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China's Fragile Economy, Its Housing Bubble, and What It Means To Us: Part III

Econophile's picture




 

We think that China is an indestructible economic juggernaut but its economy is very fragile and it is sitting on a property bubble which will burst. What China does in response has major implications for their economy and the rest of the world. This is the third part of a three-part series on this topic

Inflation is on the Rise

I think they will panic if they see western economies weaken. They will panic further if real estate prices start to collapse as a result of tightening policies and western economies weaken. The panic will result in more fiscal and monetary stimulus.

This is right out of the Keynesian playbook and the result will feed the bubble, create inflation, and result in more debt. And, since a substantial part of their official "growth" comes from quasi-government entities (local  and regional governments, Red Army and other State-run enterprises) which are highly inefficient as a result of top-down dictates from Beijing, much of this spending is just a waste of capital. Japan tried the same thing and it didn't work for them either.

It is remarkable that Premier Wen can get up and say that China will have 8% growth this year. In light of poor exports, a financial bubble, poor internal demand, and the severe risk from  the quasi-government and local government debt bomb, it is unlikely that China will see real economic growth this year approaching that number. Understand that they can claim to have such growth because of how they measure GDP, but it isn't real.

And they are already seeing  inflation. In February consumer prices rose 2.7% YoY, a 16-month high. Producer prices rose 4.3% in January and 5.4% in February. In light of money supply targets, inflation can only grow. The fact that there is an "output gap" has nothing to do with inflation; idle capacity and high inflation are compatible (remember stagflation). The government's target is to keep it under 3%. No one believes that.

It is clear that, officially, the CPI won't exceed 3%, but unofficially? There will be no way to know for sure. I doubt they will announce price controls to achieve their goal, but they have the power to do it unofficially by either fudging the numbers or "jawing" prices down, or both. If they attempt de facto price controls, the evidence of such will be shortages of certain commodities.

The Consequences to China and the World

1. China will lead no one out of the recession. Despite what many commentators tell you, China has weak internal consumption and lives on exports. We cannot look to them to be a leader of the world’s economies because they live off of the U.S., Europe, Japan, and other buyers of Chinese products. The U.S. will lead them out of the recession, not vice versa. The only way they can rapidly spur internal consumption is for them to abandon their wasteful planned economy, fully embrace capitalism, and let those who know how to create wealth and jobs do their thing.

2. The last thing they will do is let the yuan rise. The government is worried about the recovery of western consumer economies. In two blockbuster statements coming out of Beijing last Saturday (March 13) and Sunday (March 14),  He Keng, vice chairman of the Financial and Economic Committee of the National People’s Congress, and Premier Wen Jiabao, said that they are worried about a double-dip global recession. This is an entirely new position China has taken on the recovery. This means also that they are more likely to increase fiscal and monetary stimulus. Maintaining the yuan may be easier when hot money bails out of their markets (maybe $25 billion flowed into China's bubble).

3. China will not seriously tighten money and credit. They will continue to inflate to try to stimulate internal consumption and let inflation bail them out of the huge liabilities they face from massive defaults of local governments, quasi-government entities, and state-run enterprises. Even if they were serious about bursting the real estate bubble, they won't because they know the economy will tank because the bubble was built on cheap money, courtesy of the People's Bank of China, not real demand.

4. They have another incentive to inflate: to maintain the "stability" of the yuan. Since China's leaders are clearly worried about a double-dip recession, there is pressure on them to stimulate exports, the mainstay of their economy. Letting the yuan rise will defeat that purpose. They can flood the market at will with new yuan and also use its reserves to sell yuan. Since they are cutting back slightly on purchases of U.S. Treasuries, they have the cash to control the yuan market.

5. The real estate bubble will burst ... eventually. There is no period in history when such bubbles have not ended badly. I recommend Rogoff and Reinhart's paper, "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises." While I disagree with many of their economic assumptions, they offer a fascinating look at debt-fueled crises throughout history. Their conclusion: bubbles inevitably crash. They just came out with a book based on this paper.

6. When the bubble bursts, the results will be severe. You will recall that most of last year's economic activity came from real estate. According to Yi Xianrong, a researcher at the Chinese Academy of Social Sciences’ Finance Research Center, mentioned above, "our economy growth will stop". Or you could listen to economist Ken Rogoff who believes such a crash could reduce their GDP to 2%. Rogoff doesn't offer much guidance on this other than to say it could happen in the next ten years.

7. What will happen to China after the crash is that they will be left with a situation similar to the U.S. where home prices collapsed, taking down many financial institutions, developers, and perhaps wiping out the equity of many home buyers. But ... things are different in China, so it will be difficult to assess. For example, most buyers put very high down payments (about one-half) into a property. Also, the government will do what it can to bailout local governments by selling bonds to turn short-term obligations into long-term debt. Such activities by the government will only delay a recovery.

8. Their recovery will be prolonged. They cannot grow substantially without a recovery in exports.  And that requires a recovery of the economies of their customers, mainly the U.S., Europe, and Japan. I believe we will see a double-dip recession in the U.S. U.S. consumption will continue to be restrained as consumers worry about the economy, their jobs, their high debt, their declining asset values, and their inability to retire on schedule. Consumers will protect themselves by increasing savings. And that won't result in a huge increase in consumption. The consequences of a flattening of our economy will be bad for China.

9. They will have no real growth in internal consumer demand. The problem is that most of the new homes being built are aimed at the "rich" who are the main drivers of consumerism in China. When their housing asset base collapses, there will be a slowdown in internal consumption.

10. The government will be tempted to inflate even more to foster a recovery. Whether capital will continue to flow into real estate is a question mark. While that is possible, and perhaps investors there have short memories, it is more likely that capital will flow into other areas. As prices rise, look for assets to flow into the stock market, and commodities, especially gold. We may see a continuation of central bank purchases of gold that they started in April, 2009. A sure sign of inflation and the government's attempt to control prices will be shortages of goods.

* * * * *

Will they continue to liberalize their economy? This is the big "if." They need to do this to create wealth which increases the standard of living and leads to greater internal consumption. While their economy is in crisis, based on the Communist Party China's  fear of social unrest, liberalization is unlikely. 

See the companion piece on political liberalization: Google: A Moral Company.

Also, tomorrow I will post a link where you can download the entire three-part article "China's Fragile Economy, Its Housing Bubble, and What It Means To Us" in one PDF file.

 

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Fri, 03/19/2010 - 09:10 | 270022 crosey
crosey's picture

Thanks Econophile.  A great brief.  I have Chinese relatives and they provide interesting insights.  One that sticks in my memory is their pure arrogance.  What I mean by pure is that they do what they do and don't really care what others think, so long as they think they're in the right.  Follow on to this is that they are working their version of capitalism now, but if it does not work, and it becomes necessary for them to raise the drawbridges and withdraw back into their 3000 year history, they will do so.  These are their words, not mine.  With this in mind, depending on any loyalty from China is a fools dream.  They're nothing more than a player, so don't expect more than this. 

I also want to personally thank all of you for your input.  One of the more civil and informative debates at ZH.

Happy Friday and Quad Witching...may all your trades be green!

Fri, 03/19/2010 - 08:55 | 270014 Rick64
Rick64's picture

 Lately there is a lot of negative news about China and right around this time they are trying to get China to revalue the yuan. On top of that they say they need a more independent ( of the Gov.? ) money system. With the outflow of money and manufacturing from the U.S. to China it looks like scare tactics to me. Banking cartel is trying to get a firmer hold on China via the U.S. government which isn't easy with a communist gov.. As with any rapidly growing economy they will of course have their problems but should the U.S. be giving financial advice.

Thu, 03/18/2010 - 23:50 | 269895 RockyRacoon
RockyRacoon's picture

The only way they can rapidly spur internal consumption is for them to abandon their wasteful planned economy, fully embrace capitalism, and let those who know how to create wealth and jobs do their thing.

Uh, yeah, that has worked real well for us.   How much luck do you think we'll have convincing them of this plan?  Here's an exercise for you:  Replace the word "China" in the entire piece and replace it with "United States".   Nice fit, eh?

Thu, 03/18/2010 - 23:58 | 269899 JR
JR's picture

Well, actually it did work rather well for us. Whose manufacturing base and patents do you think they have?

Fri, 03/19/2010 - 01:28 | 269946 jeff montanye
jeff montanye's picture

it works well until it doesn't. capitalism tends to deflationary depressions: look at the nineteenth century and the first half of the twentieth.  socialism/communism tends to inflationary depressions: look at the demise of communism and the flirtation with an inflationary end-game in the west at the end of the '70's, after the most, relatively, "socialistic" period in the west's history.  after the pendulum swung from labor to capital from 1980 to now, we're back with the deflationary depression and, mocking true keynesianism (run surpluses in expansion, deficits in depression) with most of our ability to counter the deflation via expansion of government stimulus/debt already spent.

Fri, 03/19/2010 - 01:33 | 269949 Econophile
Econophile's picture

The rise of capitalism led to the greatest expansion of wealth, health, peace, and freedom the world has ever seen. From the fall of Napoleon to WWI, there was relative peace, a breakout of freedom, and a massive rise in health and wealth. Notice that I said health and wealth because the standard of living of the average person went way up. The rise of the "isms" in the 20thC lead to the problems we have today. Read Capitalism and Freedom by Milton Friedman.

Thu, 03/18/2010 - 21:00 | 269807 swmnguy
swmnguy's picture

About a year before the Olympics, I took a cab from the new Beijing airport way out in the sticks to a hotel right by Tiananmen Square.  My cabbie happened to speak very good English, so we jabbered away the whole time.

We passed miles of these huge, 20-story apartment blocks.  I mean there were hundreds of these god-awful buildings, which each probably had two or three thousand residents.  Just from the cab I could probably see the residences of half a million people.

I asked him all kinds of questions. If I got the conversions right, he was telling me he made (officially) about USD $300 a month as a cabbie.  He lived in one of those apartments.  They are sold as condominiums.  His was about 600 square feet.  He was paying on an 80 year mortgage; a total of about USD $200,000.

He swore up and down that there was nothing unusual about that sort of thing, and I had the conversions right.

OK, you tell me.  None of that adds up in my book.  Not the income, not the price, not the idea that those crap cement-block buildings will stay up that long; nothing.  Almost makes Angelo Mozillo seem reasonable.

Something's going to give.

Thu, 03/18/2010 - 23:38 | 269891 bc0203
bc0203's picture

If the system is designed to keep you a serf for life, and you don't own the property (in effect making you a tenant), who cares what the loan term is as long as your cab driver can keep making the payments?

80 years is a long time for China to be able to inflate-away the difference in property value.

And there is part of how they work their way out of the housing bubble.

Fri, 03/19/2010 - 00:53 | 269932 three chord sloth
three chord sloth's picture

But a person like that cab driver will never rise to a standard of living that can be called middle class. So where is the "internal demand" the China says is around the corner going to come from?

In order to reach a point of stability, China's going to need a society structure much like Japan or the West. That means they need about 800 million people in the middle class. I don't see them getting there before the whole shithouse goes up in flames.

Thu, 03/18/2010 - 23:18 | 269872 JR
JR's picture

This reminds me of a story related by Fox Butterfield in his book, CHINA Alive in the Bitter Sea, written in 1982 after Mao’s death in 1976 when the Cultural Revolution ended. The vast majority of Chinese peasants still lived at the time in great poverty in the countryside where villages had no pension plans and all housing was built at an individual’s expense.

In the cities, however, where living conditions were much better for workers, the author noticed in Peking a new, two-mile-long series of ten-story buff-colored apartment buildings, built on the former grounds of the capital’s magnificent old ancient walls that the Communists had destroyed in the 1950s as “sinful waste.” Wrote Fox:

The concrete structures, more than forty of them in all, were a startling contrast to the shabbiness of most Chinese buildings.  Instead of the usual dingy exteriors and cracked windows, the new buildings had large perfect windows and small balconies, with space for shops on the ground floor.

But as I walked farther, I began to sense something amiss.  There were no children playing outside, no curtains in the windows, no laundry hanging out to dry.  The apartments, in fact, were virtually empty.

“They are beautiful buildings,” a taxi driver said to me over his shoulder a few days later as we drove along the avenue where the apartments stood. “But whoever built them should be shot.”

They had been completed more than a year before, I later learned, but most people who had been offered housing in them had refused to accept.  The trouble was that the plumbing could not supply adequate pressure to lift water above the third floor; there were no gas mains for the stoves, no elevators, and the heating system didn’t work.  The reason for the mess, a friend confided, was that there had been no coordination between the different government construction, engineering, and architectural agencies involved.

“Whoever arrived at the job first just set to work,” he said.  “That way, one group of workmen came to lay the  foundations and put up the walls before the water company came to install the pipes.  No one cared about the results, because no one had overall responsibility."

Said Fox, “The apartment project symbolized for me both the achievements and blunders of Chinese industry…” representing the waste and bureaucratic bungling and lack of any real increase in the standard of living for the people that the accomplishments of  Mao’s ironfisted Iron Rice Bowl-Industry masked.

“Indeed,” said the author, “until a sharp redirection of economic policy started in 1979, there had been no significant official interest in the supply of food and other consumer goods.  From 1965 to the end of the 1970s, real wages in the cities actually fell.  The Party’s industrial successes somehow didn’t connect with people’s livelihoods.”


Mao copied the Soviets, equating heavy industry with socialism and commerce with capitalism. Again, following Stalin’s lead, he treated housing as an item of consumption with little legitimate claim to China’s resources.

Does this bode well for America’s standard of living as the Obama Administration follows the socialists' lead down the road to serfdom, beginning big time with Soviet-style Obama Motors and Obama Healthcare? 

The Carter Administration normalized U.S. relations with China in December 1978; I think it is especially telling that it was in the early 80s that the massive transfer of America’s manufacturing base to China began.

Fri, 03/19/2010 - 01:28 | 269947 Econophile
Econophile's picture

Excellent comment, JR.

Thu, 03/18/2010 - 21:52 | 269824 Buck Johnson
Buck Johnson's picture

Your correct, it doesn't make sense.  The Chinese are running a controlled ponzi scheme that is going to implode big time.  China needs for their people and not  the rich to become a middle class but to do so would require a raise in salaries and/or a decrease in living and products to buy so the individual workers can afford to buy those things and places.  There afraid to totally open the market and population to full capitalism because they fear they will lose control.

Thu, 03/18/2010 - 19:26 | 269769 dumpster
dumpster's picture

no bldg codes in usa in 1920   some of those homes are many degrees better than the false brick plastic housing in many subdivisions

china been around for thousands of years ,, many of the old bldges will be standing long after the analysists have dies and gone to heaven ,,

 

what is this china is weak,, nothing better to do that try to find a straw in a mound of hay, usa in the one rotting at the roots ,,

 

you mean tanks in Lost angels

 

 

 

Thu, 03/18/2010 - 18:34 | 269746 Howard Beale
Howard Beale's picture

China real estate market is different.

In US a good portion of bubble AG was recent immigrants building houses for recent immigrants to buy with nothing down. This was not a plan for long term growth. In China, what portion of their GDP growth is driven by  housing built as investment and not real demand?

In US there are building codes and more important a lot of expertise in building housing that will last. What is the expected lifetime of housing in China? Or are the crumbling apartment blocks an aberration and not representative.

http://www.bdcnetwork.com/article/440156-Chinese_apartment_building_fall...

In China there is no property tax so people buy houses or apartments as a long term investment. (In US people buy HD-TV's.) What are the real vacancy rates?

If the housing market collapses the above elements could be disastrous. Tanks in the square disastrous.

Thu, 03/18/2010 - 22:58 | 269863 three chord sloth
three chord sloth's picture

There is no property tax in China because you don't own the land, it all belongs to the state. I don't think they can be truly stable until the people own the land they live on... it's like having the sword of Damocles hanging over your head.

Fri, 03/19/2010 - 09:03 | 270019 Rick64
Rick64's picture

 I have to disagree. In Singapore most property is sold on a 99 yr. lease and it works fine there. The government housing (HDB) are sold at a discount (a lot less than market value) and with low loan rates. The owner then has to hold the property as well as occupy it (first time buyers) for a certain amount of yrs. before they can sell it, otherwise it stays with the family for 99 yrs.. They can sell it anytime before the 99 yrs. is up.

Thu, 03/18/2010 - 18:38 | 269743 dumpster
dumpster's picture

china .. has capacity , POPULATION that will consume, manufacturing .. leads the world now in high speed transportation,  developing many aspects of its coming #1 power in the world

 

do not kid your self  .. with the idea that china is  on the cusp of some sort of melt down,  they are ready for expansion in to the 22nd century,, amd beyond .

 

save the type for the USA ,, and its deludge of dollars, its unfunded debts, its disjointed ways..

china will surprise to the growth aspect... cars, roads , internal growth,, in my humble opinion.

waiting for Godot will be s long time coming ,

 

they are a banker to the world .. learn mandarin

 get some different opinions

 

http://emsnews.wordpress.com/2010/03/15/china-laying-the-tracks-for-global-domination/

 

 

Thu, 03/18/2010 - 17:37 | 269713 Booky28
Booky28's picture

Econophile,

In your estimation what happens to copper, iron, wheat, soybeans, corn, etc.

 

I assume you think the grains will go up due to the shortage of food, but how is that possible?

 

Demand for these items will decrease if your scenario holds true, no?

 

Furthermore, I assume you think copper and other industrial metals will go down...?

 

In this event, what happens to the dollar?

Thu, 03/18/2010 - 19:09 | 269765 Shameful
Shameful's picture

It would be possible for grains to fall, in so much as when people are low on cash they could be more likely to eat grains vs meat.  Just like most of the developing world does not eat meat because of the cost.  Animal feed is of course different but it costs more to feed animals for the meat vs just feeding people with it.  Not saying that will happen but I think that is a scenario where hungry people will still eat but costs could come down because of dietary changes.

Thu, 03/18/2010 - 17:32 | 269706 JR
JR's picture

Econophile, this is a very powerful and comprehensive report, necessary for gauging and balancing the daily play that China’s moves now make on U.S. markets and politics as reported by the financial media. 

As sovereignty lines blur and the international bankers concentrate world operations, I fear it does not bode well for America as Obama morphs her economy toward more socialism while the Communist China’s state-run economy is venturing into what Jim Rogers calls “Red Capitalism.”

While it is hard to believe Rogers’ contention that China's leaders “seem quite intent on creating the world's dominant capitalist economy,” and that, in the meantime,  “China will have to settle for being the world champion in commodity consumption,” it also is hard to believe Obama’s, Emanuel’s, and Pelosi's hell-bent drive toward socialism for America.

As national lines erase and entities meld together, is it oversimplification to say that the world is morphing into socialism?  I contend that if and when the US hits a certain point in its slouch toward socialism, that China will revert back into totalitarianism and that the international bankers will be at the socialists’ side as they grapple for world control of resources.

The question is, just how dark is the outlook for the United States?  The vote this weekend on healthcare will be an indication, IMO. And, of course, Americans’ response.

Thu, 03/18/2010 - 22:45 | 269854 three chord sloth
three chord sloth's picture

I don't know if the goal is socialism so much as it is a global oligarchy. Those in charge don't seem to care about the economic or political philosophy, nor the label we put on it, as long as their position is secure. They will pick and choose any idea or policy from any "ism" that brings the maximum level of control (with the minimum level of direct public accountability, of course) to themselves.

Fri, 03/19/2010 - 01:00 | 269934 jeff montanye
jeff montanye's picture

it certainly doesn't look like their goal is socialism unless by socialism one means the continued corrupt drive by the wealthiest individuals and most powerful corporations to increase their wealth and power by controlling the world's (current) reserve currency and that currency's sovereign debt at the cost of the very possible destruction of the nation's working and middle classes.

Thu, 03/18/2010 - 23:21 | 269876 JR
JR's picture

Exactly. Well said.

Thu, 03/18/2010 - 17:30 | 269704 Gimp
Gimp's picture

Premier Wen can make up any number he likes for GDP growth and then confirm a year later they met their mark. Who the hell is going to know any differently, they are communists.

On second thought we are doing the same propoganda here.

Thu, 03/18/2010 - 18:32 | 269745 dumpster
dumpster's picture

yep... and the usa is a bag full of holes .. china will walk the talk ,,, in my very hunble opinion

Thu, 03/18/2010 - 17:20 | 269693 Glen
Glen's picture

It's got me stuffed how China can have 10% growth and massive increases in money supply with less than 3% inflation. It's just not right. 

Thu, 03/18/2010 - 17:22 | 269696 SteveNYC
SteveNYC's picture

Right you are. "It" is anything but. They are applying their Communist brain-washing manifesto to the rest of the world. Hey, as long as Washington and Wall St. are buying it, who cares? What could possibly go wrong?

Thu, 03/18/2010 - 16:19 | 269649 DoChenRollingBearing
DoChenRollingBearing's picture

Econophile, that was a very nice piece.

I have long thought that China is not the Big Bad Boogeyman, gonna take over the world and blow us away by selling our T-Bonds.  Nor will they likely rise (anytime soon) to become a real superpower.

You summed up other pieces of the "China Pie" that I had not considered.

All we and .gov have to do re China is just stay cool, and nothing ugly will come from that.

I am NOT saying that we will avoid a firestorm.  Like many (most) here, I think the SHTF pretty soon.

Physically held PMs.  Lead and lead delivery systems.  3 - 6 mos. of FRNs.

Thu, 03/18/2010 - 15:49 | 269621 economessed
economessed's picture

Cliff's notes:  Communists are lousy capitalists.

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