Thinking about a Chinese Crash

It seems worth referencing this discussion of Citigroup's Chief Economist Willem Buiter's opinions about a possible Chinese bubble.

Although we still seem to be in the early stages of an asset boom, bubble and bust sequence in the property and land markets, and perhaps just in the recovery stage for the stock market, it is nevertheless likely in our view that China will experience such a sequence, starting in the residential real estate market. From there it is likely to spread to the commercial real estate sector and to the stock market also. Predicting the timing of the bubble phase (when asset price movements decouple completely from fundamentals) and of the bursting of the bubble (when the fundamentals exact their revenge) is not a science – probably not even an art, but more something akin to witchcraft. Our best guess is that a significant bubble may still be one or two years away, and the bust probably at least three years.

That sounds possible - usually, whenever talk about a bubble starts amongst a minority, it's at least a few years before the top (eg consider Alan Greenspan's famous "Irrational Exuberance" comment in Dec 1996, at least three years before the tech bubble burst).

The reason we are quite confident that a boom, bubble and bust sequence will take place in China is simple: whenever credit conditions like those seen since late 2008 in China have presented themselves in countries where the fundamentals are strong (as they are in China today), where structural change, including financial innovation, is occurring at a frenetic pace (as it is in China today), and where the monetary, regulatory and fiscal authorities are untried and untested (as they are in China today), a boom, bubble and bust sequence has occurred. This time is unlikely to be different unless the authorities in China act differently from the authorities in China and elsewhere in the past.

Although I'm not persuaded by the case that China is in a severe bubble, it certainly seems possible - it's uncertain, but it's a risk - and so I've been trying to think through what that would mean when it bursts.  It's not a straightforward case to analyze at all, because the world has very little (or no) experience in speculative bubbles occurring in half-Communist, half-Capitalist countries.  The Chinese system is somewhat unprecedented, and therefore, not straightforward to reason about.  The nearest analogy was probably the Fascist states of Germany and Italy in the 1930s, but those were fairly short experiments, and ended in total war.  That outcome seems less likely here due to nuclear deterrence (nor is the current Chinese regime obviously militaristic in the same way).

Here are my initial speculations.  Firstly, it doesn't really seem that this would be a housing bubble.  All reports are that Chinese consumers have to put down large deposits on new houses, and so there is limited leverage in the housing sector.

Instead it seems to have to be diagnosed as a state-sponsored bubble in industrial and commercial capacity.  The state is (one could argue) pushing too much credit into the economy to build too much production capacity, which it will not be possible to use any time soon, and therefore will be unprofitable, and thus will not be able to service its debt.  It does seem quite possible that this either has, or could, arise (particularly given the stagnant condition of the US and European economies, which is likely to continue for an extended period, and the rising protectionist sentiment here).

However, in a state-controlled system, bad debt secured by excessive capacity can be kept around as long as the government itself is solvent.  The government is going to be extremely motivated to avoid recognition of the bad debts and the resulting crash.  The government itself can never become insolvent in yuan terms (since it can create as many yuan as needed).

So it seems to me that for the situation to come to an end, China would have to run out of foreign currency and lose the confidence of its suppliers of raw materials, or its people.  But it's a little hard to see how loss of confidence by the raw material suppliers happens, given that it's the lowest cost supplier of manufactured goods, which it can always trade for those raw materials. 

I guess the end would have to go something like this: the US and Europe finally institute seriously protectionist policies to protect themselves from an ever larger flood of cheap Chinese goods at a time when their own demand is stagnant.  Then the Chinese engine for earning foreign currency ends, and China starts to run a trade deficit as it tries to buy ever more raw materials building unused capacity, and eventually runs out of the means to do this and runs into a sovereign debt crisis.  Or alternatively, it stops building excess capacity and faces a presumably severe recession and possible loss of confidence by its own people.  And maybe that triggers the social revolution that the government seems to be always running scared of.

So I guess the defining syndrome here is this: commodity prices getting ever higher, while prices for manufactured goods get lower.  It's kind of a new beast - inflation in commodity prices, but deflation in manufactured goods, since it's a bubble in the capacity to turn the one into the other.

If something along the lines of the end-game outlined above did occur, it seems like it could be a real mess given how central China is now to the global economy.

Anyone got any brilliant thoughts, or links to brilliant thoughts, on how this plays out?  I must admit to being a bit stumped in trying to think this through.