China’s Bubble Economy

The inevitable slowdown will affect all – from commodity producers to governments issuing debt

China is not only a booming country, for years it has been one of the
world's fastest growing economies. Industrialization, urbanization,
modernization and entrepreneurship all appear to be on steroids in the
world's most populous nation.

There's relative consensus among
global investors that China will continue growing at 8 percent for the
foreseeable future, providing much needed support to the global economy.
By
almost any metric, economic progress in China over the past several
decades has been phenomenal: GDP per capita, literacy rates, health
care, infant mortality, life expectancy and national wealth have all
improved remarkably.

However, as the famous disclaimer reads on
most mutual fund advertisements, "past performance is no guarantee of
future performance," and this appears to be the case with respect to
China's progress. In fact, China today exhibits many of the signs that
characterize the great speculative manias throughout history.

Might
China slow to a more sustainable GDP growth rate, say 5 percent, in the
coming years? Significant evidence suggests that such an outcome is not
as outlandish as the global investment community currently believes. A
Chinese slowdown of this magnitude would have material impacts upon
commodity markets, emerging markets and even the S&P 500's business
and earnings mix. In short, how China goes, so goes the world economy.
Given this global economic interdependence, it's highly imprudent for
policymakers and investors not to consider the possibility of such a
slowdown.

Given the highly uncertain and probabilistic nature of
booms, busts and the sustainability of growth, the application of a
multidisciplinary framework seems particularly apt in determining
various scenarios and their relative probabilities. Consider the
approach one takes to identifying animals: You stumble upon an animal
and seek to determine what type it is. You might first look at it,
followed by listening, and observing its behavior. So if the animal has
feathers and webbed-feet, and "quacks" while waddling, the probability
of it being a duck is high.

Likewise, the same method can be
used to assess the Chinese economic boom, using multiple lenses to
determine the relative likelihood of a forthcoming bust.

From a
microeconomic perspective, one method of identifying an asset-price
bubble is to spot self-fulfilling or reflexive dynamics underway. In
China today, higher prices in many of its asset markets are generating
demand more rapidly than supply. Such dynamics are rarely stable and
create situations prone to rapid corrections.

Consider property
markets in which willingness to lend and prices rise together in a
self-fulfilling manner. Chinese bankers have been lending money against
collateral, the value of which is in part rising because of the banker's
willingness to lend. As property prices rise, banks' collateral is
worth more; the bankers feel more secure and smart, so they lend more.
The cycle repeats. Unfortunately for the bankers, they'll eventually
discover that they themselves created the sense of safety and
intelligence that they enjoyed. As happened with the subprime collapse
in the West, reality eventually sets in, bankers step back and
collateral values fall.

From a macroeconomic perspective, most
asset bubbles are associated with "easy" or cheap money that drives
overinvestment and overconsumption. Evidence of such easy money can be
found in Chinese commercial real estate, where both entire cities – like
Kangbashi, in Inner Mongolia – as well as gigantic malls remain
virtually empty. Time magazine profiled Kangbashi as a modern "ghost
town," and foreign newspapers have referred to the South China Mall in
Dongguan as the "mall of misfortune." Despite a 95-plus percent vacancy
rate six years into its opening, the solution proposed by the mall's
management is as disturbing as its existence: an expansion of
approximately 200,000 square meters.

Turning to psychology,
bubbles are usually associated with an "it's different this time"
mentality, along with a rising sense of national confidence and hubris.
Evidence of such thinking can usually be found with world record prices.
Consider the fact that Chinese buyers have been setting, and continue
to set, world record prices in the art markets. Or the reality that
Chinese thirst for Chateau Lafite seems insatiable, even at record
prices. Another useful indicator is the world's tallest skyscraper under
construction. In this domain, five of the world's ten largest towers
under construction are in China today.

Chinese buyers have also set recent world records in the prices paid for a dog and a pigeon!

From
a political perspective, we need to acknowledge the fact that the
Chinese government remains communist in spirit, albeit increasingly less
so. The party's structure drives uneconomic activity as provincial
leaders aspire to get noticed by producing more jobs and generating more
GDP than the other provinces. Anecdotal reports are alarming: Perfectly
usable infrastructure is destroyed and rebuilt to generate GDP.
Likewise, job creation and economic activity are prioritized over
sustainability and profitability.

Finally, employing an epidemic
perspective and analogizing speculative manias with a fever or flu
proves useful. In particular, a dwindling population of
yet-to-be-infected participants highlights the later stages of a bubble.
In this regard, that state-owned enterprises today are the dominant
buyers in land auctions should, pardon the pun, raise red flags. If
private developers are squeezed out by state-owned enterprises, financed
by state-owned banks, in buying state land, we are far more likely to
be entering the ninth inning of the ballgame rather the third inning.
The end is likely not far.

The ramifications of a meaningful
slowdown in Chinese economic activity are profound, ranging from the
risk of domestic social instability to a collapse of several commodity
markets.

On the global economic front, China's voracious
appetite for commodities has motivated significant expansions throughout
the global commodity complex, and many industrial markets, including
shipping, capital goods and more, continue to be driven by Chinese
demand. China's critical demand role for various commodities represents
more than 40 percent of global demand for cotton, aluminum and crude
steel.

Unfortunately, the forthcoming slowdown may arrive at a
particularly inopportune time. Many Australian and Brazilian mines have
undertaken massive capacity expansions. Likewise, many Norwegian and
Greek dry bulk shipping companies have expanded their fleets in
anticipation of rising demand. To accommodate this need for more ships,
many Singaporean and Korean shipyards expanded their capacities. And so
the story goes… What happens if the very foundation upon which these
expansion stories are built is faulty? Might the emerging-markets tale
that's been the darling of global investors be less compelling than
widely believed?

And what happens to multinational companies in a
slowing world? Might the demand for US treasuries drop, resulting in
higher costs for capital in the United States? Is it conceivable that
the consensus belief that the renminbi will appreciate is instead met by
depreciation as Beijing grasps at hopes of export-led growth? How might
25 percent depreciation affect global imbalances?

The stakes
are high. Policymakers, investors and corporate boardrooms must consider
the risk of a material Chinese slowdown. Despite the allure of "China
is different" explanations, there is a reason well-read and seasoned
investors claim the four most expensive words in the English language
are "it's different this time."

Vikram Mansharamani, PhD, is
the author of Boombustology: Spotting Financial Bubbles Before They
Burst (Wiley, 2011). For the past two years, he has taught the popular
undergraduate seminar "Financial Booms and Busts" at Yale University.
This is reprinted with the permission ofYaleGlobal the magazine of the
Yale Center for the Study of Globalization

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