China: The Bear Case

Today I read a brilliant interview with Vitaliy Katsenelson – author, teacher and Director of Research / Portfolio Manager at Investment Management Associates Inc, a money management firm based in Denver, Colorado.

Vitaliy provides possibly the best discussion of the Chinese economy that I have read, as well as some discussion on Japan. Like Jim Chanos, whose recent article in Fortune also warrants reading, Vitaliy’s outlook on China is bearish.

Whilst there are differing opinions about what’s going on in China, Vitaliy’s ability to connect the dots is impressive. Regardless of your perspective, whatever happens in these two economies – China and Japan – is of paramount importance to Australia since they represent our two largest export markets (see below chart).

Below is an extract of the best bits, split-out by theme, as well as some observations of my own. I recommend that readers with spare time check out the full interview for themselves.

China: an inherently unstable economy:

Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended…

When we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way… but it is impossible to centrally manage an economy of China’s size…

Having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That’s the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences…

When you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption… Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to…
When you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate… The true magnitude of these excesses will come to the surface once the economy slows down…

In essence, you’ve got a relatively small group of individuals who are making big decisions about China’s economy and where production should be, in what sectors, etc… but it’s not a sustainable growth… Because the growth is being induced by government spending, by a misallocation of capital…

The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won’t be building new skyscrapers for a very long time…

The Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China… The equivalent of building bridges to nowhere, but on a very large – Chinese – scale… As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital…

The problem with China is pretty much the same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many…

The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far… China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect… The actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming. ..

The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people who lose jobs don’t complain, they riot…

The Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it’s impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows…

One way to think about the Chinese economy is by comparing it to the bus in the movie Speed… In the movie, a bus was wired with explosives that would blow up if the bus’s speed dropped below 50 miles an hour.

Since China is manufacturer to the world, that manufacturing business comes with a lot of fixed costs. Factories, equipment need financing, and they are mainly financed by debt – another fixed cost. The high level of fixed costs doesn’t afford China an economic slowdown, but when it happens, the consequences will be dire. High fixed costs are great when revenues are rising as income grows at a faster rate than sales. But they are devastating to profitability when sales decline: costs decline at a slower rate than sales and you start losing money, fast…

A return of U.S. and European consumers is extremely important to the health of the Chinese economy… Chinese consumers represent one-third of a 5-trillion-dollar economy. If you look at the size of the U.S. and European Union together, they are equal to a 30-trillion-dollar economy, and the consumers there constitute about two-thirds of those economies.

So on the one hand, you have U.S. and European consumers representing 20 trillion dollars in purchases, versus Chinese consumers at about 2 trillion dollars. In other words, U.S. and European consumers are 10 times the size of the Chinese consumers. As a result, a very small change in consumption in the U.S. and Europe has to be overcompensated by a huge increase in consumption in China, and that is going to be very difficult to do, especially considering that the Chinese currency is kept at artificially low levels. That, of course, diminishes the purchasing power of the Chinese consumer….

When will the bubble burst?

One thing that makes predicting the end of this bubble very difficult is the amount of firepower the Chinese government has. The government can drive this bubble further than a rational observer would expect… Because they have a significant influence over the economy. Chinese government can force banks to lend and can force companies to borrow and spend (or build)….

In the same way that everyone in the United States decided they “must” own a house, this belief was reinforced by continuously rising house prices. You can see how big a problem this became in big cities such as Beijing and Shanghai where the affordability ratio is horrible, so the property-value-to-income ratio in Beijing is pushing 15. In Shanghai it is over 12. If you look at the national average, it is over eight times…

In Tokyo, at the peak of the massive Japanese bubble, the ratio stood at nine times. In Beijing it’s already 14 times. In Shanghai it’s over 12 times. The national average for China is pushing 8.2 times right now. So housing affordability is very, very low, and the housing prices are extremely high….

Property investment in China in 2009 was 10% of GDP, up from 8% in 2007. In Japan, at the peak of its bubble, it did not exceed 9%; in the U.S. it never exceeded 6%… A recent study found that 64.5 million apartments basically don’t use electricity because they are empty. Chinese people buy those condos, and they don’t rent them. Similar to new cars in the U.S. when taken off the lot, in China an apartment is worth less once rented out. So they just keep them unoccupied with the hope to flip them, and you know how that story ends…

I recall a conversation with another Chinese man who lives in the States half a year and in Beijing half the year. When I asked him about the real estate bubble in China, his comment was, “Well, the government would never let it fall,”… The average citizen has been brainwashed into thinking of the government with respect. This has led to an unconditional belief that the Chinese government walks on water, that the laws of economics are somehow suspended when they touch things… Sure, they have a greater control of the economy, but at the long-term cost we talked about earlier. That’s point number one.

Point number two can be understood by asking why people are buying those apartments, why are they buying this real estate? In part it is because if they put money in the bank – where the government basically sets the rates on savings accounts and the checking deposits – they are getting very little interest on their savings. Therefore they look at real estate as basically a form of savings.

Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment. It is a large down payment. But think about how much wealth will be destroyed when real estate prices decline – and that in itself could trigger a serious crisis in China because it would destroy a lot of wealth, and that could lead to political unrest. So that would be very important psychologically and for the political stability of the Chinese economy…

To some degree, a real estate bubble is like a Ponzi scheme. As long as there is an incremental buyer, prices keep going up, but at some point everybody who wants to buy a house has bought a house, so when an incremental buyer is not there, the prices start declining and then it becomes self-feeding. It’s very difficult to time the end, but there is always an end…

If you look at commercial real estate, it’s often one subsidiary that is borrowing money from another subsidiary to put a down payment to build or buy a building. And a lot of times land is used as collateral. As land prices decline, so the loan-to-value ratio can jump through the roof very quickly when real estate prices collapse…

The Chinese government still has enough chips to keep the bubble going a while longer. These bubbles usually last longer than the reputation of the person who predicts their demise… GMO became famous for predicting the Japanese bubble collapse, but they started predicting it in 1986, so they were “wrong” for a while because it actually burst in 1989-1990. The point being, these bubbles typically last longer than you would expect, but it’s going to burst.

Implications for Australia:

China has been responsible for a very large portion, if not all, of incremental demand for commodities in recent years. If you’re talking about copper, about oil, or pretty much all the industrial commodities, China was responsible for a very large portion of the demand. When the economy slows down and the bubble bursts, then the demand for those commodities will decline dramatically.

It’s going to impact economies that benefited tremendously from China’s ascent, so Australia will be impacted, Russia will be impacted because oil prices will decline and Russia is basically a commodity-driven nation. Brazil will be impacted. Any economy you can think of that benefited from China’s ascent will get hurt from its descent as well.

In order to understand the importance of China’s commodities demand to Australia, consider the following Reserve Bank of Australia charts. The first chart shows Australia’s resource exports. Remember from the chart above that China is now Australia’s largest export destination, having grown from 5% of Australia’s exports in 2000 to 22% in 2009. The lion’s share of this growth has been in two commodities – iron ore and coal.

Now consider the price received by Australia per tonne of bulk commodities exported. Most of this price growth has come on the back of demand from China.

Finally, consider how this increased commodities demand from China has fuelled Australia’s terms-of-trade, which is at 60-year highs.

You don’t have to be Einstein to conclude that continued growth in China is fundamental to the health of the Australian economy. If China catches a cold, Australia will catch pneumonia.

Anyway, back to the article.

But also think about industrial goods. Getting commodities out of the ground, building empty shopping malls, ghost towns, and bridges to nowhere requires a lot of equipment. Industrial goods companies benefited tremendously from Chinese demand. In the past, those were very cyclical companies, and it seems like this time they almost didn’t have a normal cycle. They declined but then came back very fast because the demand came back very fast, and a lot of that demand came from China.

I have very little exposure to commodities and industrial stocks, and very little exposure to countries that will get hurt from China’s bursting bubble – the countries we mentioned, like Australia, Brazil, Russia, etc…


Japan’s story is very simple. The economy slowed down in the 1990s. To keep the economy growing, the government lowered taxes and increased government spending, sending budget deficits up. In order to finance those deficits, the amount of government debt has tripled.

The only reason they were able to finance that debt was because over 90% of the government debt was purchased internally; therefore, thanks to Japanese interest rates declining from 7.5% to 1.4%, the government was able to dramatically increase the amount of debt without the total borrowing costs going up.

Today, Japan is one of the most indebted nations in the developed world, and its population demographics are horrible because every fourth Japanese is over 65 years old. There’s no immigration into Japan, and the population is aging rapidly, and the savings rate went from the middle teens to quickly approaching zero…

With the demand for Japanese bonds declining, they are going to have to start shopping their debt outside of Japan, and the second they do, they’ll realize that no rational buyer would buy Japanese debt yielding 1.4% when they can buy U.S. debt or German debt with yields double that.

So the Japanese are going to have to start paying high interest rates, and they can’t afford that, because one-quarter of the tax revenues already goes to servicing their debt. If their interest rates were to double to just 2.8%, it basically wipes out the funding for the country’s Departments of Defense and Education. So this is a situation where they go from deflation to hyperinflation, because they’re going to have to start printing money to be able to keep paying off their debt, so this is the case where they are going just from one extreme to another…

Japan is past the point of no return. It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know just how long it will take to go down. That’s basically what is taking place in Japan…

We’ve got some serious issues with Asia, which obviously will have some global implications…

Yeah, and Australia is front-and-centre. Food for thought…

Cheers Leith

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  1. thank you so much leith. and yes, we have held our head high, one of the most robust economies – survived the gfc like no other country did – mmmmmm, sure, where is brad setser? i always looked forward to his china analysis and then he's gone. like a mirage…is it all a mirage?

  2. This looks like the most fragmented period of Financial History is yet to come and the GFC was a mild down-turn.

    The 10's are going to be an interesting decade.

    Decade debt maybe?

  3. It looks that this time the whole world is going to sink. It was hard every time when one of G7 economies had serious economic problems. How it may look when all of G20 have the same huge problems at the same time? It happened once in last 1000 years, it ended in the most horrifying war that humanity ever experienced.

    Or, shall we say, this time is different.

  4. I've been following Vitaliy's blog for some time and have read his first book.

    While I agree everything Vitaliy has said, there are 2 issues worth considering:

    1. The anecdotes of China overbuilding circulated in the western media and quoted by Vitaliy have always been its New South China Mall and the Inner Mongolia city. I haven't seen others. We can't confirm if these are just isolated cases or not. (Granted that the electricity usage is a very strong indicator of very high vacancy.)

    2. If we want to analyse China's "planned economy", we need to do more differential analysis. Apart from comparing it to USSR and Germany, I think it's instrumental to compare it to Singapore. Singapore's political system is effectively a one party system and its economy has effectively been a planned economy and pretty successfully. For one thing, corruption is low. (Granted that China's scale is in a completely different magnitude.)

  5. Leith

    I have two quick comments.

    "Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment."

    I saw a report quite some time back (BBC???) stating that the equity that Chinese apartment buyers had to stump up for apartments was borrowed on a black market from friends and family. Failing to repay this money would involve significant loss of face, so the preference in the case of a forced sale is likely to be to pay back family and friends and hand the loss, as much as possible, to the loaning bank.

    The point here is that actual equity to the property buyer is much lower than supposed, and the banks are doubly leveraged in that they have loaned out against overpriced assets, and in that they are likely to eat more than their share of the losses if a forced sale occurs.

    My other comment is about the section on Japanese government debt. The Japanese Gov't has not "borrowed" money, but rather spent it into existence in order to stimulate economic activity and ward off deflation. A lot of that money, rather than remaining in the economy, is being returned to the central bank by recipients via the purchase of central bank bonds. If the savings rate is declining, then that means that less of the stimulus $ is flowing back to the central bank, so less bonds are being issued.

    In a sovereign currency, Government budgetary deficit (it is not 'debt'!) is exactly equal to private savings, since the sole source of reserves is the Japanese Government, through the agency of the central bank.

    The problem in Japan is that they have large sums of money "at rest" with the central bank, rather than flowing around the economy, so while the money exists it isn't being used to generate economic activity. The money that the central bank has to pay as interest on those reserves is simply waved into existence with a few keystrokes on a computer terminal.

    The whole point of bond sales is to soak up cash flowing around an economy, so as to avoid inflation. They are not, repeat not, a revenue raising instrument in a sovereign economy, like Japan, the UK, the US, NZ or Australia.

    Japan does not face any form of solvency crisis, and nor does Australia.

    The real problem is, what happens when the owners of those reserves decide to use those reserves on a nation's currency?, and this is an important question which is not being asked.

    I wonder whether our foreign holdings of RBA reserves will be eventually used to buy Australian national assets or commodities at rock bottom prices during an economic crunch.

    While the family of Australian economics blogs are generating lots of brilliant analysis of current events that shows up the embarrassingly poor journalism of our mainstream media, I also think you all are still falling down on understanding exactly how private banks make loans; and on how a sovereign monetary system actually works.

    I'm Melbourne based – I'm happy to meet and give you a "crash course" in how it all actually works. If you'd like to take up this offer then contact me at: andrew#[email protected] (replace '#' with '1976') – cheers!

    Keep up the good work.

  6. Leith van Onselen

    Thanks for the link Anon. I had never read Elvis' articles before. I will make sure that I follow him going forward. He sure knows his stuff.

  7. Hi Leith, this is an excellent abridged version of a very long interview I was frankly afraid of wading through. While I've got no doubt that a crash in China will hurt Australia's terms of trade I haven't worked out the impact on Australia's residential property market, beyond the sentiment and income sides of the price equation. How much will the much vaunted under-supply in housing absorb the hit? What's your current view of housing supply?

  8. Ironically, one of the greatest strengths of China's centrally planned economy is the government's ability to respond quickly and forcefully to mitigate negative shocks to its economy, and it is one of the few governments with the resources to do so. It is also important to recognise that the CCP's primary motivation is to retain and consolidate power (as is the case with any authoritarian state), and any negative shocks to the Chinese economic miracle which could potentially lead to social unrest and therefore political instability (e.g. mass unemployment, destruction of wealth and / or social unrest) is likely to jeopardise that power base. In this context, it would be reasonable to assume any major negative internal or external shocks to the Chinese economy will ultimately be buttressed by government stimulus. This can and will go on for as long as the CCP has sufficient resources as its disposal.

    This is not to say that China will not have some significant swings both on the upside and downside in relation to its growth rate (it most certainly will), but over the medium to longer term it is highly probable that the trend in growth will be upwards (with some potentially nasty bumps along the way).

    I am always cynical when scarce resources are allocated by the visible hand of government, however as Vitaliy rightly points out, any inefficiency in resource allocation could be propagated for far longer and on a far larger scale than any of us betting against it can stay solvent, especially when the counterparty to the transaction is the cashed up Chinese government. Alas potential investors are left with a conundrum which has become all too familiar in recent decades:

    whether to ride the wave of hot money and momentum upwards knowing China is potentially in unsustainable bubble territory that will have to end sooner or later (but keeping a keen eye on indicators in the hope of bailing out before the proverbial hits the fan), or not participate in folly at all and potentially bypass some very easy and tempting profits…

  9. Am I the dumbest person on Earth? When house prices first double I thought it was unsustainable and didn't buy. I thought the same 4 years ago. And two years ago. Bottom line is, I am now stuck way out in the burbs – the irony is I could be sitting in a City middle ring home worth $2million unencumbered if I hadn't been so conservative/dumb. I keep telling my friends, as they contemplate the their next investment property that it can't last. That in fact the vast majority could now not afford to buy their current homes if they started out tomorrow. If they can't, who will replace them. They all say the Government won't let housing prices fall. That China will keep booming and wages will keep going up (They'll double every ten years, don't cha know?).

    So is this a web site for fools or the less courageous investor, the conservative? Or someone, somewhere with some real knowledge/influence know something they're not telling us>

  10. Leith,

    Steve Keen has just posted his submission to the Senate enquiry on banking.

    His proposed reforms/solutions don't impress me but a lot of his analysis is very impressive. Here's a couple of extracts that might interest you and other readers.

    "…. the sheer scale of debt, its rate of change, and whether it is accelerating or decelerating, have very significant impacts on the macroeconomy. If Bernanke, Krugman and other neoclassicals were correct, the correlations between the acceleration in debt and the change in unemployment should be insignificant."

    "Instead, the correlation is highly significant, large, persistent, and causal, since it leads changes in employment and GDP by about 3 months. The correlation during the Great Depression was -0.72; over the whole post-WWII period from 1955 the correlation was -0.59, and since 1990 it was -0.82 (see Figure 31)."

    So the odds are 5:1 that any of the following will make the primary trend in employment downward:

    1. A slowdown in the rate of growth of aggregate debt or;
    2. Debt stabilising (no YOY increase) or;
    3. Deleveraging (YOY decrease in aggregate debt levels).

    If either debt servicing costs increase or the borrowers' capacity to service debt decreases as well we are in big trouble IMO.