Canadian Business on China’s bubble economy

I read an interesting article today from Canadian Business magazine on the challenges facing the Chinese economy and the risks to commodity exporters like Australia and Canada (h/t Financial Insights).  It’s a worthwhile read, particularly for readers seeking a detailed overview of the bear case on China. But a warning – at 5,400 words the article is long.

Here are some key extracts from the article, along with some commentary and charts for additional context. Note, I have added the subtitles in order to split the article into themes.

Trouble brewing:

Over the past year, a growing number of analysts and investors have argued all is not as it appears in the Middle Kingdom. What they see instead is a government desperately priming the pump to maintain an illusion of prosperity… As a share of the economy, household incomes have actually declined over the past decade. With the domestic economy too weak to maintain China’s high growth rates, and with exports to the West hurting, the Communist Party in Beijing and its regional offshoots have come to rely heavily on cheap exports and debt–fuelled investment to sustain China’s fragile fortunes. And the problems will only get worse as China’s massive population starts to age rapidly over the next decade…

Massive stimulus:

In a country that’s often been called the world’s factory floor, China’s Pearl River Delta is the industrial engine that keeps the assembly lines running. So, when America’s economy tanked in 2008, and western consumers stopped buying TVs and sneakers, the region was hit hard. Exports to the U.S. and the rest of the world plunged, and more than 100,000 factories shut their doors, throwing millions of Chinese labourers out of work. As protests broke out, officials worried the backlash could escalate…

Faced with crisis, China’s leaders swung into action with a mammoth stimulus plan. In November 2008, Beijing unveiled a US$600–billion rescue effort that, relative to GDP, was several times larger than what America put in place. More important, the government ordered its state–run banks to crank up lending, especially to residential and commercial developers. The banks promptly obliged, shovelling more than US$1.5 trillion of loans out the door last year, an amount equal to 30% of the country’s economy. It worked better than the Chinese could have ever hoped — on paper at least…

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

Too little domestic consumption:

The crisis and the government’s response exposed just how fragile China’s economy has become. The problem is simple — for all the hype around China’s emerging middle class, Chinese shoppers contribute very little to the country’s fortunes. In any economy, domestic consumption typically makes up roughly 55% to 65% of GDP. The remainder is typically split between exports and investment. Not so in China. Over the past decade, domestic consumption’s share of the economy has plunged from around half to a miniscule 35%, the lowest of any significant economy ever, according to Michael Pettis, a finance professor at Peking University…

With almost nothing in the way of health insurance, welfare or a social safety net for retirement, Chinese feel pressure to save every penny they earn. At the same time, official policies that favour Chinese banks and exporters — namely artificially low interest rates, an undervalued yuan and cheap labour — come at the expense of household savers…

The days of China being able to fall back on cheap exports is coming to an end, say experts. It’s not just that consumers in developed countries have retrenched, though that’s an immediate threat. China’s policy of devaluing its currency to grab export market share from the West is now squarely in the crosshairs of politicians in the U.S. and Europe…

With the writing on the wall for China’s export machine, officials have to scramble for an alternative way to juice the economy. So China has increasingly looked to investments in infrastructure and construction to keep Chinese workers employed. In 2009, the peak of China’s stimulus campaign, fixed investments accounted for a whopping 95% of the country’s GDP growth. Even last year, despite all the efforts by Beijing to rein in its stimulus efforts, investment in fixed assets was the fastest–growing segment of the economy…

Absolutely. The Chinese economy has become increasingly dependent on fixed asset investment, as shown by the below chart.

And here’s the break-down of China’s fixed asset investment by industry, courtesy of the RBA:

Massive over-building:

“Crazy” fails to capture the utter insanity of what’s gone on in China’s property markets. In January, home prices in 70 Chinese cities jumped another 6.3% from the year before, and have more than tripled in the past five years. In prime markets like Beijing and Shanghai, prices have risen far faster. It’s no longer surprising to find taxi drivers and teachers who claim to own two or even three apartments each. At one point, Shanghai economist Andy Xie cited local media reports that some 65 million urban homes reported zero electricity consumption over a six–month period, suggesting there are enough vacant homes in China to house 200 million people. While power companies denied that was the case, in the regions around Shanghai, Beijing and other cities, fancy new apartment blocks stretch off into the horizon, their surfaces pocked with black holes where windows would otherwise be. Policy–makers have attempted to deflate prices. They’ve limited the number of homes Chinese can buy, restricted many state–run companies from buying up land, and ordered banks to rein in their lending, yet still prices continue to rise.

It’s not just the residential sector. Commercial developers have engaged in their own orgy of debt–fuelled construction projects, bidding up land values threefold last year and erecting countless office towers, malls and hotels. It’s all adding to a glut of properties that are sitting vacant. In Beijing, where the official commercial vacancy rate is 30% but approaches 50% in many pockets, developers go to great lengths to make empty buildings look occupied, going so far as to paint silhouettes of office workers in stairwells…

How could there be so many new buildings going up when, at the same time, so many others already sit empty? Simple. China is engaged in an elaborate shell game to hide a mountain of bad debts piling up on the balance sheets of its banks, developers and state–owned enterprises. In the case of real estate, it’s a matter of turning a blind eye to staggering losses… buildings sit half empty, yet landlords refuse to lower their rental rates. To do so would sink the value of the underlying land, which was used as collateral for the developer’s loans… This same scenario is playing out across the country on a massive scale…

Non-performing loans:

Beijing and the World Bank officially claim China’s government debt remains very manageable, at less than 20% of GDP — far below levels in the industrial world — but the truth is, local governments are piling on new debt at a staggering pace. In research last year, Victor Shih, a political economist at Northwestern University, examined the borrowing records of 8,000 local–government entities. He found that at the end of 2009 local governments had taken on US$1.7 trillion in debt, with another US$1.9 trillion in lines of credit available. Coupled with other obligations, Beijing is on the hook for nearly US$6 trillion next year, bringing it to par with GDP — making China seem almost as profligate as America. The trillion–dollar question is: How much of that debt is going to go sour? For his part, Shih has warned of a “wave” of non–performing loans hitting the country in 2012, while in August there were reports the China Banking Regulatory Commission conducted a stress test and found 20% of loans to be in “trouble.”..

There are at least a dozen other ghost cities scattered across the country. In November, the government of Hebei said it plans to build three new cities in the region around Beijing over the next few years… The New South China Mall lays claim to being the largest mall in the world, yet is bereft of tenants. Likewise, in Beijing, Pangu Plaza, a hotel and mall complex shaped like a dragon and which runs the length of seven football fields, is largely vacant of shops and people… The list goes on and on. But for how much longer, wonder some China watchers.

Readers may remember my December article entitled China’s empty cities, showing satellite photos of entire cities laying vacant.

Manufacturing and infrastructure overcapacity & malinvestment:

The rush to build over the past five years has left China drowning in overcapacity in many key sectors. In Liaoning province, the government is spending hundreds of millions of dollars to build five mega–ports over the next couple of years, even though China’s ports are already operating far below capacity… China continues to build new steel mills, cement factories and aluminum smelters even though up to one–third of existing plants sit idle…

As for China’s ever–expanding network of bullet trains, Chinese media report trains on several of the new lines frequently run with more than half their seats empty. Some worry China’s high–speed rail experiment will lead to a debt crisis, since the mammoth project has already saddled China’s railway ministry with US$150 billion in debt. Over just the next few years that figure is expected to rise to half a trillion dollars.

Demographic time bomb:

But above all, China faces a demographic time bomb that’s as bad, if not worse, as the one plaguing Europe. Largely as a result of the country’s one–child policy, instituted in the 1970s, China’s population is aging fast. The number of workers aged 20 to 29 will peak in about four years, then drop sharply over the next 15. At a point in the not distant future, China’s population will actually begin to shrink. All of those factors will curtail the number of people who are likely to move to cities and take up new jobs. “Their labour force is getting old and shrinking,” says [Vitaliy] Katsenelson. “I don’t think migration is going to be as big a force as people are expecting it to be.”

As explained in an earlier post, the ageing of China’s population is likely to significantly curtail its growth potential. There is a good chance that China will grow old before it gets rich.

What it means for commodity exporters:

China is inextricably tied into the global economy. What happens there will have far reaching repercussions, especially in countries like Canada and Australia that have supplied China with the raw material to remake itself…

By some estimates, demand from China is behind half the rise in global commodity prices, such as copper, oil, nickel, iron ore, coal and potash — all resources hauled from the Canadian [Australian] landscape. China has become Canada’s fastest–growing trading partner [and Australia’s largest], and three–quarters of what we now sell to them comes from the ground [it’s a similar story in Australia]. This dynamic shielded us from the brunt of the global recession. In 2009, Canada’s exports fell 28% from the year before because of the crisis in the U.S., yet at the same time our exports to China actually rose 7%.

Some have argued the resource sector isn’t all that crucial to Canada’s well–being, since mining and oil and gas extraction directly account for just 4.5% of the economy. But this figure fails to capture the wider influence the commodity boom has had here…

In plain terms, should China’s economic miracle turn out to be a mirage, all of that would be at risk. “If China fails, or even if this fixed investment model fails, countries like Australia and Canada are in deep trouble,” says John Lee, a foreign–policy expert at the Hudson Institute who is also a research fellow at the Centre for Independent Studies in Sydney, Australia. For one thing, commodity prices are likely to plunge…

An article in last weekend’s Australian newspaper shed some light on how reliant Australia is on continued Chinese construction:

Professor Shi He-ling of Monash University says that 70 per cent of China’s steel consumption — which grew an annual 16.7 per cent between 2000 and 2009 — goes into construction. Of that, housing comprises 69 per cent, infrastructure 25 per cent and commercial buildings 6 per cent.

China has unusually high steel intensity against GDP, benefiting Australian iron ore and coal exports immensely… About half of all steel made in China goes into housing, 17.5 per cent into other infrastructure.

So any significant slowdown in construction activity in China would likely send the prices of iron ore and coking coal – Australia’s two biggest exports – into a tailspin. And the impact would be even greater if the fall in demand happened just as new sources of supply come on-line.

The impacts on the Australian economy from a commodity price collapse would be pronounced. The terms-of-trade would fall precipitously, sending the Australian dollar south. Mining investment, which currently accounts for around 4% of GDP would likely contract, as would incomes and employment. State and federal government budgets would come under pressure from falling tax revenues. And Australia’s banks, which have borrowed heavily offshore to inflate the housing bubble, could once again find it extremely difficult to roll-over their maturing foreign borrowings, possibly leading to widespread credit rationing and a sharp fall in house prices.

I’m not predicting that China and Australia will each experience such a hard landing. Rather, that it is possible, and readers should plan accordingly.

Cheers Leith

[email protected]


  1. Leith,

    “I’m not predicting that China and Australia will each experience such a hard landing. Rather, that it is possible, and readers should plan accordingly.”

    I think your being to nice. People need to wake up and face reality about China especially Australians and the govt. Thats all I hear is how China is so great and going kick everyones, especially the US, ass. If you look below the surface of China then people would start to realize that all is not well. China isnt any different from anyone else. People can argue with me all they want but it doesnt make since to keep building empty buildings, ports, factories, and roads that are not being used. Chinas issues are not far from surfacing.


  2. Leith,

    Thanks for continuing to post these articles about China. While I disagree with you when you analyze housing in the developed world, I am in complete agreement with this article’s analysis on China. The paragraph beginning with “Crazy” in that article is exactly what I have been calling as “ABSURD” over the past many years. It is unfathomable, but the reality is that home prices in India and China have gone up a totally ABSURD one thousand times (100000.00 percent) in the past 30 years. Compare that to any developed country. In the USA, most homes have barely even doubled in the past 3 decades, and yet, the USA is reeling from an economic downturn, yet China is seemingly flourishing.

    I hope Wendell Cox from Demographia finally acknowledges the absurd/crazy bubble in China and India, and compares it to the developed world. He continues to staunchly defend China’s housing prices as reasonable while trashing the developed world as being “expensive”.

  3. Some thoughts:
    Massive stimulus: Yes.But China is a surplus country that is not hobbled by the amplifier mechanisms of derivatives as in the West.

    Too little domestic consumption: from 50% to 35% over 10 years. Good, there is a target for reversal for the next 10 years. Sticks and carrots in a command economy.

    Massive overbuilding: 65million urban units, possibly housing 200million people. Where are the workers going to retire to if they can’t afford to stay where they are?
    Where will the people who will be moved off the land to create large scale broad acre farming move to? Many children go east to work whilst aging parents stay on the small family plot. Both of these demographics will need housing and centralised services. State public housing. Ever seen a mining accomodation construction camp being built before the mine? Sticky prices, sticky peasants.

    Non performing loans: No external debt levels as in the West.

    Manufacturing & Infrastructure overspending: Are those ports quoted import or export orientated? A couple of years ago I read where there was under capacity in import orientated ports.

    Demographic timebomb: Yes. Hence the need for speed. Speed vs control. Three darts, one bullseye? No darts, no cigar.

    What it means for commodity exporters: China wants supply security.China is in the jockey seat. It would love to break the back (not the neck) of the sea borne iron ore triopoly. The steel makers reminisce about 1994 when the yuan was strong and iron ore prices were US$10 a tonne.
    Strategic stockpiling, no one seems to know.
    Commodity speculation- 2008 showed some very large shake outs. John Mauldin’s Frontline had an article on this last year, which was terrifying in its scope if there’s another global rout.

    China controls demand and tolerates speculation to drive speed in supply response. When time is up (balance) prices will reverse. Watch for the Keynesian imperative-the euthanisation of the rentier classes.

    When China gets a seat at the Global SDR table it may drop its Keynesian facade and opt for a more classical approach, or other.

    China is a strategic changeling. Butterfly, moth or dragonfly?

  4. This has so many resemblances to Japan’s property bubble and crash in the 1980s and 1990s. I think one question should be: can Asian countries observe the cost of capital? Because these are the kind of absurdities you get when there is no cost of capital in an economy. I don’t think it is overstating the case to say it is about the future of the most basic arithmetic underlying capitalism because there is no doubt China will be a major player in the future.

  5. Thanks for posting Leith.

    This is a great little article by Barry Eichengreen (via twitter!) on what he sees as China’s impending significant slowdown.

    It focuses on the shift that will have to be made away from manufacturing and exports to domestic services and domestic spending. And also features historical comparisons with other economies that have grown rapidly. Great stuff.

  6. Paul Hutchinson

    I often wondered, those millions of apartments I saw last year on a 5 hour bus trip from Yangzhou to Shanghai. Were people living in them; I think not.
    And that long freeway from Nanjing to Yangzhou,with only a handfull of cars on it?

    “At one point, Shanghai economist Andy Xie cited local media reports that some 65 million urban homes reported zero electricity consumption over a six–month period, suggesting there are enough vacant homes in China to house 200 million people”

  7. Leith,

    Read this article. Really good actually I thought.

    I think he says it all in this paragraph. He is exactly right everyone that thinks a govt can control everything. The thing is they cant.

    “While the economic systems of China and precrisis America are certainly different, below the surface China is plagued by staggering levels of credit expansion, speculation, malinvestment, and toxic loans — much like what we saw in America. The notion that the iron-fisted Chinese government is in control of this situation is a dangerous one. The laws of economics are omnipresent and cannot be overridden simply by force. Trying to apply top-down central planning to an economy that is more and more driven by bottom-up market forces will inevitably have grave consequences. Wild credit expansion always leads to the same things: price inflation, malinvestment, and bubbles. “

  8. That’s an absolute cracker Leith? Is Canadian Business a mainstream mag like BRW or something?