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The China Bubble’s Coming — But Not the One You Think
Financial commentators are obsessively debating whether the recent rise in the Chinese stock market means there’s a bubble — and if so, when it’s going to burst. My take? Who cares! What happens to the broader Chinese economy is what we should really be watching. It will have a far-reaching impact on the rest of the world — much more far-reaching than a decline in stocks.
Despite everything, the Chinese economy has shown incredible resilience recently. Although its biggest customers — the United States and Europe — are struggling (to say the least) and its exports are down more than 20 percent, China is still spitting out economic growth numbers as if there weren’t a worry in the world. The most recent estimate put annual growth at nearly 8 percent.
Is the Chinese economy operating in a different economic reality? Will it continue to grow, no matter what the global economy is doing?
The answer to both questions is no. China’s fortunes over the past decade are reminiscent of Lucent Technologies in the 1990s. Lucent sold computer equipment to dot-coms. At first, its growth was natural, the result of selling goods to traditional, cash-generating companies. After opportunities with cash-generating customers dried out, it moved to start-ups — and its growth became slightly artificial. These dot-coms were able to buy Lucent’s equipment only by raising money through private equity and equity markets, since their business models didn’t factor in the necessity of cash-flow generation.
Funds to buy Lucent’s equipment quickly dried up, and its growth should have decelerated or declined. Instead, Lucent offered its own financing to dot-coms by borrowing and lending money on the cheap to finance the purchase of its own equipment. This worked well enough, until it came time to pay back the loans.
The United States, of course, isn’t a dot-com. But a great portion of its growth came from borrowing Chinese money to buy Chinese goods, which means that Chinese growth was dependent on that very same borrowing.
Now the United States and the rest of the world is retrenching, corporations are slashing their spending, and consumers are closing their pocket books. This means that the consumption of Chinese goods is on the decline. And this is where the dot-com analogy breaks down. Unlike Lucent, China has nuclear weapons. It can print money at will and can simply order its banks to lend. It is a communist command economy, after all. Lucent is now a $2 stock. China won’t go down that easily.
The Chinese central bank has a significant advantage over the U.S. Federal Reserve. Chairman Ben Bernanke and his cohort may print a lot of money (and they did), but there’s almost nothing they can do to speed the velocity of money. They simply cannot force banks to lend without nationalizing them (and only the government-sponsored enterprises have been nationalized). They also cannot force corporations and consumers to spend. Since China isn’t a democracy, it doesn’t suffer these problems.
China’s communist government owns a large part of the money-creation and money-spending apparatus. Money supply therefore shot up 28.5 percent in June. Since it controls the banks, it can force them to lend, which it has also done.
Finally, China can force government-owned corporate entities to borrow and spend, and spend quickly itself. This isn’t some slow-moving, touchy-feely democracy. If the Chinese government decides to build a highway, it simply draws a straight line on the map. Any obstacle — like a hospital, a school, or a Politburo member’s house — can become a casualty of the greater good. (Okay — maybe not the Politburo member’s house).
Although China can’t control consumer spending, the consumer is a comparatively small part of its economy. Plus, currency control diminishes the consumer’s buying power. All of this makes the United States’ TARP plans look like child’s play. If China wants to stimulate the economy, it does so — and fast. That’s why the country is producing such robust economic numbers.
Why is China doing this? It doesn’t have the kind of social safety net one sees in the developed world, so it needs to keep its economy going at any cost. Millions of people have migrated to its cities, and now they’re hungry and unemployed. People without food or work tend to riot. To keep that from happening, the government is more than willing to artificially stimulate the economy, in the hopes of buying time until the global system stabilizes. It’s literally forcing banks to lend — which will create a huge pile of horrible loans on top of the ones they’ve originated over the last decade.
But don’t confuse fast growth with sustainable growth. Much of China’s growth over the past decade has come from lending to the United States. The country suffers from real overcapacity. And now growth comes from borrowing — and hundreds of billion-dollar decisions made on the fly don’t inspire a lot of confidence. For example, a nearly completed, 13-story building in Shanghai collapsed in June due to the poor quality of its construction.
This growth will result in a huge pile of bad debt — as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much.
Another casualty of what’s taking place in China is the U.S. interest rate. China sold goods to the United States and received dollars in exchange. If China were to follow the natural order of things, it would have converted those dollars to renminbi (that is, sell dollars and buy renminbi). The dollar would have declined and renminbi would have risen. But this would have made Chinese goods more expensive in dollars — making Chinese products less price-competitive. China would have exported less, and its economy would have grown at a much slower rate.
But China chose a different route. Instead of exchanging dollars back into renminbi and thus driving the dollar down and the renminbi up — the natural order of things — China parked its money in the dollar by buying Treasuries. It artificially propped up the dollar. And now, China is sitting on 2.2 trillion of them.
Now, China needs to stimulate its economy. It’s facing a very delicate situation indeed: It needs the money internally to finance its continued growth. However, if it were to sell dollar-denominated treasuries, several bad things would happen. Its currency would skyrocket — meaning the loss of its competitive low-cost-producer edge. Or, U.S. interest rates would go up dramatically — not good for its biggest customer, and therefore not good for China.
This is why China is desperately trying to figure out how to withdraw its funds from the dollar without driving it down — not an easy feat.
And the U.S. government isn’t helping: It’s printing money and issuing Treasuries at a fast clip, and needs somebody to keep buying them. If China reduces or halts its buying, the United States may be looking at high interest rates, with or without inflation. (The latter scenario is most worrying.)
All in all, this spells trouble — a big, big Chinese bubble. Identifying such bubbles is a lot easier than timing their collapse. But as we’ve recently learned, you can defy the laws of financial gravity for only so long. Put simply, mean reversion is a bitch. And the longer excesses persist, the harder the financial gravity will bring China’s economy back to Earth.
Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo., and he teaches a graduate investment class at the University of Colorado at Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets" (Wiley 2007). To receive Vitaliy's future articles my email, click here.
There is a school of thought which says that China will attack India or force Pakistan to attack India to divert attention.
Both of them stand to wgain from a small attack, not a full fledged war, so that they get the kind of nervous attention from the rest of the world that would help them run their countries for a couple of years.
There have been a publication by somebody in China,an officialy recognised magazine, that proposes braking up India into smaller states.
One difference, THEY CAN print money for internal use and 'force' that to be spent...but NOBODY yet in the World Currency Market thinks that the "renmimbi' is more than the paper it is printed on -
yet, still the USA dollar, mere paper promise, is yet THE world currency of TRADE, international Trade. China 'needs' those US dollars, now that the G8 has confirmed it will hold value, at least for long enough to do a deal, just hedge a little....
Oh, yes, i almost forgot - the reason for the March 8 Little Bull was the not well publized FACT that the USA Federal Reserve ESSENTIALLY promised to back ALL US dollars everywhere in the World PERIOD 100% - THAT ALONE CAUSED THE RALLY
there is NOT and will not be a 'currency basket' trade dollar, nor 'renmimbi' trade yuan, despite minor efforts with Brazil regards the long term raw iron shipments, nor anything with ANZAC iron either...
its nothing, now its China, that is the 'Paper Tiger' slave workhouse to the ONLY consumer market out there - USA and Europe still -
China has no true mass-middle-class, where 70% of all productive capability can be 'dumped' - WE the USA, and Japan, too, by the way ARE the market...
Fear not China, they remain coolies to the West, still building the Railroads from California to the Golden Spike, still indeed
You have to go to China to check it out yourself. There are fundamental differences between the West and China with regard to saving, spending, borrowing and exporting/importing.
The Chinese save and then spend. There is a time gap between saving and spending. We borrow and spend at the same time. The Chinese stimulus are on infrastructure building which have been allocated and planned long time ago. What they did is to speed the delivery of the fund. They boost up the domestic spending by giving out discount and incentives to the Chinese to buy Chinese made products e.g. small home appliances, tools. etc. In the last 3 months, China has replaced US as the largest trading partner in Africa, India and other nations. Basically, they are eating our lunch by replacing our export goods with theirs. India, for example, has trade surplus with US. However, with China as a trade partner, India has the trade deficit against China. We have been too proud to use our judgment on the Chinese but don't realize there are things which may be normal here are not normal to the Chinese. They do things differently. The Chinese stock markets have a lot infusion of foreign money - hot money. The up/down of the Chinese stock market does not affect most Chinese companies as much as it affects us, foreign investors.
I have been in/out of China for the last 20 years. It took me at 15 years before I realize that they operate differently from us. Go to China and check it out yourself.
China is in a jam. They have 2 billion in foreign exchange reserves but they can't spend it in China. Since China is a closed system in order for the PBOC to spend dollars in China they first must convert dollars into yuan by selling dollars to buy yuan. However, since it is a closed system the end buyer of the dollars that the PBOC is selling to is in fact the PBOC. PBOC can spend yuan by either printing or borrowing.
China bags GDP in good times and stuffs it in bad, a sort of turbo charged United States, and this looks like a bad period coming up. They will have to dig deep to keep their GE impersonation of 'beat the numbah' intact.
China market p/e 25, Hong Kong 36,
that's bubble territory, period.
Oh yah, i'm so afraid, "what if they yank" pull out of the dollar holdings...strict propaganda, same thing we said back in 1988-89 to bolster the Japanese EGO,
ERGO Bank of Japan
'bang' 39,000 to eventually, what 7000 something...their big band stockmarket died with less than a whimper
we conned THEM Japs, then, we con China NOW... have no fear, China is the workhouse of the West, their entire production/factory/skilled workforce is tendered toward producing only one type of Product, and that is USA and Europe, plant-in-place and their American University Trained Engineers are unable to 'convert' to domestic production - for which there is no Demand anyway, Pig Farmers speculating in the LME included
Don't compare Wall Street with China! Wall Street made out like a bandit, laughing all the way to Israel!!
good write up
good articles;
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I've read that China has been on a buying spree (Natural Resources for example) using US Treasuries as a medium of exchange.
Not everything revolves around the US...
Counterpoint provided by Ivy Asset Strategy:
Recently, there’s been a lot of conjecture about the Chinese
economy, the role of exports in fostering growth as well as
press reports of economic data inconsistencies between growth
as reported in rural provinces and the country as a whole. As
portfolio managers who have travelled extensively throughout
China and seen for ourselves what’s going on, we don’t see big
structural imbalances or an emerging asset bubble.
What we have said for a very long time is that we feel the
property market and domestic consumers in China are more
important in the long run than the export market. In our view,
that continues to be the case today. Asia, and China specifically,
started from a very different place in this economic cycle than
the U.S., with very little leverage, and we feel this will help
prevent a U.S.-like property bubble.
We think the Chinese government acted prudently and
counter-cyclically by expanding credit by 7 trillion Renminbi
since November, and focusing on rural, inland areas. As
2009 progresses, we think they will begin to pare back
lending, and that charge-offs (for non-performing loans)
are not likely to be much of a banking problem for the
foreseeable future. We will keep a close eye on things, but
we think the market talk of a bubble in China is premature.
As far as its equity market is concerned, we do not believe
China is overvalued. We think overall 2010 earnings growth
of companies on the Hang Seng Index may be as high as 25
percent, with return on equity (ROE) in the high teens and
revenue growth in the low teens. Even though the Chinese
market (H shares) is up substantially since this past winter, to
us stocks are still trading at only about 10 times next year’s
projected earnings. We wouldn’t be surprised if investor
enthusiasm picks up further and remains high should the
U.S. dollar continue to weaken.
I'm sorry, but forcing 25% of gdp into the system through bank lending is the definition of bubble. Reports suggest that half the money went into the stock market and another big chunk into commodities and real estate speculation. Those are the types of investments that yield long term results (sarcasm off).
In the end, we may find that China never really made any money over the past twenty years - much like the Wall Street banks never really made money. That's because offering vendor financing, like Lucent, only works if you can collect the same value that you underwrote. In the case of China, they'll be collecting severely depreciated dollars. If we treat China like corporate financial statements and adjust past earnings for current depreciating value of their A/R, we may discover a net negative ROIC and a bankrupt nation.
In the end, we may find that China never really made any money over the past twenty years - much like the Wall Street banks never really made money. That's because offering vendor financing, like Lucent, only works if you can collect the same value that you underwrote. In the case of China, they'll be collecting severely depreciated dollars. If we treat China like corporate financial statements and adjust past earnings for current depreciating value of their A/R, we may discover a net negative ROIC and a bankrupt nation.
ON THE CONTRARY, the US dollar has saturated the World of Trade, not just oil pricing by far more....debt is money, USA has created the 19th Centurey British Perpetual - what with derivatives, including their insurance derivatives of derivatives of $40 trillion alone mostly USA dollar denominated -
there, the USA by far dominates regards the 'money illusion' yes, there WILL be SOME inflation, and mostly debt instruments recognize the inflation premium...
no big deal, the dollar is for trade, only trade, not as a place-marker-holder of 'value' - leave that to the plant-in-place, the true 'value of the moment'
and certainly not Gold its minicule 150,000 tonnes total above ground wouldn't be much, even if the Bank For International Settlements had it all, in the vault, horded and useless, excepting to provide the 'credo' - which as it turned out, at the crucial turning point just before March 8th 2009 to be reified truth. The Dollar Won, permanently, forever!
We, they, everyone does believe "credo in One Currency" and it is the dollar,
parallel by the way to the World linguistic of choice - the English Language of Trade, of useage, of books, of everything International...
Thank you for instilling sense, Sir. Read my other replies, which you might've done already.
I totally echo your comments.
Wall Street made a lot of money and still counting and it's being shipped to Israel.
morningstar posted this 3 weeks ago
Like the president in my country said:
"You only need to fix something when it's broken"
For now? Stocks will go up :)
and when it pops? we'll see!
Don't worry about what could happen, worry about what happend and how to fix it.
Well said. However, I am not so sure about the robustness of those economic numbers. It would not be new for China to cook the figures. Usually the lower downs would massage the figures into what their superiors want to hear.
That's how you arrive a fabulous wheat growth in the provinces where the wheat grows so dense, that a man can stand on top of it without sinking in.
Aren't the Chinese going to run into the same issue? Pumping money into the economy for internal consumption has potential for creating an inflationary cycle while the world continues to deflate. Messing with the exchange rate and increasing the cost of exports.
So I guess it would be best to lie about your economic growth if you are China. Creating confidence in the world markets while protecting your own currency by avoiding inflation.
deflation in consumer nations will mean declining wealth growth in China (along with other BRIC nations). The manufacturing over-capacity will create environment of deflating profit margin. As ranks of jobless rises amid the increasing wealth gap, the likely chance of civil unrest increases (as we have seen in western provinces of China). When this blows over in next decade or so either we'll see either hard-line Chinese government that will take the country back twenty years or fragmented China with democratic government.
"The United States, of course, isn’t a dot-com..."
Yes, it isn't - it's a Ponzi Scheme.
this is not coherent.
Interesting. Thanks
A great summation of the obvious...
Relatedly, Pali Cap put out a comment yesterday about China:
'Gradual recovery instead of sharp rebound in China's economy - We had previously expected China's economy to start rebounding in 2H09 starting from 3Q09 driven by the government's economic stimulus package to spur domestic consumption. However, post our recent trip to China at the end of July we believe the stimulus package has not made any positive impact in the real economy. '
Me thinks Chinese officials know this and are getting very worried.....
In the interest of seeing both sides to eveything, Jimmy Rogers rebuttle is flashing on my radar.
And that rebuttle is what? Link?
Such is the strategy of Goldman Sachs and Morgan Stanley, designed to cause the maximum amount of pain possible in the shortest period of time.
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