2012: A Year Of Crisis For China

Includes: CAF, CNY, CYB, FXI, GXC
by: Ethan Backus

For the majority of 2011, housing prices in China mostly stalled, with some second and third tier cities advancing moderately. In the last three months, prices have begun to decline ever so slightly in major cities. However, new investments and construction hit new all-time highs this year. The market is already saturated with empty investment properties, 60 million apartments by some accounts. Massive new projects are still under construction and this new wave of completed units that will be dumped on the market in 2012 and will probably create major turbulence in the housing sector and perhaps the economy.

In 2009, China’s stimulus package, combined with unprecedented bank lending, injected much more cash into their economy than the American stimulus plan did into the American economy as percentage of GDP. Money growth accelerated which caused corporations, individuals and local governments to all borrow unprecedented amounts of money. Fixed asset investment skyrocketed. Even though consumer spending, as a percentage of GDP, actually shrank.

The Chinese government has tried to rein in speculation in real estate, but they have not addressed the primary causes, which are that there is too much cash in the system and Chinese citizens have no real investment choices other than real estate. Profits in dollars or euros pour into the country from international trade, but then it is almost impossible for a citizen to use those dollars to purchase assets abroad with those dollars or euros. So these dollars are exchanged for yuan in China with the government printing the yuan and using the dollars to buy Treasury bills (this is why China has $3 trillion in foreign reserves, but that money doesn’t technically belong to the government and has massive liabilities against it from China’s citizens.)

So China is being stuffed like a piggy bank with capital it can’t use to purchase foreign assets. So they use cash and a mixture of cash and debt to buy apartments, which they then either flip or keep sealed off. This is why supply for medium to high-end apartments has been growing so much faster than demand, yet price has continued to skyrocket for the past few years. The bull market in real estate has been creating giant fortunes for some and boosting the entire economy.

In 2012, this unsustainable bubble will be begin to deflate. Many economists predict a soft landing, but they always do. For every bubble. It was Benjamin Graham who contended that “eventually all bull markets end badly.” The central problem is that the bubble in one sector also distorts our perceptions of economic growth and productivity in other sectors, therefore when economists try to predict the effects of a slowdown they don’t anticipate these important relationships and they think that they are seeing independent phenomena, and independent sources of growth, which they are not.

A probable recession in Europe and a possible recession in America (because of government spending cuts reducing GDP) will create soft export demand from China’s major markets, as happened in 2009 when exports fell off a cliff to the tune of 50%. A credit crunch, coupled with massive oversupply of high-end apartments will cause Chinese consumers to hoard cash and pay down debt. Unemployment will increase significantly due to factory layoffs, construction layoffs and less consumer spending. Late 2012 or 2013 could bring protests and social unrest.

In the classic book “Manias, Panics and Crashes: A History of Financial Crises”, Charles Kindleberger and Robert Aliber describe how some unforeseen yet retrospectively explainable shock to the system occurs. The most common event is a financial institution that was previously thought to be well capitalized and solvent suddenly reports itself to be insolvent, thus jolting the markets and bringing into question the solvency of other financial institutions. In China there are already reports of real estate developers needing desperately to raise cash. With inventories high, liquidity may dry up and force them to unload properties at firesale prices. In fact, no major Chinese real estate developer has ever failed; therefore, I believe that many of them will fail when things get choppy in 2012 and 2013.

If things begin to get bad the government will no doubt step in to support banks, lower interest rates and create new stimulus programs. Therefore, 2012 and 2013 will be immensely volatile. The Chinese central bank has many bullets that it can shoot at the problem. However, Chinese monetary policy is nowhere near as advanced as say the Federal Reserve. Moreover, unlike in the United States and Europe where the political problems can be worked out by legitimately elected officials, the Communist Party of China believes that economic growth is its source of legitimacy. The central bank can’t lower interest rates too much for fear of increased inflation which could spark social unrest. Social unrest and protests could, even if they don’t topple the government, cause even more crisis as foreign direct investment reverses itself, as it did after the Tiananmen Square demonstrations of 1989.

So, in 2012, look for a possible liquidity crisis in China that will spark years of unrest and crisis through 2013 and 2014. Bubbles have a way of going on and on, but when they do get pricked events can move faster than anyone imagined.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.