China Bubble: More Bears Come out of the Wood Work

Following on from my earlier post, China: the Bear Case, a number of other commentators have come out publicly and warned that China is a bubble economy that risks imploding.

Last Monday, The Telegraph ran an article on how Corriente Advisors, a Texas-based hedge fund manager that made millions predicting the crises in US sub-prime market and European debt, has launched a hedge fund to bet on the “imminent implosion” of China.

According to Corriente Advisors:

China is in the “late stages of an enormous credit bubble”. When this bursts…[the] “economic fall-out” will be as “extraordinary as China’s economic out-performance over the last decade”…. “Complacency among market participants regarding China is eerily similar to the complacency exhibited prior to the United States sub-prime crisis and European sovereign debt crisis.”

In the presentation, which amounts to a devastating attack on the prevailing belief that China is an engine for growth, the financier argues that “inappropriately low interest rates and an artificially suppressed exchange rate” have created dangerous bubbles in sectors including:  

Raw materials: Corriente says China has consumed just 65pc of the cement it has produced in the past five years, after exports. The country is currently outputting more steel than the next seven largest producers combined – it now has 200m tons of excess capacity, more that the EU and Japan’s total production so far this year.

Property construction: Corriente reckons there is currently an excess of 3.3bn square meters of floor space in the country – yet 200m square metres of new space is being constructed each year.

Property prices: The average price-to-rent ratio of China’s eight key cities is 39.4 times – this figure was 22.8 times in America just before its housing crisis. Corriente argues: “Lacking alternative investment options, Chinese corporates, households and government entities have invested excess liquidity in the property markets, driving home prices to unsustainable levels.” The result is that the property is out of reach for the majority of ordinary Chinese.

Banking: As with the credit crisis in the West, the banks’ exposure to the infrastructure credit bubbles isn’t obvious because the debt is held in Local Investment Companies – shell entities which borrow from Chinese banks and invest in fixed assets.

…”bad loans will equal 98pc of total bank equity if LIC owned, non-cashflow producing assets are recognised as non-performing….[And] the market belief that the Chinese government has “ample resources” to bail out its banks is flawed.

Corriente’s analysis of the ratio of China government debt to GDP comes out at 107pc – five times higher than official published numbers. The hedge fund says this number uses “conservative assumptions” and the real figure could be as high as 200pc.

The result is that, rather than being the “key engine for global growth”, China is an “enormous tail-risk.”

Today, The Telegraph published another article noting how the Royal Bank of Scotland (RBS) has advised clients to take out protection against the risk of a sovereign default by China, as well as highlighting some recent bearish analysis by the IMF and other commentators.

According to this article:

[RBS] warns that the Communist Party will have to puncture the credit bubble before inflation reaches levels that threaten social stability. This in turn may open a can of worms.

“Many see China’s monetary tightening as a pre-emptive tap on the brakes, a warning shot across the proverbial economic bows. We see it as a potentially more malevolent reactive day of reckoning”…

Officially, inflation was 4.4pc in October, and may reach 5pc in November, but it is to hard find anybody in China who believes it is that low. Vegetables have risen 20pc in a month.

The Communist Party learned from Tiananmen in 1989 how surging prices can seed dissent. “Inflation is a redistributive mechanism in favour of the few that can protect living standards, against the large majority who cannot. The political leadership cannot, will not, take risks in that regard”…

RBS recommends credit default swaps on China’s five-year debt. This is not a forecast that China will default. It is insurance against the “fat tail risk” of a hard landing, with ramifications across Asia.

[Meanwhile] Diana Choyleva from Lombard Street Research said the money supply rose at a 40pc rate in 2009 and the first half of 2010 as Beijing stoked an epic credit boom to keep uber-growth alive, but the costs of this policy now outweigh the benefits.

The economy is entering the ugly quadrant of cycle – stagflation – where credit-pumping leaks into speculation and price spirals, even as growth slows. Citigroup’s Minggao Shen said it now takes a rise of ¥1.84 in the M2 money supply to generate just one yuan of GDP growth, up from ¥1.30 earlier this decade.

To provide readers with some context on the explosion of credit in China, consider the below chart from Societe Generale:

Anyway, back to the article:

The froth is going into property. Experts argue heatedly over whether or not China has managed to outdo America’s subprime bubble, or even match the Tokyo frenzy of late 1980s. The IMF straddles the two.

It concluded in a report last week that there was no nationwide bubble but that home prices in Shenzen, Shanghai, Beijing, and Nanjing seem “increasingly disconnected from fundamentals”.

Prices are 22 times disposable income in Beijing, and 18 times in Shenzen, compared to eight in Tokyo. The US bubble peaked at 6.4 and has since dropped 4.7. The price-to-rent ratio in China’s eastern cities has risen by over 200pc since 2004.

The IMF said land sales make up 30pc of local government revenue in Beijing. This has echoes of Ireland where “fair weather” property taxes disguised the erosion of state finances [see my previous post].

Ms Choyleva said China drew a false conclusion from the global credit crisis that their top-down economy trumps the free market, failing to see that the events of 2008-2009 did equally great damage to them – though of a different kind.

China is trying to keep the game going as if nothing has changed, but cannot do so. It dares not raise rates fast enough to let air out of the bubble because this would expose the bad debts of the banking system. The regime is stymied.

“The Chinese growth machine is likely to continue to function in the minds of people long after it has no visible means of support. China’s potential growth rate could well halve to 5pc in this decade,” she said.

Societe General’s Albert Edwards appears even more bearish on China, pointing to leading indicator indexes calculated by both the OECD and the Chinese National Bureau of Statistics, which are both signaling strong coming weakness in China’s economy. Here is what Edwards had to say (taken from Zero Hedge):

“Once again, investors see China plays as the only investment game in town….I remain convinced we are witnessing a bubble of epic proportions which will burst – catching investors as unawares as the bursting of the Asian bubbles of the mid-1990s.”

China’s leading indicator is pointing towards a very significant slowdown in economic growth ahead. The last time the Chinese OECD leading indicator was this weak, commodity prices had just reached their euphoric mid-2008 peak, having spent the first half of the year resolutely ignoring the clear signals that the economy was about to slow sharply. Commodity and EM bulls ignore the weak Chinese leading indicator at their peril.

It’s not just the OECD leading indicator that is very weak. The Chinese National Bureau of Statistics publishes its own leading indicator. And it absolutely confirms the OECD’s version of the future:

Finally, Bloomberg reports that Fitch Ratings is performing analysis of what would happen if China’s economic growth halved to 5% in 2011; although it does not predict such an outcome. Here are the best bits from the article.

If China did slow markedly, Fitch says, the fallout would have negative consequences for sovereign and corporate credit risks of trading partners such as Australia, Hong Kong, Malaysia, Singapore, South Korea and Taiwan. Commodities markets would take a sizeable hit, as would industries such as auto making, chemicals, heavy manufacturing and steel. All export industries would be rocked…

Increased market volatility would be another side effect. Risk aversion and potential financial contagion emanating from China would be the last thing the world economy needs. The hobbling of a key economic pillar might shock markets already on edge…

For a nation at China’s level of development, 5 percent growth is crisis territory. The chances of social unrest would explode among the nation’s 1.3 billion people, putting the onus on the government to take drastic measures to boost growth…

There’s also a bad-loan risk. Recent data show that Chinese credit growth hasn’t really slowed from 2009’s rapid pace. The reason: new bank lending has been offset by a surge in off- balance-sheet loans. So in other words, all those efforts in Beijing to rein in credit are coming to naught…

The trouble for Asia is what happens to all this lending once growth slows. One risk is the infrastructure arms race unfolding in dozens of cities around China — all vying to be the next “it” destination for capital, companies and tourists. Once the music stops and all those debts are tallied, China may be looking at a bumpy few years…

No country ever grows in a straight line, though, and China is no exception. Even if the odds don’t favor an abrupt slowdown, it’s wise to contemplate that possibility and prepare for it. Stranger things have happened in this crazy world of ours.

Dire implications for Australia:

As I have said many times before, any significant slowdown in China would be catastrophic for Australia. China is Australia’s largest export destination, with its export share having grown from around 5% in 2000 to 22% in 2009 (see below IMF chart):

No other commodity exporter has benefited as much from the China boom than Australia, as shown by the below IMF chart. Australia’s terms of trade (ToT) has literally exploded since 2003 as China drove-up the price of iron ore and coal – Australia’s two major exports.

Now Australia’s ToT are sitting at 60-year highs (see below RBA chart), which has significantly raised national income, increased the Government’s tax take, and sent the Australian dollar to near parity with the USA. Readers seeking a detailed analysis of the impact of the ToT on Australia’s economy are advised to read Tom Conley’s excellent article on this issue.

Finally, the surge of the ToT has led to a significant increase in mining investment, as mining companies look to build supply capacity (see below RBNZ chart). This investment, in turn, has significantly boosted Australia’s GDP. But it, along with investment by competing commodity producers (e.g. Brazil’s Vale), risks bringing down commodity prices over time even if demand from China and India remains robust.

However, if China’s growth slows considerably, as suggested by the above commentators, then Australia’s ToT could crash as increased commodity supply meets diminishing demand. And if this happens, then all the positive effects on employment, incomes, growth and the Government’s fiscal position received by Australia over the past decade would unwind.

To make matters worse, Australia’s banks, which have borrowed heavily offshore to inflate the housing bubble, would once again find it extremely difficult to roll-over their maturing foreign borrowings. Only, unlike in 2008, the Australian Government might not be in the position to guarantee their debt given the significant other drains on the budget from diminishing tax receipts and rising welfare payments. Obviously, any contraction of credit would also have a devastating effect on house prices.

Michael Pettis provides an excellent commentary on the relationship between high external debt, commodity prices and asset prices, which is particularly relevant to Australia:

With inverted debt [structures], the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times (when asset prices and earnings rise) and rise in bad times…

Foreign currency and short-term borrowings are examples of inverted debt, because the servicing costs decline when confidence and asset prices rise, and rise when confidence and asset prices decline. This makes the good times better, and the bad times worse…

Inverted debt structures leave a country extremely vulnerable to debt crises…Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.

This is especially a problem for countries whose economies are highly dependent on commodities. Not only are commodity prices volatile, there is a long history suggesting that global liquidity dries up at the same time that commodity prices collapse. This is a deadly combination for highly indebted economies with big commodity sectors…

Countries with a lot of short-term debt, external debt, and asset-lending-based banks, especially large amounts of real estate lending, are far more vulnerable than they might at first seem because the debt burden is likely to soar at the worst time possible – just when everything else is going wrong…

In fact some of the recent “star” sovereign performers may very well be the biggest risks, since their great performance may have been caused in part by highly inverted balance sheets [Australia?]. These kinds of debt structures ensure that good times are magnified, but they also ensure that bad times are exacerbated…

When the economy is doing well, rising asset prices make existing loans seem less risky and encourage riskier debt structures (i.e. loans whose servicing cannot be covered out of minimum expected cash flows) because creditworthiness seems constantly to rise. But once the crunch comes, asset values and creditworthiness chase each other in a downward spiral.

The situation that I have outlined above – whereby China slows considerably causing: (1) Australia’s ToT to crash; (2) increased unemployment; (3) severe worsening of the Budget bottom-line; (4) credit rationing and severe bank stress; and (5) a house price crash – is clearly the doomsday scenario for the Australian economy. And the chances of such an event occurring might even be remote. But they are, at least, possible if not probable. Hence, it pays to keep a watchful eye on the situation in China since any change to their economic fortunes will have an amplified effect on Australia.

Impact on New Zealand would be just a severe:

As I have said previously, New Zealand is both directly and indirectly leveraged to China. As shown by the below table, New Zealand’s third largest export market is China, whereas its largest export market is Australia, who is itself highly leveraged to China for the reasons outined above.

Any meaningful slowdown of the Chinese economy would, therefore, adversely impact New Zealand both directly and indirectly via slower Australian growth, and would translate into a contraction of aggregate demand, higher unemployment, and a worsening Budget bottom-line. And because New Zealand has even higher external liabilities than Australia – predominantly due to offshore borrowing by the banks to fund housing – it would be equally if not more exposed to a liquidity crisis.

Once again, I hope that the bears are wrong and the China growth story continues. Otherwise the Trans-Tasman economies face an extremely challenging period ahead.

Cheers Leith

Leith van Onselen

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.


  1. Financial Follies

    Another great read, although I'm not sure I would agree that the possibility of the doomsday scenario you describe is "remote". If Pettis is right, a significant slowdown in China is exactly what we should be expecting in the coming few years. It's very hard to imagine a "soft landing" for the property market under such a scenario…

  2. Nice post. I can remeber when the GFC started Lawranece Summers said one thing we know about finacial crisis is that they end. The same can be said about commodity booms. When this one pops the result will be painful hopefuly our government does not follow the Irish lead and make us bail out bank bond holders.

    As an aside I cant believe all this bullishness on the domestic economy. Manufacturing, construction and services all going backwards as is retail government spending easing off the only thing left is exports and business investment. I think the recession has started here already and we will only accept this reality come mid next year.



  3. Excellent article Leith.

    History will judge our politicians and economists poorly for their lazy steering of the Australian economy by relying on the China story.

    Though of course, we are all partly to blame. Who doesn't love non-manual labour and inflation busting cheap trinkets!