conversation he had with a businessman from China. I chose it because it seems to aptly represent the polar opinions that characterize the China debate.
If you’re a regular Daily Reckoning reader as I am, you wouldn’t have been surprised to detect Mr. Bonner’s disdain for government meddling. In fact, he goes on in the same article to predict: “They will control too much…and then they will lose control.”
I had a distinct feeling of déjà vu when I read that article, and not just because I’ve heard Mr. Bonner (and many others) express the same sentiment regarding the US government. As a matter of fact, there were a few familiar themes in much of the material I read to prepare for this short China series. Let’s take a look at some of the basic factors that make China’s economy unique, and some that might seem uncomfortably familiar.
China Is Different
I won’t spend a great deal of time on these, as we’ve covered them in the first two parts of this series. You’ll recall that there are a few main characteristics that make China’s property market unique:
- Size: China is huge in terms of both area and population. What’s more, it has a long way to go before the majority of the potential for growth and development is realized.
- Government Efficacy: As Byron Wien pointed out in part two of this series, the Chinese have far fewer political hurdles to jump in light of the fact that they do not operate within the trappings of democracy.
- Less Leverage: The Chinese are voracious savers and tend to buy hard assets with little or no credit.
These factors do separate the Chinese property market from some of the recent markets that have experienced bubbles and subsequent busts like those in the US and Japan.
. . . Or Maybe Not
And yet I found a few recurring themes in my reading that seemed to indicate that China’s markets face some of the same challenges as those in the Western Hemisphere. See if any of these ring a bell:
1. Government Meddling
Many critics complain that the Fed’s quantitative easing programs and the government’s generous bailouts of select companies constitute a level of interference that should not be part of a capitalist economy. I suppose you could argue that, while not ideal, more government interference is to be expected in China’s economy. For a while, it seemed to be helping. They have so far managed to stave off any potential crises.
But the Chinese need to avoid social unrest in order to maintain control of the country, and runaway inflation is something they want to avoid at all costs. The Telegraph article cited in part one of this series observed that, while China’s officially-reported inflation rate hovers around 5%, the price of vegetables has risen 20% in a month. This is reminiscent of the ex-food and energy inflation readings that the Fed uses. Official core CPI readings may not be very elevated, but those of us who frequent gas stations and grocery stores know otherwise.
2. Hidden Liabilities
Jim Chanos warned that, although there doesn’t seem to be a lot of debt in the Chinese property market on the surface, much of it is hidden in local financing vehicles and kept off balance sheet. In fact, the Royal Bank of Scotland recently recommended buying CDS on China’s 5-year debt as a top trade for 2011. (See the Telegraph article mentioned above.) It’s not that they see a sovereign default in China’s future, but they do see a risk that efforts to cool inflation may trigger a hard landing in the property market and the economy as a whole.
A rise in interest rates due to inflationary pressures would cause the cost of servicing the debt on fractionally-utilized infrastructure to rise above the income these projects produce. A Zero Hedge recap of the HSBC report on China observed that the “Wuhan to Guangzhou bullet train, which started operating earlier this year, was running at less than half its capacity and would never make enough money to pay off the loans used to finance it.” One can only imagine that this dynamic is not restricted to this one project, and that its effects would be exacerbated by rising interest rates.
Of course, hidden liabilities are not exactly rare in the Western banking system either, especially since FASB suspended mark to market accounting. Off balance sheet items remove the transparency from markets. So in that respect, our financial system is not much better than China’s.
3. Vested Interests Control the Rules
We touched on this in part one of this series as well. While the central government tries to institute changes to cool the property market and economy, some of these measures are not being carried out on the ground. Special interest groups negotiate favourable arrangements at the local level and the bubble continues to inflate. So Mr. Wien may be correct in his assertion that it’s a little easier to get things done in China, but there seem to be a few signs of crony capitalism creeping into Communist China.
Similarly, the powerful financial and energy lobbies have been the subject of criticism for quite a while in the US. There are accusations that they have had an outsized influence on policy and that this influence has caused irreparable damage to the global economy: GM killed the electric car and then resuscitated it years later to pull itself out of a taxpayer-subsidized bankruptcy process. Goldman Sachs got a sweet deal on its AIG CDS. The financial lobby successfully watered down the financial regulation bill. Numerous banks committed fraud in the foreclosure process. All of these accusations have been leveled, but not yet proven, and certainly never prosecuted.
These are just observations that occurred to me. I don’t know what impact they will have on how all of this turns out. I would, however, welcome your thoughts. Am I just seeing things or do some of these themes seem rather familiar?
What Can We Conclude?
With all of the information we’ve looked at over the past week, what can we conclude about China and the prospect of a property bubble there? I’m afraid we’re still left with many questions that only time can answer. Further, any answer has to come with a time frame. Most people (bears and bulls) seem to acknowledge China’s long-term economic advantages.
If, however, China is experiencing a true bubble, it will pop at some point. The trade for that scenario would be to short commodities and watch for collateral damage, especially in markets like Brazil, Australia and Canada. If China’s growth story can continue without a severe correction, then the trade is the opposite, and the entire global economy (especially other strong emerging market economies like India and Brazil) would likely benefit.
The Chinese may or may not have a lot of leverage in their property market, but the market players betting on the Chinese miracle most certainly do. If that crowded trade rolls over, it will likely be more swift and violent than the subprime liquidation. It may also represent a unique long-term buying opportunity.