Uncovering a financial bubble before it pops is a difficult task. Alan Greenspan, former chairman of the Federal Reserve, remarked that predicting a bubble cannot be done – only in retrospect are the causes and effects clear. Economists Hyman Minsky and Charles Kindleberger have made studying financial bubbles their legacy. In their book, “Manias, Panics, and Crashes,” they uncover a basic trend underlying all bubbles. First is a “displacement,” or a shock to the financial system, such as new technology that offers a compelling story for why things are different this time around. Second is the rapid growth in credit, which allows people to borrow money to buy inflated assets. At the peak, investors forget about what they buy and simply join in the popular enthusiasm. Finally, the euphoria gives way to “revulsion,” where markets correct and the cycle starts again with a new displacement.
China has enjoyed the fastest-growing major economy for the past 30 years with an average gross domestic product growth rate of more than 10 percent annually. After a closer analysis, however, the China story starts to look more like that of Japan shortly before its stock and real estate markets collapsed almost two decades ago. With a skeptical eye toward the economic numbers released by the Chinese government and some investigative work, overheating of the Chinese economy becomes apparent. In my opinion, the country is investing heavily in infrastructure for which there is little demand, creating enormous excess capacity and putting the bubble at risk.
The global credit bubble that began to unravel during the later part of 2007 had two major legs. The first was cheap credit fueling excess in personal consumption and the real estate market, primarily in the United States. The second, which has yet to burst, is the excess of capital spending financed by credit, primarily in China. For China, the primary driver of economic growth has been capital investment. A research report by Pivot Capital Management, however, shows that China’s investment spending is far greater than that of other countries’ periods of rapid industrialization, including post-World War II Germany and South Korea during the 1980s.
With a government bent on short-term growth and investors eager to buy into China’s growth, credit is feeding inefficient capital investments in manufacturing, infrastructure and real estate. The declining return on these investments eventually will lead to a pullback in capital spending. Further analysis shows that China already has ample manufacturing capacity and does not require the additional capital spending. China is in line with developing countries with regard to its manufacturing base. It produces a lot more than the light industrials like toys, apparel and electronics that foreigners have come to recognize. In 2008, China produced 500 million tons of steel, more than the European Union, Japan, United States and Russia combined. Even at those levels, China has an additional 160 million tons in idle capacity. Cement production tells a similar story. China has an estimated spare capacity of 340 million tons in cement production, which is more than the consumption of India, the United States and Japan combined.
Easy access to credit in China has been a boon to residential construction activity and the real estate market. These construction projects have boosted GDP numbers while increasing the paper wealth of many Chinese government officials. Affordability ratios suggest that these real estate prices are unsustainable, and that we could see a mortgage meltdown in China on even larger proportions to that of the US. Indeed, since 2003, residential construction has far surpassed household formation. International Monetary Fund statistics note that home ownership is at 86 percent in China, compared to 69 percent in the U.S. at the peak of the U.S. housing bubble.
Inconsistencies in the Chinese official statistics serve as another red flag. For example, the surging car sales coupled with essentially flat gasoline consumption indicates that something is wrong. China optimists points to surging car sales – up 94.7 percent in August. Yet, gasoline sales have been up only 6.4 percent in August. Some reports allege that Chinese government officials have ordered state-run enterprises to buy fleets of vehicles and store them in parking lots across the country to generate predicated growth figures. It is difficult to believe that rapid increase in vehicle sales is not accompanied by corresponding increase in fuel usage. Investors cite consumer sales figures for 2009 that show 15 percent growth year-over-year, but because China’s figures include wholesale numbers, it is possible the manufactures are stuffing warehouses with inventory and booking sales. Also, because the government accounts for 40 percent of sales, much of the increase could be the result of unsustainable government spending.
Another inconsistency in the numbers occurs in electricity consumption. Official figures state that the GDP grew 6.1 percent during the first quarter of 2009 year-over-year, while electricity production during the first quarter was 4 percent lower than a year earlier. Yasheng Huang, director of the China lab at Massachusetts Institute of Technology’s Sloan School of Management, explained that for electricity consumption to plummet in a supposedly fast-growing economy is “an extraordinary pattern, a pattern, I might add, that is absent in all other countries.” In a recent interview with CNBC, James Chanos, president and founder of Kynikos Associates, expressed surprise that investors who shun U.S. government involvement with the economy can be bullish on China when the country’s government “fine tunes” the economy to its liking. He believes that China’s GDP numbers are “massively inflated by under-depreciating a very, very, very shaky capital asset base.”
Vitaliy Katsenelson, a writer for Foreign Policy magazine, compared China’s situation to that of Lucent Technologies in the 1990s. Lucent sold computer equipment to technology companies. She explained that, at first, the company grew naturally by selling equipment to cash-generating companies. Once it conquered that market, Lucent looked to start-ups financed by private equity and equity markets. Once these dot-coms couldn’t raise equity to buy Lucent’s equipment anymore, Lucent offered its own financing, which worked out well until it came time for the dot-coms to pay back the loan. The United States is no dot-com. But the growth of the Chinese economy during the past decade largely was the result of Americans borrowing from the Chinese to buy Chinese goods. Now that the United States is pulling back on credit-based spending, the cycle may stop, leaving China with bad loans and fewer exports.
The most likely result is an asset price collapse followed by Japan-style deflation. Japan during the early 1980s was very similar to present China. Both were emerging powers with economies based on exporting to the U.S., supported by an exceptionally low-pegged currency. At the time, the United States also had a rising trade deficit and blamed the deficit on the weak currency policy supported by the Japanese. The Japanese real estate and stock markets began a long fall in 1991 after a sharp currency appreciation. The appreciation continued for a few years; by 1995, the yen/dollar rate had appreciated nearly 50 percent, which increased the real burden of Japanese borrowers, crippling the banking system with non-performing loans. The Chinese economy is on track for a similar deflationary spiral. The country’s excess capacity and reliance on American consumers indicate that this turn of events is imminent.
With the Shanghai stock market up more than 60 percent since the start of last year, investors around the world are looking to China to bring us out of a global recession. The country’s recent GDP numbers that suggest 8 percent growth for the year give signs of hope. Closer scrutiny, however, reveals the Chinese economy is in the midst of a debt-fueled asset bubble likely to burst within the next five years.
Rahul’s column runs biweekly Thursdays. He can be reached at r.gorawara@cavalierdaily.com.
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