THE BEAR'S LAIR Even China faces meltdown
By Martin Hutchinson
Shares are trading at 35 times earnings. Banks in the last six months have lent
more than the entire gross domestic product for the period. Interest rates are
below the inflation rate, while monetary growth is far above it. The seven
largest bond transactions in the world in 2009 were domestic deals in this
Looks like a bubble to me, and bound to end in tears. In a Western economy, one
would be sure of it. So why should we think China's different, and what would
be the effects of a Chinese economic meltdown?
Various very intelligent people have seen their hair turn grey waiting for a
Chinese bubble to burst. Ever since 1998, it has
been clear that the Chinese banking system has contained hundreds of billions
of dollars in bad debts. A real estate boom in empty office buildings in
2003-04 pushed the assumed total of bad debts up further, and when Ernst &
Young in 2006 estimated its total at US$911 billion (and then retracted the
figure under pressure) that seemed a reasonable estimate.
Yet the Chinese economy has continued to grow almost as fast as the estimates
of bad debts in the banking system and no signs of collapse have been seen.
Indeed, international initial public offerings by the major Chinese banks in
2006-07 were all outstandingly successful.
So why are things different now? It has been clear for a decade that Chinese
public data overstate the country's growth rate, so that the apparent 16%
growth in the second quarter of 2009 is largely fictional. Indeed, income tax
receipts data suggest that growth in the first quarter may have even been
However, that is hardly surprising; after all, the country's exports were down
around 30% at the peak of the trade recession of last winter. Even if China's
second-quarter growth was really at an 8-10% annual rate, after, say, a 5% rate
of decline in the first quarter, that is still a better growth rate than any
other major economy in the world. So why should we image that China's relative
outperformance cannot continue?
Here the example of Japan is instructive. From the 1950s to the 1980s, Japan
enjoyed apparently unstoppable growth. The global recession of 1974-75 brought
only a brief interruption of that growth. That of 1980-82 (when the Japanese
economy had adapted better to high energy prices) brought no interruption at
all, although during the 1980s there was a noticeable slowing.
Yet in 1990, after an incredible boom in real estate and stocks that took the
theoretical value of the emperor's back garden higher than that of the state of
California (it was admittedly better tended) it all stopped. The real estate
bubble burst, the stock market bubble burst and Japan has now suffered almost
two decades of negligible growth and relative economic hardship.
Nobody now considers Japan to be the world's great growth economy as they did
in the 1980s. Yet the Japanese virtues of superb education, dazzling technology
and a grinding work ethic are still as evident as ever.
In some ways, the Japanese example should be encouraging to China. While some
areas of the country have enjoyed astonishing growth, its overall relative
wealth is not even that of Japan in 1973, let alone that of 1990. Indeed, the
Japanese example suggests China should enjoy several more decades of
exceptional growth before its living standards get close to those in the West.
At that point we may indeed see a crisis, but on that analogy, the crisis
should not occur before 2030, at the earliest.
Yet it is not inevitable that growth economies must almost catch up to Western
living standards before crisis intervenes. Thailand suffered a crisis in 1997
after 30 years of excellent growth but far before it had reached Western living
standards. Even South Korea at the time of its 1997 crisis was well behind the
relative position Japan had reached in 1990.
Thailand and South Korea have enjoyed some growth in this decade, but the
intervening transition was painful indeed, involving a sharp drop in output
and, in Korea's case, the passage of the entire banking system through
On examination, China looks more like Thailand than Japan. Even 30 years ago,
the Japanese economy was known for its transparency, with its own equivalent of
the Glass-Steagall Act and a careful division not only between lending and
brokerage, but even between different kinds of lending. National statistics
were produced meticulously, according to norms laid down during the US
Politically, the same party won every election, but elections were properly
contested democratic polls, and there was open competition between different
factions in the ruling party as to whose policies would be followed. The state
sector was small, and only a small fraction of the banking system was state
owned. Much of the private sector dated back for centuries, and followed the
stable traditions of family capitalism not dissimilar to Germany of the period.
As Japan's labor costs approached those of the West, inefficiencies in the
Japanese system became more apparent, and it was always likely that a crisis
would intervene before Japan was fully modernized. But its education system was
so superb, and the openness of it political and economic institutions so great,
that it was unlikely to reach a crisis before that point. Finally, in 1970 or
so there was no great overhang of bad debts in the Japanese banking system, nor
was real estate in any obvious excess. (The infrastructure excesses came later,
in the 1990s.)
China has none of Japan's transparency. The government is undemocratic and a
poor respecter of human rights; in this respect it is like Japan's pre-World
War II governments, aggressive and chauvinist. Unlike Japan, it maintains a
huge military machine, which itself owns a plethora of companies. The state
corporate sector is still gigantic and supported by state-owned banks.
Savers are not permitted to take money out of China, and their huge savings
prop up an overvalued stock market and a bond market that is comparable in size
to the freely flowing international bond market. Private sector companies are
either youthful fly-by-night operations or dubiously privatized state
behemoths. Prices are still largely administered, and investment flows mostly
to the politically connected rather than to the economically attractive.
Education is relatively poor outside the main population centers, and land
ownership is still restricted.
China is thus much more like pre-1941 Japan than post-1950 Japan and its
economic inefficiencies are correspondingly greater. Because of those economic
inefficiencies, the chances remain high of a meltdown far before China has
achieved Western living standards.
From the excesses now seen in the Chinese economy, that meltdown appears now to
be impending. Companies have more liquid assets than they can usefully invest
and have been gambling with them in the stock market, a phenomenon last seen in
size in Japan in the late 1980s. Shipments to retailers have increased by 15%
in the first half of 2009, an increase reflected in the gross domestic product
statistics but not necessarily in sales to final consumers, although households
without electricity or running water have reportedly been dragooned into buying
The most likely form of meltdown to occur is that of a banking system collapse,
as the gigantic volume of recent loans goes bad and liquidity in the economy
finally dries up. That would drain the huge Chinese savings pool and cause
steep output contraction, particularly in the overleveraged and inefficient
The excess money in the system, with M2 money supply up 28.5% in the year to
June, also suggests that a price explosion cannot be far away. Although
official inflation is currently negative, the People's Bank of China has
already warned of a possible inflation resurgence.
It must also be remembered that the social structure of China is now quite
Latin American in nature, with a Gini (inequality) coefficient rising rapidly,
already at 47 by 2007, well above its Asian neighbors and not far below Mexico
(48) and Argentina (49). Thus an economic collapse is unlikely to be survived
quietly, as was the case in South Korea and Thailand.
A Chinese economic collapse, which might well be accompanied by an Indian
balance of payments crisis due to that country's perpetual government
overspending, would cause a sharp "second dip" in the global economy.
The amount of foreign capital tied up one way or another in the Chinese economy
is now so great that a Chinese market collapse would have global repercussions
in an already weakened financial system. Furthermore, it is by no means certain
that China would quickly resume its role of global growth engine; Japan didn't,
China could be different - it always has been. But at some stage, the
mysterious Chinese economy and its thoroughly opaque banking system must
respond to the same constraints that affect the rest of us. Chinese economic
policy has been more stimulative than ever before, its bank lending more
reckless. If China's run of apparently miraculous immunity from normal economic
forces is finally about to end, the result will not be pretty for any of us.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)