Vitaliy Katsenelson: Why China will crash

In November 2010, I published a fascinating interview with Vitaliy Katsenelson – author of the Little Book of Sideways Markets (highly recommended), and teacher and Director of Research / Portfolio Manager at Investment Management Associates Inc, a money management firm based in Denver, Colorado.

In this interview, Vitaliy provided possibly the best discussion of the Chinese economy that I have read. Now Vitaliy has returned with an article in Forbes entitled How China will crash and burn. In under 700 words, Vitaliy nicely summarises the bear case against China:

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 U.S. 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 U.S. 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 U.S.)?  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 blacks swan! [from Forbes: China will crash and burn, 6 July 2011].

Vitaliy’s detailed slide-show presentation – China: The Mother of all Grey Swans – is also provided below.

Unconventional Economist


  1. Interesting observation about the Chinese banking system in the 1990’s, no wonder Chinese people put their money under the mattress. As I (and many others here) have observed, they don’t operate under the same rules as everyone else in China so its really hard to predict what the Communist Party will actually do once a bit of wobble is evident.

      • Fanboy, considering how much China economic p*rn has infested the media in recent years, what’s wrong with a little site like this pushing the alternative view?

        The tech boom boosters didn’t like hearing that Nasdaq 1999 was a bubble either. Neither did the Florida property spruikers in the mid-2000s.

        If you don’t like hearing an alternative point-of-view then please go elsewhere, or perhaps restrict your reading to Gittins, or forecasts from Treasury and ABARE. They never tell you anything you don’t want to hear.

        • “what’s wrong with a little site like this pushing the alternative view?”

          This site *is* pushing the mainstream view… only a couple of commentators are bullish. Obviously you have not read a lot of major bank and economists reports on this subject.

          Fanboy has indicated a perfect foil for your argument with Pettis, who has far too much nouse to ignore.

          Unless of course you are far more familiar on the China subject, which I personally doubt!

          May I also remind you that a forum is for open discussion on readers points of view. If these differ from those that believe they ‘know’ what is going on then great .. more the merrier.

          • This site *is* pushing the mainstream view

            Really?! Please forward me a few links from the RBA, Treasury or ABARE where they forecast a significant downturn in China.

            BTW, I’ve been reading Pettis for years.

          • Regretfully politics stops RBA and the others quoted from saying what it wants to say.

            You know that, otherwise you would not have posted that reply.

            You can type in the phrase on google and UBS and all the way through to Bloomberg will pop up.

            But I will leave you with this from 2001…


            And people read Pettis, some do not understand him that well.

        • China Watcher

          I strongly doubt that no-one in RBA and Treasury is thinking about the fat tail risk of a China collapse. And I suspect there will be a restricted brief with a roadmap with which to respond to such fat tail risk. To think otherwise underestimates several highly experienced smart individuals. On the other hand, if there truly is no thought going on, that would be a concern. But just bacause they don’t publish a “hell in a handbasket” view does not mean no thought has gone into it.

          • Exactly. They would make very similar assessments to major resources companies, run a variety of best case/worst case scenarios and appropriate responses.

            Resource companies do comprehensive analysis prior to development, after all, it’s their money, their project, their risk.

            Some think they just get a shovel from the shed and dig.

  2. An important misconception when people compare the American real estate collapse with China’s situation is that many make the case that Chinese individuals are not as highly leveraged as Americans. As the article above states Chinese borrow from relatives, but the more substantial issue is that the State Owned Enterprises are the ones loaded up with debt. They are very inefficient, opaque and the owners of most of overbuilt luxury housing market (64 million unoccupied apartments), office space (there’s 25 square feet of office space for every man woman and child in the country!), airports, steel mills, railroads, and shopping malls.

    Few of these projects have any chance of making a positive return on investment. When the banks run out of money to lend or investors realize that they can not sell or rent their properties, investment will stop. And when investment makes up 60-70% of your GNP, that’s not a problem, it is a catastrophe.

  3. China will collapse. Yada Yada Yada. And MacroBusiness appears to be making it its mission to reprint every article on the net predicting this (well, in fact, I confess to linking to this recently – only in the interests of keeping a certain section of MB readership in a rapturous state.

    While we’re at it, here’s the always thoughtful Michael Pettis:

    As I always say, Australia best hope that any collapse is years away. And if it is, I hope we won’t be reading of the ‘coming collapse’ here at MB every single day until it happens. Perhaps a monthly summary of links will suffice.

    • Fanboy,

      It isnt just MB.

      “This morning, Moody’s is out with a report that says China’s local government debt may be 3.5 trillion yuan ($540 billion) larger than auditors estimated. ”

      This debt is about 25% of their GDP. You can praise China all you want but this will catch up with them. I suspect sooner rather that later. Plus all the Chinese companies are being investigating all over the world on their book and account keeping. China will be worse than Japans fall.

      • There is probably alot more debt that is on the black market that they cant account for either. Like Chanos said they are on the treadmill to hell.

        • Montgomery Burns

          Chanos’ presentation(s) is/was pretty convincing but unlike most of us here he claims to be putting his money where his mouth is and that can’t have been working out well over the last 18 months.

          • Actually Chanos says he’s been shorting Chinese and Hong Kong Property developers, and is well ahead on the trade.

            There’s a recent CNBC interview on the intertubes somewhere where he discusses this.

          • What Lorax has said is exactly right. There are several recent interviews of him stating this. He would not continue shorting it if he was losing money

          • Montgomery Burns

            Fair enough but I have also seen him on videos (on the intertubes) talking about shorting resources so his gains on being short HK property must be financing his resources losses.

          • Here is a recent interview with Chanos.

            Compelling as always. Here’s a choice quote:

            Private ownership is only 12 years old in China, so they’ve only seen an up market, so you have the arrogance of the first time bull

            At about 8 mins in the interviewer says “Your bets have not paid off so far” and Chanos responds “Of course they have”. He then goes on to say “the Chinese market is down and the property sector is down even more over the past year and a half”.

          • That depends on where he has his shorts. The Shanghai composite index is down over 8% in the last 2 years (up 16% over last 12 months though, but still underperforming the S&P500)

    • So that’s – 3 Yada’s
      1 rapturous steak
      1 certain section
      1 Pikelets-no-grease
      and 2 hope’s….would you like anything else with you’re order,Sir..Thanks for that..
      Next week
      carbon-fizz-collapse’s are on special,and fully expecting by the end of the month to have a full range of Benny-Sweat available..Do be sure and call at MB every single day…for your fill..cheers
      Thanks UE…JR

    • australia is different, houses will be 5 million in a few years, i just bought 3 on credit card.
      im gonna be rich, ill have a 5 million house that i can rent for 250k a year, sweet living.

  4. China’s monetary system is structured such that it earns so much additional money from export growth that it does not need any growth in bank credit to stimulate the economy.

    Any growth in bank credit would raise imports and reduce the foreign funds available for sovereign investment.

    Given that China is engaged in using its sovereign investment funds to buy up strategic assets around the world, it is likely that one of the main reasons for credit restraint would be to make more funds available for its foreign investment program.

  5. If something cannot continue forever, it will stop. The Chinese economy cannot keep growing forever. However, those who predict ‘crash and burn’ don’t understand China at all. The Chinese government does not believe in ‘free market’. It will act forcibly to prevent a crash, and how it’ll act will be the true danger to the Chinese economy.

    Under the textbook economic theories, the real interest rate should never be negative (i.e. inflation greater than interest on loans). China have negative interest rate for like 20 years!! The entire economy is distorted by political decisions.

      • The Mainlander

        But textbooks do have the answer. The problem is that the type writings that I am referring to are not listed in the curriculum of any major economic school.

        All of my readings since Uni, where neo classical economics was thrust down my throat, have a classical bent and in the main found on the Mises forums.

        Try reading some, you will be surprised at Hayek, Glahe, Mises, Rothbard, Bogutoglu and numerous others.

        Note: Majority are even predictive!

    • +1

      The totalitarian govt will keep this going for a while, even falsifying all the official economic releases if needed, including inflation numbers.

      That’s for us foreigners. But people in China will know what’s going on. And there will be a point when the totalitarian govt will finally ‘crash and burn’, not China.

      China will be reborn then and finally on its way to a bright future for its people.

    • ronin what are you smoking mate??
      are you saying australia inflation is below the rate of interest? then how does the principal and interest get paid?????
      with fish fingers?

      • Take Australia as an example : inflation rate if 4% per year, and your term deposit rate is 6%, and you borrow loans at 8%.

        In China, inflation rate is 10%, your term deposit interest rate is 4%, and well connected businesses borrow money at 8%.

        See the problem?

  6. So the reports of huge growth in personal ownership of gold & silver in China is explained. I read that this is encouraged by the govt. too. China has just started local Gold ETF trading too. There is a strengthing interest in gold in China.

    So if you are one of the little people in China and have some cash:
    buy gold (not real estate or bank deposit)

    • i think the chinese little people are 100x smarter than you are, they been thru currency issues many times b4.
      by little i mean the middle class millioniares, the majority are peasants and most of their money goes to food.
      and no, china is not different they are creating demand to offset deflation which is a normal thing in “free” markets whatever they are. you can create demand but when food and commods get expensive, you have to stop or the currency will be toilet paper.

  7. When this little deck of cards (China)collapses, it will make the slow collapse of Japan look pretty insignificant.
    I’ve lived in China and driven on 6 lane freeways that go nowhere.
    I’ve been to empty cities, many of them.

    I’ve been telling people this for years!

    Meanwhile the market will rally strongly. Can’t beat the press/media for brainwashing idiots.

    How close to a default in the USA? A few weeks away?

  8. Folks, let’s put things into historical perspective.

    The USA, in its 100 year runup in becoming the biggest economy in the world by WW1, went through countless depressions, currency collapses and panics along the way.

    And deflation, and inflation (and hyperinflation). And eventually, world dominance.

    The same thing happened to Great Britain.

    It is ridiculous to assume that another burgeoning power won’t go through similar growing pains.

    But on the other side of that will emerge a vibrant and developed economy that has learned its mistakes.

    It is hubris indeed to consider China at THAT STAGE now. It is still learning – albeit exponentially – having been stuck in the Dark Ages whilst the rest of the world advanced and developed.

    What is important to realise is that economies on the periphery of China must be robust to these secular “fluctuations” – and Australia, whilst taking advantage of China’s inexorable rise, is fragile to any of this movements.

    That concern is not being addressed in the mainstream.

    • The Prince,

      China will go through what Japan is going through years of stagnation and deflation. Not to say they wont be a power in the global economy but they are going to come back to earth with a hard landing.

    • The possibility of a hard landing is of concern, to the Chinese people themselves and of course, the Australia’s resource sector. To remain cognisant of the possibility is prudent. But that’s it!

      That’s it because we have no alternative than to run with what we’re given at present – and what we are given is an unprecedented resources boom.

      Miners need to invest in projects to reap the benefits of commodity demand. This is their business. This should be supported in practical ways by government (fast-tracking approvals, streamlining permits and regulatory handbrakes, not imposing unrealistic unexpected taxes).

      The nation can collectively rejoice that we are indeed The Lucky Country at this particular moment in time, because without resources we’d be in a dire position. Instead there is all this moaning going on, it is counterproductive and evidence of a spoilt populace – all this ‘Whadda ’bout me”. We’ve got it pretty damn good.

      We have lowish interest rates, near full employment, a generous welfare system, adequate free education – a lot to celebrate but all the focus is on the negative. Just like all these China Collapse scenarios.

      China may collapse. It will be terrible for Australia if that happens (not just Australia).

      We can’t plan a future economy on a collapse scenario that has yet to materialise. We’d never move forward.

      It ain’t over, until it’s over.

    • prince, i dont think china will dominate anything in the near future not while your still alive anyway.
      china is a command economy thats why there is 1 billion serfs and the rest rich. the west is following, should be interesting times…the west is bankrupt, who is china going to be selling to?
      do they have enough food to feed themselves? if so, why is there 1,3 billion and 1 billion of them are peasants while they have trillions in reserves, what a joke. Biggest corrupt ass holes on the planet, they love money and materialism and would sell their mother for a profit. stock scams, envelope money, etc etc.
      absolut power=absolut corruption.
      big gov=big assshaft///

  9. I’d be prepared to bet a bit of my money that Jim Chanos has not bet all his money on a Chinese collapse. As a close-up observer of China for over 25 years, it remains a puzzle to me. I’ve found it always difficult to determine which is the cart and which is the horse! In a normal market economy it can be hard enough. In China, well who really knows?
    In the last few years the government, in an effort to make the economy more domestically driven, has had a deliberate policy of raising wages. This has resulted in wages increasing at, typically, some 23 to 30% each year for the last three years. At the same time they have engaged in gross stimulus in ter4ms of, as pointed out here, credit but al;so in Govt expenditure and development particularly in the Western areas. At the moment wage cost growth has taken on a life of its own as a result of these factors and their serious demographic problem. There is curre4ntly a serious shortage of labour.

    Add in the massive increase in commodity prices and it looks like a pretty toxic mix, It is a toxic mix not only for China!
    The Chinese Credit expansion is only part of the problem. The problem is kept fed by US Fed where much of the expansion of its Balance Sheet ends up, not in the US itself, but in China and other developing economies.
    I doubt I’ve added any clarity here and only added to the confusion. But, to paraphrase the old saying, if you aren’t confused by China you don’t know enough about the place.
    I’d agree with Peter…buy Gold!

    Maybe a little off the point of this particular topic but….
    I think it is always ‘amusing’ when we, the holders of all knowledge, criticise, in this case, the Chinese for running negative real interest rates.
    The Western world, and in particular Australia, has run negative after-tax real interest rates for about 50 years of my lifetime. I agree with the writers that such a policy is, and clearly has proved, a disaster.
    Yet again on these pages, even though real after-tax interest rates are now close enough to zero or negative, we are advocating that the RBA lower interest rates even further and scoff at them as total fools because they might even consider increased rates.
    Lowering rates is seen as the answer to all ills.

    • China does not only have a negative interest rate on deposits savings : it has a negative interest rate on loans!!

    • China Watcher

      +1 to Flawse.
      At last, someone who has the depth of knowledge and understanding of China to realise its almost impossible to predict how things will unfold!
      Beware the economist/forecaster that has unswerving confidence in their view of the future. Most of us underestimate the contribution of stochastic processes and over-estimate our ability to predict in thinking about the future. Some humility on China is warranted.

    • I’d be prepared to bet a bit of my money that Jim Chanos has not bet all his money on a Chinese collapse

      Chanos runs a hedge fund. I’d say he’s hedged.

      Add in the massive increase in commodity prices and it looks like a pretty toxic mix, It is a toxic mix not only for China!

      Er, Flawse, you do realise the Australian economy depends on this “toxic mix” continuing don’t you? All the forecasts out of Treasury, the RBA and ABARE show the “toxic mix” continuing for decades.

      Really, I don’t see your point. Surely the Chinese (and others) really want to pay absurdly high prices for our iron ore and coal. After all, the entire purpose of China’s economic development is to make Australian miners rich. Isn’t it?

  10. Hi Ronin
    True. I guess in our case it depends a little on who is doing the borrowing as this affects the interest rate paid and the deductability. It also, of course, depends on how you measure inflation. I’d think a largish commercial borrower is looking at zero to negative real after-tax rates.
    Similarly, deposits attract a very negative real after-tax rate. Given that much of our lending has been for housing which has been inflating at some 7 to 10% per year then lending for housing has been done at real negative rates since the bears were bad. Hence we over-consume goods, over-consume houses, under-save and under-invest.

    My only real point is that it is a bad policy no matter who implements it and it is not just the Chinese who are doing so.

  11. ronin, b4 you type think about what your saying.
    there is never enough money to pay off loans because when the loan is created the interest is not….tell us how positive rates would work you genious.
    its like asking greece to pay off its 450 billion debt, the joke is it cannot because money itself is a debt.
    the masters of the universe are very smart, in a criminal way.

  12. wayne from st albans

    ‘command and control economy’, MMT, etc
    let imprudence on both sides of the ledger
    be severely punished,
    in ideal economic world let
    there be price discovery!

    china will eventually pop and so will our banks/taxpayers

  13. Lorax
    I think, perhaps, you read my post with a pre-ordained position in your own head. Truthfully my point is that people making definite predictions about China ought be damned careful about backing their mouth with too much money.
    In applying a bit more discipline to my own thoughts I’d guess it is very POSSIBLE that our problems emanating from China MAY well come from a very different direction to that outlined in this article. Who knows? Both trends may happen at the same time in which case my own pessimism will seem like a picnic.

    If you ever read any of my posts you would know that my opinion of Treasury is that the whole place is so monumentally incompetent that it ought be disbanded. It’s fair to say that our government and bureaucracy are operating in almost total ignorance of what seems to be coming down the pipeline. Hence my reference to toxic mix being not only for China itself.

    My point on interest rates is that almost continuous negative after-tax real interest rates are largely responsible for where we, and other others such as the US, UK et al, find ourselves. I just don’t see how anyone can view continuously lowering interest rates that are already too low will repair our economic (and social)structures.

  14. Martin Unimportant

    This is true. I don’t know why many people still don’t see that China’s end is near. Perhaps, all newspapers are loaded with reports about the USA’s financial problems and we forget that in the background, there is another movement: China going bankrupt, slowly, but sure.