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The Chinese Black Swan
Party rulers in China are trapped in a position that chess players deeply fear — zugzwang — where any move made puts you at disadvantage. In China, the potential cost of both action and inaction is economic collapse.
China is slowly starting to face the consequences of its actions — loans grew over 30% a year over the last few years — and inflation is rising fast. Inflation in developed countries is unpleasant, but it is tolerable. For a developing country — and China, despite its size, is still a developing country — it can be catastrophic. In developed countries, we spend two or three times less on food as a percentage of our income as do people in developing countries. Therefore, though food inflation is unpleasant, we have a much greater tolerance (margin of safety) for it. While food inflation the US can mean fewer trips to restaurants or no summer vacation, food inflation in China leads to hunger.
The Chinese government is desperately trying to put the brakes on the economy. It is shutting off lending to land developers and has raised bank reserve requirements five times this year. However, its success on the inflation front will likely lead to a slowdown of the economy and high unemployment. Ironically, those were the issues party planners tried to cure when they stimulated the hell out of the economy over the last few years.
China bulls are arguing that the almighty Chinese government will be able to soft-land the economy. Unlikely, I’d say. Forced lending was at the core of Chinese economic growth. Simply put, there is too much debt to go bad. According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems. The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post. Once lending is cut off, property prices will stop appreciating (and likely collapse — that is what usually happens in a Ponzi scheme). Also, the overcapacity in the industrial sector and commercial real estate will come to the surface. And suddenly everyone will discover that the venerable emperor has no clothes.
I often hear the argument that China will not have a real estate crisis of US proportions because home and condo owners have to put 30-40% down when they buy. So where do people get the money to buy a house that costs, on average, 8 times their annual income (a figure several times higher than in the US)? Some of it comes from savings, and some comes from borrowing from relatives.
Let’s pause for a second. In the 1990s, the Chinese banking system basically collapsed. To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity). Banks started to function as though nothing had happened. To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 1% or so. In a country with a very high savings rate and 5% inflation, this resulted in a 4% annual loss of purchasing power.
Chinese consumers were punished severely over the last 10 years for the banking crisis of the late ’90s. And they’ll be punished even more soon. Keeping money in the bank didn’t make that much sense, and investment alternatives were limited. However, they could invest in an asset that supposedly never declines in price – a house or condo. So they did. As China slams the brakes on the economy and as housing prices fall, the banks will lose plenty of money. But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose. The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest. That is the Chinese Black Swan!
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.
Copyright Vitaliy N. Katsenelson 2011. This article may be republished only in its entirety and without modifications.
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So are the Germans. Ever been in a hyper-inflation before? These grandparents have. I'm still trying to figure out Argentina which is going right back into one--and if what i've read is true about Bolivia it's looking pretty grim there as well. Does it matter if your million dollar apartment is worth 30,000? Well--relative to what? Relative to price of a pound of rice? I would say absolutely. On the good side the American West has had an amazingly wet growing season.
I call BS, the real estate boom had not really begun yet in the 90's.
There isn't really much demand certainly rings true with 64m empty apartments that no one can afford.
...the real estate boom had not really begun yet in the 90's.
That's exactly what I said above.
There isn't really much demand certainly rings true with 64m empty apartments that no one can afford.
Yea, the government wants their GDP numbers. House flippers have made a killing. And now oversupply will take hold. People will be wiped out. But my point is, that this isn't the real issue.
The real issue is the migrant workers and how they are going to deal with the imminent recession and more importantly, how they will be dealt with if things get out of hand.
A dualistic society may have never left China. It seems, from your comments, that the migrant workers are content in their place of having no equity and working for the man.
When the poor migrants get hungry then the revolution will start all over again. The west is not exempt from this either. It will all come down to food or the lack of it. Housing is all speculation.
A dualistic society may have never left China. It seems, from your comments, that the migrant workers are content in their place of having no equity and working for the man.
Its even easier than that. The migrant workers are labourers. They generally have little education or skills and in places like Beijing or Shanghai usually end up working in service or construction. If you didn't have any education or skills, you'd probably be contempt working for the man with no equity, as long as you can feed your family.
When the construction boom comes to an end, the large portion of construction workers will feel the pinch first. Then when the recession sets in, the rest of them get the pinch. Most people are unaware of it, but when a migrant worker gets a job in service or construction, they tend to live in company provided accomodation. When they don't have a job, they're on the street. That's why I say they are the wildcard here.
Won't migrant workers just head back to the country side either voluntarily or by force? The Chinese govt will deal like they deal with farmer's land the govt wants to steal or poor people infected with tainted blood - clubs and military goons.
Many will go back to the countryside. But the risk is the time between "a big fall" and their resettling back home. There is also the risk that the ground is no longer tillable back home, leading to famine. The party is well aware of this issue and they are taking steps to deal with it before it comes to front. Only time will tell the outcome there.
"These people don't care if prices tumble."
Ohhhh, OK. It all makes sense now. Only westerners care when the value of their assets plummet?
Can you explain why you actually believe this? WTF?
Leverage is the key. Many are not leveraged on their property and have no intention or need of selling it. Therefore, it matters not the price of it. Westerners care because most of us are underwater and in debt. This makes people panic. Just like 1929, 1987, 2007/2008, and probably this year or next we'll get another reminder.
Exactly this - its all about leverage.
The average Chinese home-owner not only owns their house outright (or has huge amount of equity), but furthermore, a tiny number of chinese people have a personal loan or credit card debt.
Therefore, if home prices do fall... there is no monthly debt to service, and therefore no forced selling (aside from those who are speculating with 4th/5th/6th homes)
Another mistake that people make when looking at the property market in China is that it really isn't China that has a housing bubble, but simply the coastal cities to the East - Shanghhai, Beijing, Shenzhen, etc. The vast majority of the population are not affected if house prices in these area's fall 10%.
I find the original article is like so many i read - applying western economic theory to a market that is completely different to that of the US or Europe - making huge generalisations on a market they simply do not understand.
The bubble is not in the house prices its in the construction.
When 60% of your economy is construction there is something seriously out of whack.
Even if its in infrastructure, those investments need to have a positive NPV, which many know is likely fantasy.
China is a massive misallocator of resources and that is what will finally blow up.
The house prices are only an issue if they cause social problems, the more educated the workforce becomes, the higher their expectations.
We probably wont see a US type house price cascade but expect real values of homes to fall as incomes rise.
Frankly I dont see how China can move to a consumption economy when wealth and income is so concentrated.
What is critical is that China can narrow the income distribution enough to maintain stability, but I dont think they can as the bureaucracy is too systemically corrupt.
That is why China will eventually fail, the little chiefs will continue to loot even as the top are trying to right the ship.
Another mistake that people make when looking at the property market in China is that it really isn't China that has a housing bubble, but simply the coastal cities to the East - Shanghhai, Beijing, Shenzhen, etc. The vast majority of the population are not affected if house prices in these area's fall 10%.
That's a very good point I was eluding to but not making clear. The people in the countryside and villages don't give a damn about the market price of their home. They only care that they have a home for their families.
Also, they neither have the money nor the desire to take out second mortgages so they can buy entertainment systems and designer kitchens. If the day ever does come when they take out second mortgages, it will be to put their kids through MIT. But there won't be many of them.
In 1929 the average American homeowner had 75% equity, yet millions still lost their homes and farms to foreclosure. And from friends in Asia I have heard that families do, indeed, loan money to each other for home down payments.
I agree. I'm not saying there won't be a crisis. I'm just saying I don't see it as being a cataclysm. See my post below.
What does Nathaly Portman has to do with any of this?!
Isn't she related to Darth Bernanke?
Swan Lake- China:http://lhmarketwatch.blogspot.com/2011/04/swan-lake-china.html
China segmented Local Muni Debt from Federal Government Liability Years ago (2 - 3), so I dont think anyone will be surprised with the Muni stuff goes bad in a hurry.. well no one with a brain will be surprised.
Adding to the challenge, most provincial governments are not authorized to borrow directly from banks; so they set up project-oriented subsidiaries (sometimes called “window companies”) to borrow on the local government’s behalf. Some of those subsidiaries may not have been properly capitalized. It is my understanding that many were granted (legally questionable) liens against the parent governments’ revenues. Those revenues are tied to tax receipts, transfers from the central government, and fees – and the fees arise from property-related transactions and development. If property markets correct, those fees may be choked off, jeopardizing the subsidiaries’ ability to repay their debts.
http://www.advisorperspectives.com/commentaries/seafarer_60311.php
http://www.youtube.com/watch?v=pbDeS_mXMnM
China's Ghost Cities
New item in your series of interest:
Currency Composition of Official Foreign Exchange Reserves (COFER) - June 30, 2011
http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf
I do that sometimes: talk to myself again and again ;-) - Ned
As long as U.S. keeps exporting inflation to China via Fed accommodative 0%-.25% interest
policy and money printing, the Chinese will be in deep doo-doo. If they keep raising their rates to
counteract inflation, they risk economy slowdown and bursting real estate bubble. If they don't
raise rates, further inflation would cause civil unrest and create wage pressures. In the U.S.'s
case, raising rates to fight inflation would bust bond bubble and compound government debt.
That is why government inflation figures don't jive with reality.
"the chinese have to put 30-40% down"....bullsh*t...!
'they borrow it from their relative'...again bullsh*t....!
if everyone is buying then is everyone borrowing from each other or is the whole premise of 'buying' bs in a commie state. the party members are given free money to buy this crap...get real. all the loans are bad just like all the liar loans in the usa will not be paid....!
20% down for a first home utilizing the housing fund up to a certain point.
30% down for anything over that housing fund benefit.
Officially (expect where limited by policy*), 50% down minimum on a second home.
And everything past that is 100% in cash.
*In Beijing the restrictions are non-residents must wait 5 years of stable employment and tax payments within the city to qualify. All others limited to 1 house now. Even with the loophole expections, no one gives a loan for a second home now... must be paid in full in cash.
The housing prices are actually coming down now, it's rather nice despite being a property owner. Furthermore Chinese are not flippers with the property, they are in it for stable income from rents and take it as a family asset. The vast majority are happy that prices are coming down at last.... no one cares about the rich people and their "suffering" which is the way it should be... In fact, we love it when they fail and cheer their downfall.
Inflation sucks, and we have speculators to blame for most of it thanks to globalization, not so much monetary policy. Drastic measures may be taken to keep food prices low, and outside of the cities they have been kept extremely low.
Tax rates have been adjusted to accommodate low income and middle income families while raising the taxes on the rich... again, as it should be. Interest rates have risen as well in keeping with proper policy. Loans in China, please remember are FULL RECOURSE, there is no "walking away" and we live within our means.
In the absolute worst case of a financial disaster, we get amazing infrastructure projects which benefit the public out of it which will lead to a rebuilding and recovery of the economy... in the US, you just get crumbling roads and bridges, expensive gas and rich pigs and criminals. We are in a much better position than you are, plus we have a giant pile of money that we are using to secure resources and relationships right out from under you... so, good luck I guess.
shh... don't let these westerners know ;) They are still harping on "empty" cities (not so empty anymore) and apartment blocks (bought and fully paid up by the crazy rich with limited investment choices).
Big giant pile of useless papaer money!
exactly - the deposit is actually an undeclared loan from the SOE to the local politician. This gets the property sold from the SOE, but it's all just a wash. The average worker cannot afford these prices and the owners cannot cut prices to affordable levels because they have NO EQUITY. Beijing declaring the war on inflation over is BS to disguise the fact that if they slow credit growth down, the ponzi collapses fast.
There are no black swans. There is an iceberg. The captains of every ship in the convoy say it is too difficult to start up the engines after slowing them down so they all go full speed ahead and hope the ships are unsinkable.
Black Swan my ass! "I often hear the argument that China will not have a real estate crisis of US proportions"- he is right it will be more like the Japanese real estate crisis that began in the late 80's and early 90's. Real Estate values have yet to recover.
just picked up a few cases of
dehydrated swan...
not sure of the colour ..
Should have got the freeze-dried swan - it'll last longer.
As China's currency rises in value, U.S. companies with operations there are considering a variety of measures to offset higher labor and export costs. Some are contemplating moving factories out of China altogether.
http://online.wsj.com/article/SB1000142405270230376340457641602074210196...
On the backside of this is the fact that the Chinese middle class has more money and the multinational companies are selling products to them. U.S. exports to China doubled from $41 billion exported in 2005 to $92 billion in 2010.
This is not the trend the central govenment was looking for when they tried to peg the Yuan.
That's why we are in a better position than China.
We can squeeze them as hard as we want as long as they peg their currency. when we want a cheaper place we will build factories in china and bangladesh.
they pegged the yuan because every developing coutnry that lets their currency float gets killed in the "free market" at some point, China is the only smart enough to not do this. Like a nation becoming a developing nation, the workers are making more and they are able to import goods with the extra money they previously did not have.
The thing China has to do is shift what they have been funding via local govt/banks for so long. 60 percent of the GDP has been going to construction. In US, construction is 4 percent of GDP. They could do this without much inflation while they were buidling productive assets and were so far behind on housing and infrastructure, but now the money is being wasted, it should be shifted to diverse benefits to country such as good maintenance of infrastructure built already, technology infrastructure, enery improvements, etc....China will feel pain when they change from a construction based economy, manufacturing is an issue for them but not nearly as much as construction...the shift will be painful, but the country will be fine. There is lots of corruption, but overall, their banks serve their govt wishes, not the other way around, and their tyrannical, undemocratic govt is more concerned with their peoples common wealth than US govt led by FED and Wall Street is...not that China is great, their workers have little security, no Soc Sec, no UI etc...but economically speaking, their general policies are more populist than US, not a big feat tho...
you can get limited in your growth by the free market and a floating currency, or you can be limited in your growth by an accumulation of misallocations. The former is sustainable growth, the latter is what leads to collapse. china has no way out.
Both as in China and the US...we are all global now.
There are black swans circling above every country on earth.
They are called Central Banks.
You're off on your ornithology, those are buzzards.
Unlike the US, China knows what to do with Banksters that have betrayed the country...they execute them.
Screw this nonsense. China is the strongest nation on the planet. There will be no collapse as far as the Chinese economy goes. We Americans need to be more concerned about the potential for a collapse of the American economy and the end of American hegemony, because both are coming.
Yes and once China and you have a big ass war, we Canadians will swoop down and take you over with our battleship and our destroyer.
Since you probably will owe reparations, we'll confiscate your naval fleet as collateral. Then Canada will enter it glory years as the world pre-eminent super nice power and since half of fucking China lives here now we'll do a partner deal with them to lord over you while they take Europe.
Where's my beer I'm done taking over the world?
The collapse of the American economy coming...it is here pal. Hope and Change.
China the strongest nation on the planet?
Tell that to the rioting truck drivers, or the manufacturing workers who are squeezed so hard that they have to install suicide nets around their barracks to catch the jumpers.
It is ready to explode. It will explode long before the USA does. We will get to watch the collapse in relative comfort with a huge amount of schadenfreude. Serves those peggers right. bunch of cheaters.
The Chinese have an authoritarian government and are at the height of their power. They are going down, but don't expect them to go down quietly. They have more options available than the FED does and they won't be afraid to use them.
"zugzwang"? "Schadenfreude"? I thought this was about China.
well said.Americans should clean your OWN house FIRST before taking so much attention to what is happening in China!
too bad that MOST of Americans are imperialists, nonetheless.
In fact, we aren't prepared for either a Chinese or US collapse, which will probably be more or less simultaneous.
I smell war...
yessirreee zing. you are correct.