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Crash landing coming for China
By Jack Crooks

"I know what you're thinking about," said Tweedle-dum, "but it isn't so, nohow." "Contrariwise," continued Tweedle-dee, "if it was so, it might be; and if it were so, it would be; but as it isn't, it ain't. That's logic." - Lewis Carroll, Through the Looking Glass

"[We will] first ease the inflow [of capital], then ease the outflow of capital, then ease the long-term capital flows, then ease the short-term capital flows," Wei Benhua, deputy director of China's State Administration of Foreign Exchange was quoted as saying by the Financial Times. That's logic!

Why so much desire for easing capital flows into China? Well, the money rushing in has created a classic bubble in the Chinese economy. Policymakers are well aware of it. And the fact that they are now applying both sets of brakes - administrative controls and higher interest rates - knowing full well the potential for social unrest if China doesn't grow, should tell us this bubble is bigger than it appears.

Recent global bubble-ology that ended badly:
  • Japan property bust, 1992
  • Asian financial crisis, 1997
  • Internet/tech bust, 2000

    Granted, the economic dynamics driving each of these situations differed. But each has one thing in common - massive liquidity created from artificially low interest rates and the virtuous self-reinforcing upward spiral of prices. The Chinese bubble is part and parcel of the bubble in global property. It's the offshoot of the US Federal Reserve Board pushing the Fed Funds rate (ffr) down to 1% in an effort to stave off deflation when the Internet/Tech bubble popped. Consider it a five-year cycle of speculative juices running amok thanks to the central bank's magical wand of liquidity.

    Low interest rates send the signal to entrepreneurs that both resources and future demand will be available to support new projects. Artificially low rates - the suppression of the "natural rate" of interest - is what leads to over-investment, excess capacity, and competition for scarce goods, driving up prices. China's annualized consumer price index (CPI) rose to 5.2% in September; but it's 10% at the wholesale level.

    What we have witnessed in China is not about efficient markets, rational investors, or bell curves of the fairy tale land of financial theory. It's about rank speculation on the part of the crowd, with the People's Bank of China and the US Federal Reserve acting in key supporting roles as accomplices.

    "The economy is not healthy enough, wealthy enough for them. The resources they need for completion are not available. The resources they need must first be drawn from other enterprises. If the means had been available, then the credit expansion would not have been necessary to make the new projects appear possible," writes Ludwig von Mises.

    As Morgan Stanley's Andy Xie puts it:
  • Speculative capital poured into China for two years as the Fed cut interest rates to 1%. Ample liquidity triggered an investment boom that exacerbated inflation. The resulting negative real interest rate amplified investment demand and caused a speculative bubble. China may have invested US$200 billion more than it should; fixed investment may be 20% above trend. This must be brought below trend for a period to absorb the excess.
  • The net wealth of US households increased from US$42.3 trillion in 2000 to $45.2 trillion in the first quarter of 2004, within which the real estate component increased from $12.5 trillion to $16.6 trillion. The value of real estate increased by 31% between 2000 and 2003, compared with 13% between 1997 and 2000. Without the extra increase in real estate value, US household wealth would have remained stagnant.
  • However, because investment levels are too high, return on capital in China is generally low. Capital inflows and export income do not automatically translate into investment.
  • Rising profit expectations due to rising property prices have driven the current investment boom.
  • As retail sales grew at 30% as fast as investment in 2003 and 44% this year so far, meeting consumption demand could not be the main motivation for the current investment boom.
  • The bulk of the profit growth in the current boom comes from the material, financial and property sectors. The growth and high margin for the first two sectors depends on the strong property demand. Hence the profitability in this cycle depends on rapidly growing property demand and high prices. 
  • The total amount of property under construction is likely to reach 1.460 billion square meters, with a market value of about 30% of the gross domestic product (GDP) by year-end. All data suggest that the market is grossly overextended.
  • One-third of its fixed investment could represent overshooting accumulated between 2002 and 2004. The adjustment to come could be quite painful.

    As much as we would like to believe that China represents a rip-roaring free market economy - the implication of a fawning financial press - the fact is that China's economy is still 50-70% centrally planned. And we know centrally planned economies are prone to shortages and bottlenecks. They lack the flexibility to properly absorb and assimilate huge investment pools. Thus they spur political corruption.

    "In China, almost every investment involves a government decision, political influence or semi-official payoff," writes Barry Naughton, professor of Chinese and international affairs at the University of California, San Diego, in an open letter to Chinese Premier Wen Jiabao, in Foreign Policy magazine. "There is no question the economy is seriously overheated, rippling electricity shortages cause blackouts and inflict significant economic damage. Huge investments in real estate and popular industrial sectors generate useless capacity that threatens to sap the country's economic strength for years to come?.The almost weekly scandals in the financial sector are making investors nervous and sinking important deals," he wrote.

    "Risk-taking is inseparable from lending. Every loan, even if fully secured, is a kind of speculation," writes Jim Grant in his book "Money of the Mind". In China, security has played little role in lending, it is all about speculation.

    According to The Economist magazine, China's banks have been little more than conduits for pouring money into local governments and state-owned companies, with little regard for risk or profit. The build-up of non-performing loans have led to insolvency of virtually the entire banking system. By end-2003, outstanding loans had surged to 145% of GDP, the highest such ratio in the world. Bad debts to banks at 40% of GDP are a threat to fiscal stability. Most Chinese bankers, particularly in local branches, cannot tell a good loan from a bad one. There is no need to, because local managers' pay has depended on asset growthˇ¦­Lending lots and attracting deposits quickly have been all that counted - risk, return and capital adequacy have meant nothing.

    The magazine also notes that local governments have illegally underwritten $100 billion in loans to bankroll favored investment projects. And though the Chinese are making strides and moving as fast as they can on reform, this system will take years to fix.

    An accident waiting to happen
    "We have learned quite a bit about emerging markets, and we know that among the many characteristics is that they are accident-prone," Moises Naim, editor of Foreign Policy magazine, said at a recent IMF Economic Forum on China. Not only on the financial side of the fence is there a bubble, but there's one on the social side as well.
  • There are an estimated 150 million surplus workers in the rural sector.
  • There are 10-12 million surplus workers in the state-owned enterprises.
  • 11- 12 million people are added annually to the working-age population.

    "Some 800 million rural Chinese make 15% of what their counterparts in the cities earn," according to Naim. That is staggering inequality. "Because the inequality is so staggeringˇ¦­and access to services and infrastructure so uneven between rural and urban areas, and unemployment so unevenly distributed, the burden to argue that China will not have some growth-impairing accident is very hard."

    And as much as Chinese policymakers understand and work to rectify the problem, local officials often exacerbate it. "Today's economic bubble began in 2001, when local officials initiated a spate of construction projects to showcase their achievements and to ease the leadership transition at the 16th Communist Party Congress in 2002. This "political-business cycle" accelerated as new leaders took office and committed themselves to another round of public and private investment projects. The abuses you have uncovered - such as the Tieben steel mill in Jiangsu, built with shady funding on land expropriated from peasants - are only the worst among many ill-advised economic interventions by local officials," according to Naughton.

    China's hike in interest rates marks the beginning of the end for a hard landing of the Chinese economy. China's growth is highly dependent on increasing amounts of capital to support infrastructure and manufacturing projects because its service sector is weak and domestic consumption is not a major driver. The service sector in China is less than 35% of GDP (the lowest among any major economy in the word). Consumption GDP was 54% of GDP (again, the lowest in any major country).

    And even the consumption side of the economy could be heading for trouble. Growing indebtedness of the wealthiest segment of the Chinese society, in the face of rising prices, could crimp demand. "The news on slowing demand is accompanied by disturbing accounts on debt levels in some Chinese cities. The Chinese Academy of Social Sciences just reported the household debt to disposable income ratio at 155% for Shanghai, 122% for Beijing, 95% for Qingdao, 91% for Hangzhou, 85% for Shenzhen, 79% for Ningbo, and 44% for Tianjin. Five years ago, household debt was virtually zero. China's household debt has experienced the most rapid rise the world has ever seen," according to Morgan's Andy Xie.

    The implications of a Chinese hard landing will ripple through every major asset market: Stocks, bonds, real estate, and commodities. The linkage will be the blowback through the American consumer.

    From virtuous circle to vicious
  • China is the world supply source
  • America is the world demand source
  • China sells goods to the US consumer
  • The consumer sends dollars to China
  • China parks dollars in US bonds
  • Lower bond yields subsidize the US consumer, spurring demand and investment
  • US consumer demand leads to investment in Chinese manufacturing.


    At the core of this virtuous circle is credit expansion. But we know that is changing. China is hiking rates and so is the Fed. Rising interest rates are the feedback loop that will suppress Chinese growth and US consumer demand. The chart at left shows US consumer expenditures make up a whopping 70% of US GDP. And the ramp-up in this ratio over the last three years coincided directly with the fall in the Fed funds rate.

    But it doesn't stop there. The chart at left shows that US consumers took on high levels of debt in order to finance this consumption binge,  and the rest of the world - primarily the Chinese and other Asian central banks - were the major buyers of the debt, as depicted in the lower chart (again highlighted is the surge in consumer debt correlated with the ramp-up in debt held outside the US).

    Chinese policymakers have chosen to risk the ravages of a hard landing before the inflationary stage of their economy morphs into hyperinflation. Many analysts believe China will be successful in engineering a slowdown without going bust. They may be correct of course. But because of massive over-investment, lack of financial system sophistication, rigidity of a centrally planned economy, and staggering and growing inequalities, a hard landing seems inevitable.

    The investment implications are vast. And the opportunities on the short-side of many markets will be exciting while they last - almost as exciting as the potential on the long-side of many markets once China works its way through this cyclical event. Because ultimately, the Chinese economy will emerge even stronger from the lessons it learns from this cycle. It's only logical.

    Jack Crooks has actively traded in global equity, fixed income, commodity, and currency markets for more than 20 years. He is president of Black Swan Capital, a currency and commodities market advisory firm - Black Swan offers a subscription-based currency advisory service for forex and futures traders.

    (Copyright 2004 Asia Times Online Ltd. All rights reserved. Please contact for information on our sales and syndication policies.) 

  • Nov 12, 2004
    Asia Times Online Community

    Economy gathers steam again: Bad news Sep 24, '04)

    News hot and cold for China's economy (Sep 2, '04)

    Coping with China's slowdown (Jun 16, '04)

    Why land at all? (Jun 8, 04)

    Applying brakes to China's red-hot economy (May 4 '04)

    China's economy in 2004: Dimming or brilliant? (Jan 6, '04)

    China's Property Bubble, Part 3. (Dec 20, '03)


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