China Bubble: More interesting data and analysis

Following on from my earlier post on China’s empty cities, more interesting analysis and data has come out about China’s bubble economy. These reports seem to add further weight to recent bearish arguments put forward by Jim Chanos and Vitaliy Katsenelson (amongst others).

First, Dan Denning has written a cracking post in the Daily Reckoning explaining how China’s massive over-investment in fixed asset investment has its root in the global credit bubble, and how continued austerity and debt deflation by China’s two main customers – Europe and the USA – could derail China’s ‘miracle economy’ (and by extension Australia’s). It’s a thought provoking article that’s well worth five minutes of your time. Even better, subscribe to the Daily Reckoning’s daily email newsletter for ongoing analysis and reports on all things economic and financial – it’s free. In the meantime, here are the best bits from the article:

China set a quota of 7,500 billion (US$1.1 trillion) in new loans in 2010 after a $1 trillion blow out in 2009… Next year’s quota is the same size. And it prompts an obvious question: where the heck is all that money going?

Why does the question matter? It tells you if China is building too many factories, bridges, roads, and office buildings…And THAT tells you whether Australia’s record terms of trade and booming mineral and metal exports to China are something you can bank on for the next ten years, or something that could smack you in the face.

So where is the money going? The most often repeated line about China is the fitting out of the country—its infrastructure—is what’s driving metals-intensive demand for Aussie resources. But by definition, fixed assets can include factories and real estate too. So is China building the backbone for its transportation network of the next 100 years? Or is something else going on?

To try and get an answer to this question, you can read a copy of this report at the Reserve Bank of Australia website. It has a refreshingly simple title for a central bank research paper:  “Sources of Chinese Demand for Resource Commodities”…What we’d consider the key chart in the report is below.

More factories, fewer bridges:


What does the chart tell you? Infrastructure has declined as a percentage of total fixed asset investment from over 50% at the turn of the century to just over 30% now. Manufacturing—China’s export engine—has caught up. Of course if total fixed asset investment has been climbing, then infrastructure investment’s decline could be more in percentage terms than real terms. But let’s assume for the moment that China’s fixed asset boom is being driven equally by infrastructure and manufacturing, with a growing real estate boom. What does that mean?

Well for starters it means a huge boom in demand for steel making materials, especially iron ore and coking coal… Australia is such a big [trading] partner because the average iron content in Pilbara ore, according to the US Geological survey, is 60%. By comparison, the average iron content in Chinese ore is just 33%…

But the real issue is whether the demand for that ore is driven by a global credit bubble. Why global? China is building factories to export metals-intensive durable goods to the rest of the world. But large parts of the rest of the world (mainly America) have been buying those goods on credit and are now broke.

Has China built an army of factories for an army of customers who are about to lay down their credit cards and surrender to the forces of debt deflation?

If China’s booming metals demand is just another aspect of the global credit bubble, Australian investors should be duly warned that what happened in 2008 (a big crash in resource stocks and commodity prices) could happen again…

To summarise: China’s factory build-out has driven its metals demand. In turn, the factory build-out—and the huge boom in domestic investment—is based on an expectation that the rest of the world will keep on buying what China’s making….

But if big chunks of the rest of the world are dialling back consumption and entering their own private ages of austerity, who will buy what China makes? “If you build it, he will come,” was a line from one of our favourite movies, “Field of Dreams.” But what if you build it and no one can afford to buy it? Isn’t that just another giant misallocation of resources with its roots in a credit bubble? Hmm.

Dan Denning’s analysis is similar to arguments previously put forward by Jim Chanos and Vitaliy Katsenelson, which claim that China is building far too many things (apartments, factories, etc) that are not needed, resulting in significant over-capacity and malinvestment that will ultimately lead to a pile of non-performing loans and destruction of wealth.

Both Chanos and Vitaliy also warn that China’s high fixed costs, emanating from its mammoth manufacturing capacity, means that China’s margins are razor thin and it cannot afford a slowdown of economic growth or a rise in costs, such as wages.

This brings me to new analysis by Harald Malmgren, who runs the Malmgren Global fund, which provides advice to financial institutions, sovereign-wealth funds, and a number of central banks and governments around the world. On China, Malmgren holds similar concerns to Chanos and Vitaliy:

[Malmgren] notes that while investors everywhere have been uneasily eyeing the rise of the inflation dragon in that nation and have anticipated that Beijing would hike interest rates to contain the beast, it hasn’t. And the reason why it hasn’t, he posits, is that profit margins for many Sino businesses are razor thin, and an abrupt rate boost would mean appreciably higher debt-service costs, really putting the kibosh on profits.

Despite all the global focus on inflation, Harald contends, the big challenge confronting China can be found in the nonperforming loan portfolios of its banks and kindred financial institutions. That enormous pile of deadbeat loans is the legacy of late 2008-2009, when exports dried up and the spooked rulers of the command economy ordered the banks to seriously step up their lending — no ifs, ands or buts. The banks dutifully complied with an awesome $1 trillion in fresh lending.

Much of that huge mountain of loans has fallen into the nonperforming category, which translates from the polite banking parlance into delinquency, big time. To avoid a financial meltdown, Harald expects, Beijing will raise capital-adequacy requirements substantially during the first few months of 2011, conceivably in incremental steps to cushion the pain. Since he anticipates Chinese banks will have trouble raising capital, he expects a large-scale shrinkage in lending.

Chinese banks, he emphasizes, aren’t suffering from insufficient liquidity. Rather, he warns, the danger to the country’s banking system is insolvency. In the current lineup of problem banks around the world, he would rank Chinese banks as the most troubled, with European banks next, followed by U.S. banks and Japanese banks probably holding down fourth place.

Another reason why the Chinese Government hasn’t significantly lifted interest rates to contain inflation is that it could crash the Chinese housing market:

Economist Cao An said that the Chinese regime has realized that the real estate bubble is serious; on the one hand it wants to stop the bubble from growing bigger, but at the same time, it worries that real estate prices could drop too rapidly. A price decline in the real estate market of more than 20 to 30 percent could cause it to collapse, and since real estate is an important revenue source for the regime, the bubble’s burst will substantially reduce revenue.

Though the Chinese regime has introduced more than 60 regulatory policies on real estate, some experts still believe that house prices can continue to rise. Cao said that some people think that they will not fall immediately because the regime is still implementing a loose monetary policy. If a large amount of money is injected into the market, people will buy a house to hedge against inflation. Hence, both sides (price increase or decline) have their own arguments, and both have some truth behind them.

Cao believes that China’s real estate bubble will burst, and its timing depends on the critical point of the overall Chinese economy. Once that point is reached, it will trigger a massive burst of the housing bubble.

Finally, my favourite Canadian Blogger, Ben Rabidoux from Financial Insights, has provided some nice commentary on the apparent slowing of world trade.

First, the Baltic Dry Index (BDI), which tracks worldwide international shipping prices of various bulk cargo carriers and provides a proxy measure for trade in commodities, is near 12-month lows:

This fall in the BDI is possibly driven by the Chinese Government’s attempts to slow its economy by raising reserve requirements at its banks.

Second, the average speed of Chinese cargo ships appears to be slowing:

And the significance of this chart is explained by Rabidoux:

Some of my colleagues who teach in the Marine Navigation program and are former mariners explained to me that when demand dwindles, shipping companies respond by either laying ships up or using more ships but having them travel at slower speeds. Apparently fuel consumption rises exponentially in relation to ship speed, so this is a money-saving tactic employed by these companies to keep their ships moving but at a lower cost.

This graph further calls into question the sustainability of Chinese GDP growth absent massive government construction initiatives. While we all associate China’s economy with strong exports, they actually only represent 5% of GDP in that country. Recall that GDP growth in the People’s Republic is still 60% composed of construction…

I won’t go into the importance of continued strong Chinese economic growth to the health of the Australian economy, since I have provided detailed analysis previously (for example, see here and here). What I will say is that the increasing bearish sentiment towards China is worrying. Twelve months ago bearish articles on China were few and far between. Now they are appearing every other day from a variety of commentators and sources. Watch this space…

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. One would have to be remarkably blinded by self interest not to see,for some time,that the Chinese enterprise in its current form is not sustainable.

    And neither is the Australian resources bubble.
    This will end in tears in the not too distant future.

  2. I think that overall your argument is correct but yesterdays financial review (page 4 I think) made the case that the drop in the BDI price was due to an increase in the supply of ships being produced not a decrease in trade as you have suggested? What do you think?

    Paul Priz