The Great Bubble of China: Next to Pop?

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Includes: CAF, CNY, FXI, PGJ
by: Frank Rong

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 (NYSE: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.