Friday, March 26, 2010

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.


Datamunger said...

The Chinese central bank is currently a weak institution and even in a society without free speech is attracting fire from the Commerce Ministry and may even be the target of its PR operations.

But here's another issue from the same article:

Export-oriented provinces in coastal China raised their minimum wages by 20 percent last week in a desperate bid to attract more workers from China’s increasingly prosperous interior to run factory assembly lines.

But I don't know enough about China to say anything brilliant.

Stuart Staniford said...

Yeah I sort that too. The question is what the hell are they making in all those factories with exports sharply down (which they've got to be, at least looking at the port traffic graphs Calculated Risk posts).

rks said...

Very nice analysis. People also say Japan is in trouble, but the debt is in yen owed to other japanese (as I understand it) who react to all difficulties by saving more. It is also interesting to consider the Australian "housing bubble" which seems to be due to rich Chinese putting money in something solid. The rest of us are then forced to rent from them. What we'd like to know is: When China gets in trouble, however far ahead, will they all try to sell their Sydney houses at once to pay their debts or can they fudge it and go bankrupt in China while keeping their Sydney houses?

porsena said...

Stuart, they're making largely export goods in those factories.

As the recession cut into export markets in 2008-09, the same manufacturers that are now short of labour laid off millions of migrant workers. Most of these returned from the coastal export hub cities to their home towns in other parts of China.

Now the orders are coming back but the workers aren't. Not only is the cost of living significantly higher in coastal cities than in the interior, but China's policy of encouraging development in the hitherto neglected interior regions of the country is creating employment closer to home.

With both labour and materials costs on an upward spiral, the cost of exported Chinese goods is likely to rise.
"We are seeing an end to the period of extremely low-cost labor in China, and Chinese-made goods are becoming less of a bargain for overseas clients," said Cai Fang, director of the Institute of Population and Labor Economics, Chinese Academy of Social Sciences.

Domestic consumption is increasing at double-digit rates, at something like 12% a year. Exports are recovering rapidly and inflationary pressures are rising. The government is not yet worried enough about inflation to take measures stronger than the recent dictum to banks to raise their reserve capital ratio, thus slowing lending.

I think you're right to focus on the expansion of productive capacity rather than housing, because the former is fuelled more by credit. However, there are 1.3 billion potential consumers out there, most of whom have not participated much in the market to date. As incomes rise, domestic consumption will increase. This pattern helped drive economic growth in the USA for a long time, so it's hard for me to see how it might end.

David said...


It looks like China may soon be running trade deficits. At least in the short term.

The question is in the short term not a problem but the question is what happens if this becomes a longer run thing?

Stuart Staniford said...


Labor costs may be going up in China, but it's going to be a very long time before they are anywhere close to OECD levels.

Eric said...

Let me preface this by saying, I've been following this about as long as you have (2 days?).

Growth in China has been dependent on expected population economic mobility. Investors look at China, and see a huge population, ready to urbanize and start a more western lifestyle (which they can profit from). The infrastructure and building development is being financed with highly delayed returns once the rural population begins moving towards the cities.

For me, the questions becomes - what happens if they are limited in their economic mobility, and what would slow that progression?

Obviously that's not an easy question to answer, but I'm beginning to feel that it's key to understanding whether their growth is sustainable.

For instance, if the supply of oil levels off (as many expect), the Chinese government will need to rapidly increase its subsidies to ensure its population who's buying cars at a spectacular rate can afford to continue to drive. How do they fund that on top of the continued economic expansion? How much can they afford?

I'm extremely interested in learning more about the current situation, and how far out of control their commercial bubble may actually be (if at all). It's a shame theres so little transparency.

porsena said...

China's customary subsidy on oil products has been whittled away in the last couple of years. The benchmark retail price of gasoline in Beijing is almost exactly a dollar a litre, so about $3.80 a gallon and maybe 10% less than at my local (Canadian) stations. That compares with the present US average of $2.82. This suggests to me that, rather than the government subsidizing the motorists, the motorists are subsidizing the government.

I suspect Chinese drivers are better able to cope with a rise in the price of transportation fuel than is their US counterparts. And we recall from one of Stuart's earlier posts that transportation fuel is a much smaller fraction of domestic oil demand. Nevertheless, I remember reading a story a couple of months ago featuring a Chines consumer complaining that the constantly rising price was forcing her to leave her car at home more often. That can happen anywhere.

Stuart Staniford said...


2 days??!! I've been following this for, oh, over 2 months! I'll be an expert real soon now :-)

Manolo said...

Maybe, as a foundation, here is an article regarding Chinas' own statistics:

From the Western World's perspective, nobody understands China. That's a fact.

Steve From Virginia said...

It's always hard to predict what is going to happen in Chian when it is equally hard trying to predict what is happening in your own country.

Nevertheless, I think the catalyst for what is happening in China, Europe and in the US is what I call the 'hard dollar hypothesis'.

The dollar is the intermediary between crude oil and the goods and services derived from oil's consumption. Ordinarily, the dollar is a proxy for the goods and services which translates into a dollar that loses purchasing power over a span of time - decades. This is a consequence of the expansion of commerce and markets and is natural.

What is happening is the value of the goods and services is declining relative to the value of the crude oil from which goods and services are leveraged. China has an advantage in the goods and services business because of cheap labor and low overhead costs - including cheap coal.

I suspect that what is happening is the dollar is shifting away from being the proxy for goods and services while becoming the proxy for the crude oil instead. The dollar is a hardening currency pegged to oil. This makes sense because a dollar that declines in value means another run up in oil costs and other bout of demand destruction.

The relationship that matters is that of crude and the derived goods and services. Oil is traded for dollar and the dollars are then traded for goods. The dollar is only an intermediary.

With a cheap dollar, the nominal price in oil increases as the dollar value declines along with the goods and services it is a proxy for. A continuation of this dynamic is the generally held assumption of most analysts including Jeff Rubin, Jeffrey Brown and others.

With a hard currency, the dollar price of oil increases little or declines. The value of goods and services still declines relative to the dollar - there is price rationing of goods and services instead.

Since this dynamic is already taking place in the US and elsewhere, the dollar appears to becoming a hard currency, pegged to oil.

In the new hard dollar economy, the world's business will be buying and selling money to gain dollars. Keep in mind that this does not mean markets will trend in straight lines. It means that the world's output of goods and services will continue to be devalued but against the dollar rather than at a remove relative to crude.

It also means the dollar supply is controlled by the US which can choose who to accept dollars from.

China has a lot of dollars and can sell other currencies as well as its Treasury hoard to buy more. At the same time, its dollar cache is finite. When their dollars are gone they are gone, probably forever. This is what the trade fracas between Washington and Beijing is about; Washington has cut off China's supply of dollars. (It also wants China's dollar reserves for itself!)

This means that China will ultimately have to conserve energy in order to save dollars and avoid the massive, worldwide dollar arbitrage 'experience' which is coming. The big investment banks are much better at this sort of thing than China is and selling dollars in order to waste fuel while getting beaten in the arb markets by Goldman Sachs will cool China's jets in a big hurry.

Ditto, the US. The hard dollar is the same as a large and increasing gasoline tax.