This week’s note will begin by reiterating our bullish theme on the Natural Gas market. We hav...
The Coming Economic Crisis in China
01/15/2010 9:14 am EST
Investors and analysts worry about a financial meltdown like the one that slammed the US and other developed nations. But Chinese leaders have other, more pressing problems.
I think investors are worried about the wrong kind of crisis in China.
Worry seems to focus on the possibility of an asset bubble and the chance that it will burst sometime in the next two to three months.
I'm more concerned about a slide into a crisis that will be an extension of the Great Recession. That slide could begin, I estimate, sometime in the next 12 to 18 months.
I understand the worry about the possibility of an asset bubble in China. After all, we've just been through two horrible asset bubbles—and busts—in the US and global financial markets. And a Chinese bubble is a distinct possibility, one that should certainly figure into your investing strategy.
But China's economy and political system are so different from ours in the US and those in the rest of the developed world—and its relationship to the global financial market so unique —that I don't think we're headed toward any kind of replay of March 2000 or October 2007.
A bigger worry is a long-term slide into a lower-growth or no-growth world in which nations strive to beggar their neighbors and all portfolios slump. As crises go, it's very different, but ultimately just as painful for investors as the asset bubbles that draw all our attention now.
To paraphrase Leo Tolstoy in Anna Karenina: Happy bull markets are all alike; every unhappy bear market is unhappy in its own way.
Toil and Trouble
Most analyses of China's economic troubles begin, rightly, with the river of money flowing into the nation's economy.
How deep is that river?
Start with the $585 billion in official stimulus spending. Add in bank lending that more than doubled, to $1.4 trillion, in the first 11 months of 2009 from $615 billion in all of 2008. And factor in continued runaway lending of $88 billion in the first week of January. If that rate were to continue, China's banks would wind up lending 50% more in January 2010 than they did in the first month of 2009.
All this has led to an explosion in the country's money supply. Money supply as measured by M1 was up 35% in December from 12 months earlier.
All that money has to go somewhere. Some of it has gone into productive loans or government-financed capital projects. But, clearly, huge amounts have been siphoned off— in ways that China's politically connected capitalists know how to do so well—into speculation in real estate and the stock market.
This has led to the enormous price increases for those assets that have stoked fears of a 2007-style financial asset bust.
At its 2007 peak, the Shanghai A-share index (A-shares are priced in renminbi and can be purchased only by domestic investors) traded at seven times book value. At its high in the 1990s, Japan's Nikkei 225 traded at only five times book value. Right now, the US Standard & Poor's 500 Index trades at 3.5 times book value.
The global financial crisis cut the price of Chinese stocks in half, but the subsequent recovery has taken them back into bubble territory. If you factor in an average of earnings over the past ten years to take out some of the volatility, Chinese stocks now trade at 50 times the average ten-year earnings per share. The comparable figure for US stocks is 15— and even that's not cheap by historical standards.
The bubble is even more apparent in real estate. According to figures in a Financial Times column by Peter Tasker, a Tokyo analyst for Arcus Research, the Tokyo real estate bubble of 20 years ago peaked with apartment prices at 12 to 15 times average household income. In major Chinese cities now, the comparable price for an apartment is 15 to 20 times average household income.
When real estate speculation exceeds that of the Japanese real estate bubble, investors are right to worry. And that's why even some minor saber rattling, such as the increase in reserve requirements by the People's Bank of China on Tuesday, is enough to rattle China's stock markets and developing markets around the world.|pagebreak|
If you own Chinese stocks or Chinese real estate, you should worry about the bursting of this bubble. It could easily take prices of Chinese stocks down 20% or more. After all, the Shanghai market fell 21% between July 31 and August 31 last year. That was in the middle of the huge rally in global markets.
This is why I'm hesitant to buy into the Chinese stock market now. For my strategy on how to buy emerging market stocks now, see this recent post.
Central Planning, with Benefits
But I don't think you need to worry about a bursting of the Chinese financial asset bubble producing a replay of the Great Recession or the collapse of the financial and stock markets. For three reasons.
First, the Chinese financial markets are still only partly integrated with the global financial system. Even a huge collapse in the prices of Chinese stocks and real estate isn't likely to spread beyond China's borders to a degree that would endanger major global financial institutions. It was the contagious nature of the problems at American International Group and Lehman Brothers that turned a crisis in the US financial markets into a crisis for international financial institutions such as ING and Royal Bank of Scotland and then into a crisis for governments in the United States, the United Kingdom, Ireland, Spain, and beyond.
A collapse in asset values in China would not likely trigger a collapse of asset values around the world because:
- The renminbi isn't a freely exchangeable currency,
- International banks don't have a lot of tricky-to-price and hard-to-trade derivative products with Chinese banks at the other end of the deal, and…
- International institutions don't have much exposure to Chinese financial assets.
Second, the Chinese government is committed to growth come global recession or high water. Beijing's reaction to the global financial and economic crisis proved that. China's economic growth slowed to 6.1% in the first quarter of 2009, and what did the government do? Panic. Beijing threw money at the economy—almost $2 trillion in spending and loans. And it continues to pour cash into the economy even as growth climbs back toward 10%.
I think that reaction should end any worries that a Chinese financial asset or property bust would lead to a collapse in the global commodity markets. Or at least one that would last very long. One advantage of running a centrally planned economy is that you can throw cash at the economy (without opponents carping about the size of the deficit) so that companies can stockpile raw materials—if you're so inclined. China's reaction to the global financial crisis should have removed all doubts that its government is so inclined.
Third, in China, the government keeps the books. As the 1997 Asian currency crisis showed, no bank in China is bankrupt if the government says it isn't. And huge debts can be shuttled to new financial institutions where they linger for decades until they simply fall from memory. I'm willing to bet that if all the bad loans of 2009 and 2010 were finally added up, more than a few Chinese banks would be bankrupt. But I am also willing to bet that nobody will ever see those tallies and that no more than a few "demonstration" banks will be allowed to go broke.
Waiting for China's Consumers
So if the bursting of any Chinese financial asset bubbles would not be contagious, would be reversed quickly with a river of government cash, and would not likely be allowed to take down any significant financial institutions, then what—other than a 20%-or-worse short-term correction—am I worried about?
I'm worried because, over the long term, a system like this can't efficiently allocate capital, and, in the long run, massive misallocations of capital in China would lead to another global supply and demand crisis—worse than the one we're now trying to end. (We tried to solve the previous one by turning houses in the US, Spain, the United Kingdom, Ireland, and elsewhere, into ATMs so consumers in developed economies could buy stuff they really couldn't afford. See how well that worked out?)|pagebreak|
China has 117 carmakers. The China Association of Automobile Manufacturers calls 17 of them major manufacturers. All 117 can raise capital if they've got the right political connections. So is it surprising that automobile manufacturing capacity in China grew 30% in 2009 to 20 million units? That compares with record demand in China of 13.6 million units in 2009, a year when Beijing cut taxes on sales of many cars and implemented its own Cash for Clunkers-style stimulus program.
I haven't been able to find figures for how many of those 117 companies were profitable for all of 2009. But in the first half of the year, profits at the 17 major manufacturers were up just 1.5% from the depressed first five months of 2008. About half of the 17 saw their profits fall in the period, and three suffered losses.
Will supply and demand or the workings of the capital markets force any of those 117 companies out of business? Not if it means putting local workers on the streets.
The effects on the global economy spill out from China. Since profit and loss don't count if a loss-making company can just keep raising capital, excess capacity in China results in low-priced exports that depress prices of competitors around the world. Countries looking at the example of China—countries that don't want to lose the jobs, prestige, and technology that come with having a domestic car industry—decide to go China's route and bail out unprofitable carmakers.
Multiply the effects from this to industries such as aluminum and wireless phones and you get:
- Rising global trade tensions. Developed and developing economies have a limited tolerance for seeing jobs shipped to China, especially when there's growing feeling that China doesn't play fair. See the tariffs the United States put on Chinese tires in 2009 as an example of what happens when these tensions start to escalate. This trend doesn't end anywhere good, especially because it plays right into a widespread belief in China that the West wants to see China reduced to the powerless status it had in the 19th century.
- Increasing inefficiencies in the Chinese economy. In the first nine years of the 2000s, it took $1.50 in new credit to add a dollar of output to the Chinese economy, hedge fund Pivot Capital estimates. In 2009, that figure jumped to $7 in new credit for $1 in additional output. Even if you factor in the delays in turning 2009's big surge in credit into actual output, the number is worrying.
But there's a way out for China and the world. It's called domestic consumption in China. In contrast to the United States, where domestic consumption makes up 60% to 70% of gross domestic product, domestic consumption is about 30% to 40% in China. That low share is intentional, the result of policies such as an undervalued renminbi that depress the purchasing power of Chinese consumers, especially when it comes to imports.
In 2009, the Chinese government made lots of noise about raising domestic consumption and took concrete steps, such as improving health care and paying school fees for more people, that were intended to make Chinese savers feel they could spend more and save less.
But the jury is still out on whether those changes were enough to change the composition of the economy, or whether the return to export growth will put China back on the same old track. I'd say China and the world have about 12 to 18 months to show convincing progress on fixing the intertwined problems of global excess capacity and underconsumption by Chinese consumers before we start to lay the foundation for a new crisis.
It won't be signaled by the bursting of a new bubble. We'll simply and gently slide back toward crisis. And that will show that we never really fixed the underlying economic problems that caused the current crisis, the one we're still struggling to fix.
At the time of publication, Jim Jubak did not own or control shares of any company mentioned in this column.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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