by Martin Hutchinson
The Bear’s Lair, posted August 04, 2009
SHARES ARE TRADING AT 35 TIMES EARNINGS. Banks in the last six months have lent more than the entire Gross Domestic Product for the period. Interest rates are below the inflation rate, while monetary growth is far above it. The seven largest bond transactions in the world in 2009 were domestic deals in this country.
Looks like a bubble to me, and bound to end in tears. In a Western economy, one would be sure of it. So why should we think China’s different, and what would be the effects of a Chinese economic meltdown?
Various very intelligent people have seen their hair turn grey waiting for a Chinese bubble to burst. Ever since 1998, it has been clear that the Chinese banking system has contained hundreds of billions of dollars in bad debts. A real estate boom in empty office buildings in 2003-04 pushed the assumed total of bad debts up further, and when Ernst and Young in 2006 estimated its total at $911 billion (and then retracted the figure under pressure) that seemed a reasonable estimate. Yet the Chinese economy has continued to grow almost as fast as the estimates of bad debts in the banking system and no signs of collapse have been seen. Indeed, the major Chinese banks did international Initial Public Offerings in 2006-07, all of which were outstandingly successful.
So why are things different now? It has been clear for a decade that Chinese public figures overstate the country’s growth rate, so that the apparent 16% growth in the second quarter of 2009 is largely fictional. Indeed, income tax receipts data suggest that growth in the first quarter may have even been negative. However, that is hardly surprising; after all, the country’s exports were down around 30% at the peak of the trade recession of last winter. Even if China’s second quarter growth was really at an 8-10% annual rate, after, say, a 5% rate of decline in the first quarter, that is still a better growth rate than any other major economy in the world. So why should we image that China’s relative outperformance cannot continue?
Here the example of Japan is instructive. From the 1950s to the 1980s Japan enjoyed apparently unstoppable growth. The global recession of 1974-75 brought only a brief interruption of that growth. That of 1980-82 (when the Japanese economy had adapted better to high energy prices) brought no interruption at all, although during the 1980s there was a noticeable slowing.
Yet in 1990, after an incredible boom in real estate and stocks that took the theoretical value of the Emperor’s back garden higher than that of the state of California (it was admittedly better tended) it all stopped. The real estate bubble burst, the stock market bubble burst and Japan has now suffered almost two decades of negligible growth and relative economic hardship.
Nobody now considers Japan to be the world’s great growth economy like they did in the 1980s. Yet the Japanese virtues of superb education, dazzling technology and a grinding work ethic are still as evident as ever.
In some ways, the Japanese example should be encouraging to China. While some areas of China have enjoyed astonishing growth, its overall relative wealth is not even that of Japan in 1973, let alone that of 1990. Indeed, the Japanese example suggests China should enjoy several more decades of exceptional growth before its living standards get close to those in the West. At that point we may indeed see a crisis, but on that analogy, the crisis should not occur before 2030, at the earliest.
Yet it is not inevitable that growth economies must almost catch up to western living standards before crisis intervenes. Thailand suffered crisis in 1997, after 30 years of excellent growth but far before it had reached Western living standards. Even South Korea at the time of its 1997 crisis was well behind the relative position Japan had reached in 1990. Thailand and South Korea have enjoyed some growth in this decade, but the intervening transition was painful indeed, involving a sharp drop in output and, in Korea’s case, the passage of the entire banking system through bankruptcy.
On examination, China looks more like Thailand than Japan. Even 30 years ago, the Japanese economy was known for its transparency, with its own equivalent of the Glass-Steagall Act and a careful division not only between lending and brokerage, but even between different kinds of lending. National statistics were produced meticulously, according to norms laid down during the U.S. occupation. Politically, the same party won every election, but elections were properly contested democratic polls, and there was open competition between different factions in the ruling party as to whose policies would be followed. The state sector was small, and only a small fraction of the banking system was state owned. Much of the private sector dated back for centuries, and followed the stable traditions of family capitalism not dissimilar to Germany of the period.
As its labor costs approached those of the West, inefficiencies in the Japanese system would become more apparent, and it was always likely that a crisis would intervene before Japan was fully modernized. But its education system was so superb, and the openness of it political and economic institutions so great that it was unlikely to reach a crisis before that point. Finally, in 1970 or so there was no great overhang of bad debts in the Japanese banking system, nor was real estate in any obvious excess. (The infrastructure excesses came later, in the 1990s.)
China has none of Japan’s transparency. The government is undemocratic and a poor respecter of human rights; in this respect it is like Japan’s pre-World War II governments, aggressive and chauvinist. Unlike Japan, it maintains a huge military machine, which itself owns a plethora of companies. The state corporate sector is still gigantic and supported by state-owned banks. Savers are not permitted to take money out of China, and their huge savings prop up an overvalued stock market and a bond market that is comparable in size to the freely flowing international bond market. Private sector companies are either youthful fly-by-night operations or dubiously privatized state behemoths. Prices are still largely administered, and investment flows mostly to the politically connected rather than the economically attractive. Education is relatively poor outside the main population centers, and land ownership is still restricted.
China is thus much more like pre-1941 Japan than post-1950 Japan and its economic inefficiencies are correspondingly greater. Because of those economic inefficiencies, the chances remain high of a meltdown far before China has achieved Western living standards. From the excesses in the Chinese economy currently, that meltdown appears now to be impending. Companies currently have more liquid assets than they can usefully invest and have been gambling with them in the stock market, a phenomenon last seen in size in Japan in the late 1980s. Shipments to retailers have increased by 15% in the first half of 2009, an increase reflected in the GDP statistics but not necessarily in sales to final consumers, although households without electricity or running water have reportedly been dragooned into buying washing machines.
The most likely form of meltdown to occur is that of a banking system collapse, as the gigantic volume of recent loans goes bad and liquidity in the economy finally dries up. That would drain the huge Chinese savings pool and cause steep output contraction, particularly in the overleveraged and inefficient state-owned sector.
The excess money in the system, with M2 money supply up 28.5% in the year to June, also suggests that a price explosion cannot be far away. Although official inflation is currently negative, the People’s Bank of China has already warned of a possible inflation resurgence. It must also be remembered that the social structure of China is now quite Latin American in nature, with a Gini (inequality) coefficient rising rapidly, already at 47 by 2007, well above its Asian neighbors and not far below Mexico (48) and Argentina (49). Thus an economic collapse is unlikely to be survived quietly, as was the case in Korea and Thailand.
A Chinese economic collapse, which might well be accompanied by an Indian balance of payments crisis due to that country’s perpetual government overspending, would cause a sharp “second dip” in the global economy. The amount of foreign capital tied up one way or another in the Chinese economy is now so great that a Chinese market collapse would have global repercussions in an already weakened financial system. Furthermore, it is by no means certain that China would quickly resume its role of global growth engine; Japan didn’t, after all. China could be different – it always has been. But at some stage, the mysterious Chinese economy and its thoroughly opaque banking system must respond to the same constraints that affect the rest of us. Chinese economic policy has been more stimulative than ever before, its bank lending more reckless. If China’s run of apparently miraculous immunity from normal economic forces is finally about to end, the result will not be pretty for any of us.
The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.
Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) Details can be found on http://www.greatconservatives.com