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One recent trend that seems to be gaining momentum is concern about China and its growth outlook. Is China a bubble waiting to explode? Will the coming collapse of China take down all emerging and commodity markets? These are some of the issues on investors’ minds these days. The concerns around China are clearly benefitting India as investors seem to be far more sanguine about India’s long-term growth prospects. No one thinks India is in the midst of some super bubble, and the noticeable pick-up in investment flows from foreign Institutional Investors (FIIs) into India can be partly traced to some asset allocation shifts on the margin from China to India.
There are two-three interesting articles laying out the bear case on China, all available on the web. The presentations by Jim Chanos, Vitaliy Katsenelson and Edward Chancellor of GMO are the most interesting. I have chosen to focus on the GMO white paper in this article, but the points being made by Chanos and Katsenelson are quite similar to what Chancellor outlines in the GMO paper.
Chancellor, who is a noted financial historian, makes the point that China today exhibits many of the characteristics of great speculative bubbles or manias. He starts out by outlining some of the common features or characteristics of previous financial bubbles and then points out how they can be used to describe China today. Historically, rapid (above trend) credit growth has been the single most important indicator of a developing financial bubble. This is closely followed by the build-up of an asset price bubble. Very low and sustained interest rates and rapid money supply growth over an extended period are also classic warning signs. Investment manias have always been built on compelling and credible growth stories like China’s. A general increase in capital investment leading to misallocation and wastage of resources is another classic sign of a developing investment mania.
Testing the current China story against these historical markers of an impending crisis, Chancellor concludes that it fits the bill on most of the criteria. In fact, there are red flags wherever you look at China. First of all China is clearly a huge economic success, and one can see why it is such a compelling long-term growth story around which a bubble could easily develop. China has 1.3 billion people, with a per capita income only about 10 per cent of US levels, and over the past 30 years the country has increased its GDP 16-fold.
Over the last year, China has overtaken Germany as the world’s number one exporter and Japan as the second largest economy. Over the coming decade, 300 million rural inhabitants are expected to move into cities, laying the foundation for continued 8-10 per cent GDP growth for many decades. Its economic momentum seems unstoppable. Chancellor’s contention is that investors are simply extrapolating recent growth rates and that forecasts for urbanisation and growth may be exaggerated. He also feels investors are ignoring the growth-inhibiting aspects of the Chinese demographic story.
If one were to look for an investment boom characteristic of a bubble, it can be found in 2009. Last year, in the midst of a global recession, Chinese fixed asset investment rose 30 per cent to a record 58 per cent of GDP, contributing 90 per cent of the year’s economic growth. Infrastructure accounted for more than two-thirds of the spending although China already has adequate infrastructure, with highway usage running at just 12 per cent of the OECD average. Capital spending in an industry like cement increased by two-thirds despite utilisation running only at 78 per cent. There are numerous anecdotal stories of empty roads, airports and huge excess capacity across the industrial complex.
Chinese interest rates are also seemingly artificially depressed. As a general rule of thumb, nominal interest rates should broadly track nominal GDP growth over the medium term. In the US, for example, the prime rate has averaged about 1 per cent more than nominal GDP over the last 40 years. In the case of China, the prime rate has averaged 9 percentage points lower than nominal GDP since 1990 (source:GMO). Low interest rates are one of the tools the Chinese authorities use to subsidise state-owned enterprises and boost investment.
China is currently going through a huge credit boom. In 2009, bank lending increased by RMB 10 trillion, approximately 29 per cent of GDP. Money supply growth exceeded 30 per cent, but it seems unlikely that credit could have expanded at this pace with no decline in asset quality, and the Chinese banking system could be overwhelmed by NPAs. In a world where most are de-leveraging, China has seen the fastest credit expansion in its history.
There seems to be an asset bubble developing in China’s property markets. First, on the residential side, prices are clearly stretched. Nationally, home prices have climbed to around eight times the income and in Beijing the ratio is 15. As Chancellor points out, in Tokyo, at its peak, this ratio was 9. Commercial rents in leading Chinese cities are already at international levels, with rents in Beijing and Shanghai rivalling those of New York.
Chancellor makes the point that China’s real estate market, its economy and financial system are all working on the assumption that past rates of growth will continue into the future. This assumption justifies continued investment, leading to strong growth and this growth drives further investment, thus confirming the initial thesis and setting up a positive feedback loop. If growth were to disappoint, this can easily reverse into a negative spiral. He equates the China of today with the last stages of the dotcom bubble when investors extrapolated growth and a surge in investment created a spike in demand that justified even the most optimistic predictions. Once the initial predictions were exceeded, investors quickly went overboard in their expectations and long- term modelling of demand.
My own sense is that predicting the timing of any collapse is impossible, and being a state dominated economy China may be able to delay its day of reckoning. It has huge resources, in terms of foreign exchange and in the fiscal elbowroom it enjoys, to keep this party going. As long as it continues to convince the world that it will underwrite 8 per cent growth, the believers will keep investing. The political consequences of dropping below 8 per cent growth, will also ensure that he government will leave no stone unturned in propping up growth. However, if history is any guide this will ultimately end badly.
How to invest with one eye on long-term structural issues like China and yet remain tuned to the short-term momentum of investor enthusiasm for emerging market assets is a dilemma that every investor faces today.