The Great Bubble of China: Next to Pop? 25 comments
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Bubble. It’s a word used often, but seldom defined. In economic textbooks, the term bubble never appears. Most academics don’t believe the existence of a bubble, since the financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information.
But in reality, for a market hypothesis to work effectively, we must have free flow of accurate information. And the critical piece of accurate information we never had, and never will have. The market is rather cyclical and emotional, but not efficient. I can list many instances of new media fabricating news, and exaggerating some story out of proportion. Chairman Mao once said, "a pen is more powerful than a gun". The Wall Street Journal and New York Times have been consistently fabricating “news”. Do you remember the New York Times “reporting” in late June that US planned to attack Iran before Bush leaves office? That’s false, but it sent oil prices skyrocketing. And the Wall Street Journal “reporting” that Citigroup (C) lost $179 million in its Credit Card Master Trust Monday this week. In reality, Citigroup marked down its I.O strip in its trust by $179 million to reflect higher charge-off expectation. The Citigroup trust is on pace to earn $4 billion dollars for Citigroup this year.
I think we use the word “bubble” too often, e.g. stock bubble, housing bubble. In a free market, some industry will inevitably encounter shortage due to a rise in demand and years of under-investment due to low prices; thus prices will rise above marginal cost of production to encourage more production capacity. After too many people believe high prices will stay, they expand capacity. The result is always simple: we end up having too much production capacity and prices then fall back to marginal cost. It’s not much different with the American real estate market in the last 6 years. I have argued that falling home prices are actually a good thing in a previous article.
A true bubble is when everyone is fully yet falsely convinced of a new paradigm, like “this time is different”. The Nasdaq Tech bubble and the Japan Nikkei Bubble were two true bubbles. Valuation was in the stratosphere. Participants were fully convinced on the ideas of the Technology Miracle and Japanese Miracle respectively. And resources were severely misallocated.
China, in many ways, I think is the next great bubble to pop. Everyone I have met, every commentator on TV, and every major news publications had some stories on why China is going to overtake the U.S. to be the next superpower. Even Burton Malkiel, most famous for his classic finance book A Random Walk Down Wall Street, is convinced that the China is the next big thing to invest in. Jim Rogers even proclaimed that the 19th century belong to the Brits, the 20th century belonged the U.S and this century should belong to China.
Here we have all of the ingredients for a classic bubble – massive hysteria on faulty facts.
I am a Chinese. For centuries, Chinese have had nothing to cheer about. For a brief blip in history, China had the largest economy on the earth. We invented paper, the printing press, the compass and gun-powder. Yet after years of internal fighting, the Chinese society disintegrated. In the 1800s, China fought Britain twice over opium, yet the Chinese lost both times. (The Opium War was over British selling of opium to the Chinese, and the Chinese government wanted to ban the trade). Yet due to the losses to the Brits, the Chinese emperor agreed pay heavy ransoms to the Brits, which led to British control over Hong Kong. China fought the Russians and lost. China fought the Japanese, and lost. The most humiliating thing that ever happened to the Chinese was the aftermath of the Japan- Russia war. Teddy Roosevelt was awarded a Nobel Prize in 1906 for bringing a cease-fire agreement between Japan and Russia in avoiding a world war. Yet do you know what Teddy’s solution was for this so-called peace treaty? Awarding China’s northen territory to Japan. Japan was awarded a resource-rich area for winning a war over Russia. China ended up paying for the war.
After years of war and resentment of foreigners, we finally thought we could have some peace and prosperity in 1949, but we ended up having Mao. Mao was an evil genius who dreamed of becoming an emperor at a very young age. He killed his political allies and enemies on suspicions, and he starved millions of people to death.
But now, "it’s different this time". China finally has an Olympics to cheer about. Due to the economic reform of the last twenty years under Deng, China actually has an economy that’s growing at a much faster rate than the rest of world. Because of this euphoria in China, resources are grossly misallocated. In fact, China has built too many factories and too many houses. People think that if they ever get into trouble, the central government in Beijing will bail them out. I have heard phrases such as "how could Beijing possibly let the stock market fall ahead of Olympics?". Everyone thinks he/she will get bailed-out if things go wrong before the Olympics.
In Shanghai, a city of 20 million people, there are 1 million units of homes being built this year alone. There are thousands of skyscrapers being or planning to be built. Home prices have tripled in less than 5 years. Housing has become extremely unaffordable in China. There are speculative orgies going around the property markets in China, which include many foreigners all over the world. In China, home price vs. median household income ratio is way out of whack in recent years. In many cities, that ratio is like 30, or it takes 30 years for a Chinese family to work not eating to pay off a home loan. Many Chinese called homes "slaves".
China is well known for its corruptions. I was told by someone that in Shanghai, realtors, buyers, builders and bankers are all colluded to make big money. Banks lend to anyone who applies and to any builder who builds, as long they get piece of the pie. Banks belong to the government and corrupted bureaucrats are in charge of handing out loans
Subprime in the U.S. was a disgrace, but in China, its lending standards are much worse the subprime. Banks lend to who they know or lend to anyone for social reasons. The primary lending decision is not based on whether borrowers can repay.
I don’t have the figures, but l know too many foreigners are investing in China, reminiscent of the Gold Rush in 1849. Decisions to expand manufacturing capacities in China are not based on economics, rather for social reasons. One indication of excessive capacity is this: now you can buy a 52 Hitachi (HIT) LCD TV for $1,500 in store, I don’t know how the manufacturers can make any money in making that TV.
The commodity bubble is fueled by the Chinese construction bubble. Building roads, skyscrapers and expanding manufacturing plants take lots of steel and energy. But underneath every bubble, there’s a pin. I think it will burst very soon. China's stock market bubble has already burst. When the real estate bubble bursts, then the whole economy might fall into a very deep recession.
When you have a true bubble, nobody sees it. We only recognize it when the bubble is over. The American housing bubble is small scale when compared to China. Everyone warned about the American housing bubble for years before it popped; therefore, I don’t think it can be called a housing bubble.
China is a true bubble. No one believes that a slowdown is even possible. Investing in China is a sure thing to many foreigners. Yet history has told us that foreigners are the dumb money and they have been very consistent: buying high and selling low.
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of course, though, when china really collapses it will drag the world with it. after all, isn't everybody and his uncle pinning the hopes for a recovery on the global economy, now the the usa and europe are in/headed for a recession?
I expect a big bull market for US stocks ahead, from money flow back into US
Thank you for your input. I sent this articel to Jim rogers first, I got a very nasty reply from him, He called me an idiot.
Anyway, let's watch the Chinese trainwreck to unfold, it may take a year or two
Thank you for some refreshing insight and an honest overview
of the situation. If your assertions about the lax lending and
overexpansion of the real estate market are correct, you may
hear back from Jim Rogers. You are also correct in your point
that commodity prices will fall if the Chinese economy falls into
recession. However, that would hurt the American economy
in the short(6-9 month) therm
totally agree. I put 60% a chance of regime change within 15 months.
The tie with Taiwan is the big issue. It won't be a one sided deal - yet both parties have so much to gain that the move almost has to happen. Taiwan has management skills and expertise and China has cheaper labor - and lots of it.
Taiwan will bring more to the table - it will be a force to open up China to political reforms, if - and don't forget this if - if China moves to a point where there is a workable system to address the corruption, then the sky is the limit.
The social part of business is alive in all cultures - I understand the gifts and forming a click breeds corruption, but it also breeds cooperation. The problem is that the markets need to be opened - China has to realize that they are becoming more capitalistic than the USA and it is moving them up (while the USA rapid move to socialism is bringing us down).
If China tied their money to gold and opened it for trade and opened their stock markets to the world (no more separate A vs B stocks) the possibilities are endless.
So the real question is how much of an anchor is corruption on the actually capitalistic culture of China? Will it only slow China or will it keep China pinned down just as corruption keeps the Philippines from moving up?
Transparency International ( www.transparency.org/ ) rates China much above the Philippines and the Chinese seem to run most of the businesses in the Philippines in spite of the corruption.
I hope that the leaders in mainland China might read
'The New Institutional Economics of Corruption'
By Johann Lambsdorff
and realize the great economic cost of corruption and find ways to fight it. Will it happen overnight? No - but as China gets wealthier it is easier to fight corruption.
1. All of Asia has relied for decades on mercantilism to encourage quick development, artificially low currencies and cheap loans to subsidized industry, with Western debt being purchased by Asia to maintain the ability of the West to consume. Japan was the first (in Asia) to take that route. China was the last to be able to develop on this model, the West cant absorb anymore debt (especially the US, suffering a crisis largely as a result of this cheap money and its own profligacy) and Western workers arent worth 10 times Chinese workers, that means that Chinese labor rates must rise relative to US and European labor rates. And the problem with this is that much industry was built on the assumption of very rapid long term growth based on this artificially cheap labor. Chinese labor is no longer cheap, its currency is rising quickly as are labor rates there. Much industry is uneconomic and will have to be abandoned. This is already happening as Chinese factories move en masse to cheap labor countries like India and Vietnam where labor rates are a third of those of China. China will face the same problems as Korea and Japan did, no longer able to fund growth with cheap labor, they must now depend on efficiency and innovation, a much harder road for which China is not at all prepared.
2. The Chinese real estate complex is a first order bubble. Government officials control the banks, land use regulation, the real estate development companies, the cement and steel companies, the stock market where these companies are listed and all other factors. Insiders (typically government officials) in every city and town in the country thus caused a massive run-up in real estate prices in order to benefit.
Imagine if the Republican party (or the Democratic, for that matter) controlled the US legal system entirely without check or balance, legally owned all of the land and could legally confiscate land at will(and often did so) or forbid development at will, owned all of the real estate companies, owned all of the banks and owned all of the steel and cement and resource companies. Can you imagine the corruption? You dont need to imagine, for that is today's China. Much wealth was created in this real estate bubble which would only have looked reasonable if China could have been expected to grow at 11% a year for the next twenty years. That wont be the case and the Chinese real estate bubble will burst. They average apartment in Shanghai is more than $130,000 USD. Average salary might be $4000 dollars per month. Shanghai is one of the largest cities in the world and these kinds of extreme price to income ratios are normal in large Chinese cities. The Chinese real estate bubble will be a heavy weight on banks (and thus on lending) ( a la the Japanese bubble) and apartment owners (and thus on consumption) for a very long time to come.
3. China's banks are bankrupt. US banks are bankrupt and the US has a legal system Can you imagine what the situation would be if there were no legal system and administration officials and local government officials controlled the banks and their lending. That is China. Not to mention the fact that the companies that they are lending to are usually majority government owned. The results of such a system are not difficult to predict. And in the meantime, private non-state owned industry that is often efficient (and yes even creative at times) is severely starved for capital except for through illegal networks banking that charge very high rates.
3. China has a one child policy. High savings rates are necessary because there is no public medical care that functions, no pension system in place. Imagine the savings rate in the US if there were no medicare or social security and parents were dependent on their children and could only have one child. China's savings are China's pensions, not a fund for consumption. This substantially limits the potential of the Chinese market. Not to mention that China is currently close to double digit inflation and real returns on deposits are negative (conveniently enough for real estate and the stock markets).
4. China's is not yet creative. While China is improving, it has spent its time copying innovation rather than creating it during that last thirty odd years. Chinese culture encourages conformity, though that is changing, however as of now China is not prepared to compete with competition at equal labor rates with countries in which innovation is fostered and more natural. Japan and Korea had two generations to learn to be creative and are still struggling, and they were much freer societies where dissent and non-conformity and innovation were encouraged to a much greater degree. China cannot be expected to become more creative than these societies in a such a short time span. This will limit China's exports volumes when it competes with countries such as India and Vietnam that can boast much cheaper labor.
4. China will have to spend a fortune to pay for its environmental mess. The north of the country is a rapidly spreading desert, desertification and its impact on farming are potentially catastrophic. This will be incredibly expensive to deal with. The rivers are polluted beyond anything the West has ever seen, this will be enormously expensive to clean up and will require the shutting down of industries or paying huge sums to clean them up. The same is true of air quality and land poisoned by chemicals and heavy metals.
6. The one child policy is a disaster waiting to happen. If Europe and Asia have aging populations, this is nothing compared to what China will face with its (admittedly spottily enforced) one child policy. China will grow old before it grows rich.
7. The peasants are poor. They never made any money during the boom and probably never will. They benefited most from money being sent home by their children in the cities. They depend on farming for their survival and dont have substantial savings. They represent 75% of the country. For China to reform agriculture, the peasants need to leave the land and farming needs to be mechanized. Then China will be able to compete internationally in agriculture. Otherwise its agriculture will be inefficient (witness the latest DOHA round and China's approach on agriculture). However if China allows land to be consolidated and becomes efficient in agriculture, peasants will receive small compensation for their land and will not be able to support themselves in their old ages. Nobody has yet found a reasonable solution for this problem, which affects a good 800 million + of China's 1.5 (likely) billion people.
China has other problems as well, but this covers the major issues. The China bubble has benefited the Chinese immensely, the smart money rode it up and used it to full advantage. Especially those selling real estate and factory deals to foreigners, but also the Chinese themselves. The smart money knows the reality. There is no such thing as an economic miracle. When you see one, run the other direction. Or sell short in the long term.
China will continue to grow and prosper over the long term. China will over time produce reasonable (3-7%) economic growth. But the days of 10+% growth and unlimited optimism will be looked upon as we today look upon the internet bubble, a beautiful illusion while it lasted.
You are very good, Tell me what you do for living and how do you so much about China?
What happened in China last 15 years is similiar to Taiwan from 1975 to 1990. Stock market and real estate went thru roof due to "export mania" and "credit expension". I still remenbered in 1960, my father bought a house there. He must pay "all cash". I mean it's real paper money. It took a cashier hours to count piece by piece and piggy backed to bank. No bubble possible that way.
Let's skip the detail. Taiwan economy was booming under the dictatorship but dropped into a hole last 8 years under a highly democratic political environment. China just copied the first half Taiwan experience, will she copy the 2nd half?
Hope not. Taiwan ecomonic base is too small in nature resource (including land) and size. As long as food and energy can get by, China doesn't give a damn (sorry) how the outside world view them. For 4,000 years, China never depended on foreign economy. What CHina must get externally is technology, so called know how - in science, military and management -, everything else is optional. Get Google?
People has a wishful thinking that the western value such as democracy, freedom ... are necessary for a good economy. But sorry, look at New York Manhatten, so many years passed, where's the 2nd Lincoln tunnel? In Shanghai, they built one almost every year.
The real hope for China, is it will copy Hong Kong model - not totally democretic, not totally dictatorship, being smart on resource and business deals. I think China will be Hong-Kongnized in 15 years.
The corruption issue? Yes, it's annoying and not good. But comparing with the size of western CEO compensation, it's a peanut. How many times a western company had $billion losses or even to chapter 11, but CEO and CFO still got away with $millions and $millions anyway. GM, Fennie, Citi, Bear, .. it's an endless list
In China, an official committed big financial crime can be executed and every penny confiscated. The subprime crysis here is caused by the same banker, developer and borrower mix. How many were jailed so far?
I'm not saying China is trouble free. Their major weakness is lack of counter force when the leadership is in wrong direction, such as Mao in his old age. Chinese deal with it by patience and tolerence. Once they get a good leader, like now, they progress fast.
A western sponsored survey last week showed among all world nations, China is #1 on people happy with their government. China could be way down the list by the noisy elite group. But the big picture and long term view shouldn't be overlooked. For this reason, my plan is to take a look at my China Holdings 10 years from now to see what surprise it offers.
Thanks
There are risks in every country & market and plenty in China as Howard9 pointed out. However, any serious global investor seeking growth should have some China investments for the long haul. It is that simple.
All China's current problems (with the possible exception of desertification) will pass and be replaced by different problems but the overall momentum and drive will continue to push China forward.
How do you think the U.S. looked to outsiders as an investment during our civil war circa 1863? How did we look during great depression etc... Don't let the problems of the day prevent you from investing in China long bull run.
Just a comment on your ideas!