China: The Bear Case

by: Balance Junkie

I remain convinced we are witnessing a bubble of epic proportions which will burst – catching investors as unawares as the bursting of the Asian bubbles of the mid-1990s. Ignore these indicators at your peril.

~ Albert Edwards

Is China a bubble in search of a pin, or the global growth engine that will save us all from our debaucherous debt? You can find plenty of smart people to argue either side, so I thought I would put together some of the information I’ve collected on the topic over the past couple of months and let you decide what you think. There’s so much analysis out there, however, that I’m going to take on this task in three parts. Today we’ll just look at the factors that make up the bear case.

Why China Is So Important

Before we delve into the yin and yang of the Chinese markets, let’s take a quick look at why it commands so many headlines and such heated debate. Obviously, the China factor that stands out most is the sheer size of the market. The fact that it is still in the early stages of development makes it all the more compelling as a source of future growth. The demand for commodities coming out of China as it builds the infrastructure necessary to move from a developing to a developed nation has been credited (blamed?) for the rising price of commodities, and of the shares of the companies that mine, refine, and export those resources to China.

In The Fearful Rise of Markets, John Authers pointed out that it was the fall in the Chinese stock index, dubbed “The Shanghai Surprise”, that first signaled there was trouble in the capital markets back in February of 2007. That was just before terms like “subprime mortgage”, “CDO” and “credit default swap” became a regular part of the financial news lexicon. Not only was China the canary in the coal mine that warned of impending financial trouble, the announcement of their very aggressive stimulus package in October of 2008, combined with unprecedented intervention by global central banks, seemed to inject a much-needed dose of confidence into the markets, setting the stage for the eventual stock market rebound beginning in March of 2009.

Like it or not, China moves markets. The slightest hint of tightening out of Beijing can send commodities into a tailspin. But it’s more than that. Many, including Jim Chanos, would go so far as to say that China is commodity demand.

The Math Doesn’t Work

I’m starting with the bear case because a lot of the bull case hinges on a rebuttal of the bears. We’ll look at the bearish side of the coin and see how the bulls respond. One of the most noted China bears is Jim Chanos, CEO of hedge fund Kynikos Associates. He is famous for shorting Enron well before the extent of its fraud became obvious to the markets. He took a lot of heat for that position and he’s taking just as much criticism for his bearish view on Chinese real estate.

As with Enron, Chanos has looked at the math for Chinese real estate and found that it just doesn’t add up. Here’s a quick summary of his view:

  • Too Much Too Fast: In 2009, Chanos found out that China was embarking on 30 billion square feet of new construction, with a little over half of that allocated to new office space. That’s “a five-by-five-foot cubicle for every man, woman, and child in the country.”
  • 60% of GDP: In a TV appearance this past Friday, Chanos pointed out that construction is 60% of Chinese GDP compared to only 5% for exports. That’s huge. “We’ve seen this movie before,” he says. “Whether it was Dubai a couple of years ago, Thailand and Indonesia during the Asian crisis of the late ’90s, or Tokyo circa 1989, this always ends badly.”
  • Empty Cities: There are, quite literally, entire cities in China that contain empty buildings. There are neighbourhoods full of unoccupied housing. There are office buildings and malls standing empty. Who will populate these ghost towns? Many of those who own these properties are investors, not residents. The people who are moving from rural to urban areas can’t afford these homes. Many of them are coming to the city to work in – you guessed it – construction.

Dylan Grice of Société Générale observed that a 400 square foot property in Hong Kong recently sold for the equivalent of $1.8 million. That type of asset inflation seems to scream bubble and Grice wonders if the Chinese government has already lost control. He worries “that Japan is a leading indicator for the rest of us.” According to Chanos, that’s the biggest risk in China. If the government has waited too long to deflate the bubble in an orderly way, they may tighten policy just as the market begins to correct lower, triggering a chain reaction of asset price deflation.

The Mother of All Bubbles

Back in early August of this year, James Quinn wrote about China: The Mother of All Bubbles, pointing out that at the time, China had “65 million vacant housing units.” Mr. Quinn further notes that the “2.2 million square foot South China Mall, with room for 2,100 stores, sits completely vacant. The Chinese have taken the concept of “bridges to nowhere” to a new level.” He also offers this telling chart, comparing residential housing value relative to GDP for the US, Japan and China:

“The question is no longer whether there is a Chinese housing bubble, but when will it pop. There is one thing that bubbles ALWAYS do. And that is POP.”

A recent report from HSBC pointed out that China’s central government tried to cool speculation this past spring by introducing tighter controls on real estate purchases. “Not a single city has rolled out the much expected property tax. Vested interests have also blunted Beijing’s repeated calls for consolidation in the country’s iron and steel industry.” Local authorities have a great deal of power in China, and tighter controls won’t work if they aren’t implemented.

There’s No Bubble Until It Pops

A recent Telegraph article by Ambrose Evans-Pritchard referenced an IMF study that concluded that:

there was no nationwide bubble but that home prices in Shenzen, Shanghai, Beijing, and Nanjing seem “increasingly disconnected from fundamentals”. Prices are 22 times disposable income in Beijing, and 18 times in Shenzen, compared to eight in Tokyo. The US bubble peaked at 6.4 and has since dropped 4.7. The price-to-rent ratio in China’s eastern cities has risen by over 200pc since 2004.

He goes on to cite Diana Choyleva from Lombard Street Research:

China is trying to keep the game going as if nothing has changed, but cannot do so. It dares not raise rates fast enough to let air out of the bubble because this would expose the bad debts of the banking system. The regime is stymied.

The Chinese growth machine is likely to continue to function in the minds of people long after it has no visible means of support. China’s potential growth rate could well halve to 5pc in this decade.

A lot of countries would be very happy to post 5% GDP growth, but for China, that’s a 50% decrease. It seems unlikely that such a drop would have no effect on commodities or global markets. The crux of the bear argument is that overcapacity can only persisit for so long before the markets eventually correct it for us. Recent history has proven that bubbles can go on for quite some time, but none last forever. As Jim Chanos said of continued bullish bets by speculators, “they’ll just be climbing up a few more rungs on the diving board. Either way, they’re going to end up in the same place.”

Did you find the bear case convincing, or are you withholding judgment until you hear from the bulls?