Recently, I’ve been reading Edward Glaeser’s "Triumph of the City." It’s an excellent read and looks at how cities have thrived, failed, and have created greater economic and intellectual prosperity that would have been unachievable otherwise.
While reading Glaeser's work, I could not help but to notice parallels with modern China. China’s central planners might be in agreement with Glaeser’s basic thesis, on one level. After all, has any nation in the history of the world promoted more rapid upward urbanization than the People’s Republic of China? China’s urban population percentage more than doubled from 1980 to 2010; an astonishing figure.
While "Triumph" points out the great efficiencies of urban economies, it also sets out to expose some of the great failures of cities, with Detroit being the classic American example. While it’s simple to look at what China’s built and be amazed, it's also simple to ignore some of the underlying realities. Diving deep into those realities suggest that China might not be creating the urban paradise that the media has conveyed over the past few years.
In "Triumph," Glaeser examines Detroit in detail in order to try to understand why it failed in the latter 20th Century. Detroit’s population fell from about 1.8 million down to 775,000 in a matter of 60 years. No American city suffered more than this in that timeframe.
What went wrong in Detroit? According to Glaeser, several things. In the 19th Century, Detroit had a rich entrepreneurial culture and was filled with innovative small businesses. By the mid-20th Century, Detroit had three lumbering goliaths, burdened by inflexible labor unions, a poorly educated populace, a lack of entrepreneurship, and had little interest in innovating.
In essence, Detroit’s great success became its failure. By allowing its economy to become completely dependent on one industry, Detroit had made itself very susceptible to economic shifts. Moreover, its one industry relied on a high volume of uneducated, low-skilled labor that lacked the entrepreneurial drive that was so common in Detroit in the late 19th Century.
Detroit only made further mistakes from there. Its police force developed a reputation for both racism and brutality, which eventually led to race riots by the late 1960’s. Detroit turned around its racial problem, but also scared away most of the wealthy whites at the same time, through boneheaded policies that tried to redistribute wealth from the rich to the poor. It didn’t work. The fleeing of Detroit’s capital base only made it poorer.
Next on the agenda was to build more things. There’s nothing that solves economic problems like building things, right? Well … this is where Glaeser’s harshest criticism comes. Detroit was a contracting city trying to build itself into prosperity, but building where there is no demand is only bound to lead to further disaster. Detroit has such an excess supply of buildings now, there’s no hope it could ever fill a significant percentage of them. Yet, Detroit even neglected its neighborhoods that were still alive; demolishing one neighborhood for a silly, expensive project for which there was no demand.
Reading about Detroit, I couldn’t help but to think that many of the same criticisms that Glaeser throws at the "Motor City" might apply to another place: China.
The Great Building Boom
China’s rising economic prosperity over the past several decades is not all that different than Detroit’s. China has made its fortune by becoming the world’s manufacturing center and it's biggest cities have thrived as a result. While many Americans lament the loss of American manufacturing and view China as capturing America’s lost glory, it might be worthwhile to take a look at how those who have adopted China’s policies have failed in the past, including Detroit.
While I’m here to write about why I do not view China’s economic miracle as sustainable, I do think it’s worthwhile to explore some of their successes. In many ways, China’s great growth came as a realization of its poverty. Market liberalization of the ‘80s and ‘90s produced major gains for China. A common theme throughout history is that the greater level of trade a nation engages in, the more prosperous it can become. China learned this and quickly became a manufacturing hub.
What attracted manufacturers to China was not a mystery: a large populace and cheap unskilled labor. While a modern economy needs more than manufacturing to be great, China’s manufacturing boom at least set the stage for increasing gains.
The Currency Peg
Where China went wrong was precisely the same area that Japan went wrong: not allowing its economy to evolve beyond exporting industries; and for China, it is dependent on cheap manufacturing, in particular. To be sure, manufacturing could be very beneficial, but increasing productivity gains, coupled with a better educated populace should produce further economic gains in service sectors of the economy.
China’s currency peg was initially a device used to let foreign capital know that China was a good place to invest. By tying itself to the dollar, China was trying to gain credibility. And China got it. However, there was an obvious side-effect of the currency peg; China’s great economic gains should have been reflected in the rising value of its currency. Instead, Chinese policymakers realized that the currency peg, by artificially preventing the Yuan from rising, increased manufacturing exports even more. In essence, the peg ceased to be about "gaining credibility" in order to grow, and more about guarding its current gains.
The major problem with the policy forced the central bank to print an excess supply of Yuan. In the real economy, the effects of China’s currency peg have been inflation, negative interest rates, and a constantly declining purchasing power. What happens in an economy where the currency is artificially being devalued over time? People flock to hard assets like real estate and gold.
China’s economy has not evolved as rapidly as it should to the service sector due to the problems associated with the peg, which has left it dependent on manufacturing. However, the peg did create another vibrant industry: construction.
Of course, there’s nothing wrong with construction, when there is demand for it. Unfortunately, there’s not a shred of evidence that supports the idea that the Chinese economy needs anywhere near as much real estate and infrastructure as is being built out.
An Economy Dependent on Building Stuff
Jim Chanos, the famous short-seller who exposed Enron, has been one of the first and loudest critics of the economic policies that have allowed China’s real estate industry to grow well beyond its function. Chanos has pointed out that over 60% of China’s GDP is now related to fixed-asset construction; a frightening number, especially when you consider that only about 15% of the US economy was construction-related at the height of the housing boom.
China is now loaded with "ghost cities" and large empty buildings that dot its urban areas. China bulls have countered that China’s rapid demand growth will eventually fill these cities. It’s also frequently pointed out that while Tier 1 cities might have overvalued real estate, Tier 2 cities are more reasonably priced. Yet, new reports suggest that does not appear to be the case at all.
What is missed by the China bulls is that there is no demand being created to fill these buildings. China’s economic growth over the past few years has been impressive, but only because they keep buildings things they don’t need. When you delve down deeper, China's economy is not growing all that much beyond construction. You could argue that China is already in an era of stagnation and only construction is masking it.
China’s currency peg has increased its dependence on manufacturing, which has deterred other service- and consumer- oriented segments of the economy from growing as rapidly as they should have. This is further complicated by the pressures created by the real estate bubble, which have driven up the cost of living significantly in China’s major cities.
As workers are increasingly getting squeezed, they demand higher wages and better labor protections. They are right to do so, of course, but this further undermines the manufacturing sector that is based around low-wage unskilled labor. As Chinese wages grow, more manufacturing shifts to Southeast Asia and other lower-cost areas.
In other words, China is stuck. The currency peg has created a situation where China has prevented its economy from expanding beyond manufacturing. Meanwhile, it’s created a credit-fueled bubble that has undermined the low costs of that manufacturing industry. The only thing that’s left is to keep building things that no one needs.
Triumph of the City?
Shifting back to Glaeser’s analysis of cities, China has created an interesting trap for itself. It has created the exact type of urban, upward city that Glaeser suggests allows for innovation to occur. Its closely-connected cities that allow people to share ideas, form small businesses, and create innovative products that stimulate economic growth. This is why places such as New York thrive!
Yet, China has also committed the cardinal sin of building massive amounts of stuff that it doesn’t need, based on economic growth that doesn’t exist. Eventually, this will led to an undesirable outcome such as either a real estate crash or hyperinflationary pressures.
All the same, China’s "economic miracle" does leave me wondering what will happen in the future. My personal belief is that there is a significant likelihood that China experiences a major real estate crash in the next few years. However, my additional question is, will China rebound if that happens? Maybe I’m putting the cart before the horse with that question, but what China has created in a short-time is very interesting; even if unnecessary right now.
As for my bet, I have made many moves towards a "bearish China" thesis in my portfolio. The most obvious implications of a Chinese real estate crash would be a commodities crash. In fact, I view a commodities crash as even more likely than the RE crash, because even if China is somehow successful at shifting its economy towards a more consumer based one, one of Premier Wen Jiabao’s primary goals over the next five years. This will still destroy demand for industrial commodities such as copper, silver, and possibly even palladium.
I’m willing to go a step beyond that, however, and suggest that China can’t engineer the so-called "soft landing" that they desire. A recent Fitch Ratings gauge suggests that China faces a 60% chance of a banking crisis within the next few years. While my viewpoints are based more on qualitative research, I’d agree with that assessment.
My main question is not whether there will be major issues associated with China’s building boom; but rather, when those issues will truly begin to manifest themselves in China’s economy. It’s possible that this situation could churn on for a few more years, even all the way up to 2016. The longer it goes on, however, the more devastating a crash will be when it happens.
The other issue is that it's not completely clear that the crash will be deflationary. While one might reason that it would almost have to be deflationary, it’s not actually clear how the PRC would respond. There are, of course, equally and more undesirable outcomes possible, such as hyperinflation. Recent moves suggest that China prefers not to go this route, but only time will tell what happens in a case of stress.
Regardless of the timing issues, I have begun to buy into puts that would profit from a crash within China over the next two years. I am primarily using this as a way to hedge my exposure to U.S. banks and homebuilders. While a China crash would not necessarily harm the U.S. all that much, it would put short-term pressure on all world markets, in all likelihood.
Disclosure: I am short FXI. I am short and/or own puts on a "bearish China" thesis, which includes various commodities, Chinese ETFs, and emerging market ETFs. I may initiate additional positions based on this thesis in the future.