Is There a China Bubble?
Will the next pop you hear be the sound of the China bubble bursting? A few of the world's savvier financial minds think so.
Jim Chanos has made a fortune betting against investments he believes are ripe for a fall. Among his most illustrious short trades was pegging high-flying Enron as a disaster in waiting. Today the hedge fund manager is taking aim at China. “Without a modicum of doubt we have a credit-driven property bubble right now,” Chanos recently declared in a talk he gave at the London School of Economics. That was a toned-down version of his quip to the New York Times that China is “Dubai times 1,000 — or worse,” a comment the manager of the $6 billion Kynikos fund now half-heartedly describes as tongue-in-cheek.
Chanos is adding his respected voice to a growing rumble that China’s economy is nearing 212°F. In a recent survey of investment pros who subscribe to Bloomberg’s news and data service, 62 percent said they believed China is brewing a bubble. Also singing in the China bubble chorus: Harvard economics professor Kenneth Rogoff, Gloom and Doom report publisher Marc Faber, and, most recently, James Rickards, a Virginia-based consultant who knows a thing or two about financial calamity — he was the general counsel for Long-Term Capital Management. To be clear, the China bubble talk is mostly focused on the country’s real estate sector, where property sales jumped 76 percent in 2009 and prices in some markets have recently been rising 8 to 10 percent a month. But the fear is that a meltdown in the real estate market could take down the rest of the Chinese economy with it, as has happened in the U.S. and Japan. And with China expected to account for about a third of global growth in 2010, the consequences could well be global.
The Mother of All Stimulus Projects
The roots of the problem lie in China’s aggressive response to the financial crisis. To make up for reduced exports, the government ramped up domestic spending and what ensued was the “mother of all stimulus projects,” says Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics. The roughly $575 billion in direct stimulus doled out by China’s central government represented 15 percent of its GDP. (Consider that if the U.S. stimulus program had clocked in at 15 percent of GDP we would be debating the merits of a $2 trillion program, not the $787 billion Congress settled on.)
China’s banks also followed the stimulus script, doling out $1.4 trillion in loans last year, a 30 percent increase from 2008. All that liquidity did the job. According to China’s official data (which are notorious for their lack of transparency) the domestic economy expanded 12.6 percent in 2009, offsetting a three percentage point decline in GDP from exports. Overall, China’s economy grew 8.7 percent in 2009, up from 2008’s anemic — at least by China’s standards — GDP growth of 6.8 percent.
However, much of the stimulus spending and lending has found its way into real estate, creating ominous imbalances and the potential for huge amounts of bad loans that the Chinese government would then have to cover. Commercial developers who were all too happy to take the stimulus money and build on spec are now often hard-pressed to find tenants; entire office buildings and shopping malls stand empty in many large cities that have attracted the most development. In the residential market, the problem is flipped: too much demand and not enough supply. Homes are the default investment choice for an increasingly flush populace that has limited access to other investment vehicles. And the prevailing sentiment is that if you don’t buy today you are going to be priced out of the market tomorrow.
In response to concerns that it’s inflating a bubble in real estate, the central government has begun taking steps to cool things off, but to date it’s more talk than action. Bank reserve requirements and a key lending rate have been increased only slightly, and official 2010 lending targets, while lower than last year, will still surpass credit outlays from 2008.
Bubble Dynamics
- 1. Leverage is muted. About 25 percent of Chinese buy their homes outright with cash. Among borrowers, a 50 percent down payment is typical; you can’t get a mortgage with less than 20 percent down and if you are looking to buy a second (or third) property the down payment is 40 percent. China also has yet to develop a HELOC market. Lardy, of the PIIE, notes that China’s household debt as a share of household income runs about 40 percent. In 2007, U.S. household debt to income was 130 percent. Nor has China fallen into the grasp of Wall Street alchemists concocting toxic real estate derivatives.
- 2. It’s not a blanket bubble. Beijing, Shenzhen, and Shanghai are China’s Florida, Nevada, and California: speculation and overbuilding have clearly fed bubble valuations. But Nicholas Consonery, China analyst at the Eurasia Group, a political risk consulting firm, says there’s still plenty of unmet demand in China’s second-, third-, and fourth-tier cities.
- 3. The ubiquitous demand argument. Consonery also articulates the most oft-heard reason for why the bubble doesn’t have to burst: China actually needs more construction, not less, to accommodate the mass migration of Chinese from their rural past to their urban future.
A torrent of commercial development, a residential market convinced that if you don’t get in today you’re toast, and a wan government response to overheating … Sound familiar? But there are several key structural differences between our real estate mess and China’s situation, which suggest it is simplistic to assume China’s bubble must end in a U.S.-style meltdown.
While China’s real estate picture doesn’t necessarily stack up as Dubai times 1,000, or even the United States circa 2006, similarities to Japan’s property bubble could be more salient. Rather than a quick burst, Japan is still working through a long slow deflation from its epic property bubble that peaked in the late 1980s. Patrick Chovanec, professor at Tsinghua University’s School of Economics and Management in Beijing, who has advised private equity funds on China investments, says that’s the danger facing China. “Never underestimate the ability of the Chinese to brush things under the rug, rather than acknowledging losses and poor investments,” Chovanec cautions. “That can create a long-term drag on the economy.”
Koyo Ozeki, head of Pimco’s Asian credit analysis team, acknowledges the Japan corollary (his comparison of China, Japan, and U.S. real estate bubbles is below), but he believes a crucial difference is that China has the ability to grow its way out of trouble. His worst case scenario is that there’s a two- or three-year cooling off period for property values, but not a meltdown. “I think that it [would be] a ‘correction,’ as opposed to a ‘burst of a bubble’ similar to those seen in the developed countries, because of China’s structural demand for modern houses,” says Ozeki.
The 437,000 Renminbi Question
- Stocks: China is the third largest economy behind the U.S. and Japan, and it is expected to push its way to number two this year. The IMF forecasts that China will grow 10 percent, more than double the overall world rate. If the bubble does in fact burst, growth will slow and we could be in for round two of a global recession. That’s an argument for being cautious with equities and making sure your emergency cash fund stays stuffed.
- U.S. Treasuries: China holds about 10 percent of outstanding Treasury debt; it jockeys with Japan from month-to-month for the top spot among foreign investors. If China’s economy hit the skids, one theory is that it might choose to sell off Treasuries to raise capital for spending back home. But dumping Treasuries is far from an easy call for China, as it would depress the value of its Treasury portfolio and cause the renminbi to rise in value (and the dollar to fall), which is not ideal for its exports. Questions about how China will handle its cache of U.S. Treasuries will likely keep the bond market on edge. That’s just another risk factor to add to why Treasuries aren’t exactly the safest investment right now.
- Emerging market funds and ETFs: These are the most obvious losers if China falters. It’s not just that China represents 17 percent of the MSCI Emerging Market Index — the single largest country weight — but that so many of the other emerging markets, especially those rich in resources such as Brazil and Russia, need China to remain a hungry consumer. Overweighting emerging markets seems especially dicey right now, despite the sector’s recent strong performance. But even beyond the implications of a China bubble, it’s also wise to understand that the fastest-growing economies don’t always produce the highest investment returns.
What does this mean for your portfolio? When you have sharp minds on both sides of the argument that should be a tip that making a big bet on either is probably unwise. Moreover, China presents a few extra challenges. Despite its large footprint — China is expected to take over Japan as the second largest economy in 2010 — keep in mind we’re still talking about an emerging market.
Volatility and surprises (both upside and downside) are the norm. Add in the fact that China’s financial system and data reporting aren’t exactly open source code and you have another layer of complexity. And even the China bears are careful to point out that they have no clue when the bubble will burst. “We are not calling for an impending crash,” Chanos reminded the LSE crowd. Rogoff, former chief economist of the IMF and co-author of This Time is Different, which chronicles the long history of global financial calamities, recently told Business Week he believes the liquidity deluge in China will eventually culminate in enough bad debt to cause China’s economic growth to slow to just 2 percent to 3 percent a year. But as for when, well, Rogoff would only pin it down to some time in the next 10 years, and added that the setback would be short-term, not a Japanese-style slow bleed.
Given all that uncertainty, it seems wise to channel Pascal’s Wager: Acknowledge you might be wrong and adjust your portfolio accordingly. In this instance, that’s an argument for taking a look at what might happen if in fact China’s bubble blows so explosively that it sends the economy into a severe downturn. Here’s how your portfolio could be affected:
Bubble or not, one thing is clear: China is teeing itself up for plenty of volatility in the coming years. And it will affect the whole world. “Even with the strong long-term fundamentals, any market that has experienced such rapid growth creates its own fragility,” says investment banker Euan Rellie, senior managing director of Business Development Asia LLC. “That makes it certain there will be declines and corrections.”
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