Yet Another Warning On China From Andy Xie

On Caijing.com China Counts Down to the Next Bubble Burst

• Naive retail investors and China itself will suffer a lot when the nation's overvalued property and asset markets collapse.
  
  By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
  
  Fueled by bank lending and inflation fears, China's stock and property markets have bubbled again. Odds are that both markets will adjust in the fourth quarter, although they might flare again next year.
  
  Fluctuations within a long-lasting bubble could be a dominant trend for the foreseeable future. But the bubble will eventually burst when the U.S. dollar becomes strong again, perhaps after inflation forces the Fed to raise interest rates.
  
  For now, I think Chinese stocks and properties are 50 to 100 percent overvalued. Chinese asset markets have become a giant Ponzi scheme, with prices supported by appreciation expectations. As more people and liquidity are sucked in, surging prices validate expectations, prompting more people to join the party.
  
  Typically, this sort of bubble ends when there isn't enough liquidity to continue feeding the beast. But liquidity isn't a constraint in China -- yet. Even though loans grew 24.4 percent in the first half this year in China, to 7.4 trillion yuan, the loan-deposit ratio increased only to 66.6 percent in June from 65 percent in December 2008. That means a lot of the borrowed money was not spent on activities in the real economy but merely supplied leverage for asset market transactions. China's property market is following a course very similar to what was seen in Hong Kong in 1997.
  
  The origin of China's asset bubble is excess liquidity, as reflected in high levels of foreign exchange reserves and low loan-deposit ratios. Excess liquidity is a serious problem, as underscored by low interbank interest rates. A weak dollar and strong exports led to this massive liquidity buildup, with the yuan falling as a dollar bear market began in 2002. Appreciation expectations drove liquidity into China, and today one-fourth of China's foreign exchange reserves could be due to this factor.
  
  China's productivity rose rapidly after it joined the World Trade Organization in 2001. Its massive infrastructure buildup and the relocation of manufacturers to China rapidly pushed up labor's productivity. At the same time, the value of the Chinese currency declined as it rose against the dollar. This combination of rising productivity and a weaker currency led to massive export growth. And the dollar earnings that resulted pumped up China's monetary system.
  
  Now, while China experiences weak exports, the weak dollar lets China release liquidity saved during the past five, boom years without worrying about currency depreciation. How far can the bubble grow, and for how long?
  
  It's not too hard to predict a timetable for a bubble burst. When the dollar becomes strong again, sufficient amounts of liquidity could leave China to pop the bubble. What's occurring in China now is no different from what happened in other emerging markets in the past: A weak dollar led to bubbles in hot, emerging economies, and when the dollar turned around, the bubbles inevitably burst.
  
  The timing of the next dollar turnaround is difficult to forecast. The dollar entered a bear market in 1985 after the Plaza Accord and bottomed 10 years later in 1995. It then rode a seven-year bull market, followed by the current bear market that began in 2002. Since then, the dollar index (DXY) has lost about 35 percent. If the last bear market is any guide, the current one could last until 2012. But there is no guarantee. The IT revolution started the most recent dollar bull market; odds are another technological revolution will be needed before a sustainable bull market for the dollar returns.
  
  However, monetary policy could trigger a short but powerful bull market for the dollar. In the early 1980s, the then-chairman of the Fed, Paul Volker, increased interest rates to double digits to contain inflation. Afterward, the dollar rallied hard. A Latin American crisis had a lot to do with that.
  
  The current situation is similar. As in the 1970s, the Fed is denying inflation risk due to its loose monetary policy. The longer the Fed waits, the higher inflation will peak. When inflation starts to accelerate, it could cause panic in financial markets. To calm the markets, the Fed would have to tighten aggressively, probably excessively, leading to a massive dollar rally. This would be the worst possible situation: A strong dollar and a weak U.S. economy. China's asset markets -- and the economy -- would almost surely see a hard landing.
  
  How far the bubble would go depends on the government's liquidity policy. The current bubble wave is very much driven by the government's encouragement for bank lending and super-low interbank interest rates. China could increase liquidity, as the Fed's interest rate is now zero, the dollar weak, China's foreign exchange reserves are high, and the loan deposit ratio is low. That would further expand the bubble. However, other considerations may prompt the government to cool things down.
  
  If the government pumps all the liquidity it can, it wouldn't have any ammunition left to pump again when it comes down. If by then the global economy has revived, the Chinese economy may have a soft landing with strong exports. Asset markets would certainly have a hard landing. However, if the global economy remains weak then, which is my view, both asset markets and the economy would have a hard landing. The political cost may be too great for the government to risk it all now.
  
  Less risky is a stop-and-go approach: The government releases a wave of liquidity, as we see now, and then turns off the tap. When it's all absorbed, markets run out of steam. When a tolerable bottom has been reached, the government can spark a revival by releasing another liquidity wave. This approach stretches out the ammunition and limits the size of the bubble, containing the damage of an eventual bubble burst. I suspect that would be the government's policy. If the global downturn continues for a few more years, China's property and stock markets could experience large, annual fluctuations. The next downward movement, ending the current wave of liquidity, may occur around National Day.
  
  Many would argue China isn't experiencing a bubble. They say high asset prices simply reflect China's high growth potential. And it's true that one can never make an ironclad case to pin down an asset boom as a bubble. But an element of judgment based on experience can help one distinguish a market boom from a bubble, and I've have had a reasonably good record at calling bubbles in the past. I wrote my doctoral thesis arguing that Japan's market was a bubble in the late 1980s, a long report for the World Bank in the early the 1990s arguing that Southeast Asia had a bubble, research notes at Morgan Stanley in 1999 calling the dotcom boom a bubble, and numerous research notes from 2003 onward arguing that the U.S. property market was a bubble. On the other hand, I've never called something a bubble that turned out not to be a bubble.
  
  I want to be perfectly clear about China's asset markets today: They are a big bubble, and their bursting will have very bad consequences for the country. However, as so many are enjoying what's going on, I don't think the government will act preemptively to eliminate the bubble. Indeed, many if not most in the policy circle argue the bubble is good for reviving the economy.
  
  This sort of thinking seems to work because the dollar is weak. That means a bubble can be revived with more liquidity after a cool-down. When the dollar revives, China's asset markets and, probably, the economy would have a hard landing. I hope people who advocate bubble benefits will stand up then to accept responsibility for the damage.
  
  The most basic approach to studying bubbles is to look at valuation, and the most important measures for property are price-to-income ratios and rental yields. China's nationwide average, per-square-meter price is quite close to the U.S. average. U.S. per capita income is seven times urban, per capita income in China. Yet the nationwide average price for a square meter in China is about three months' salary -- probably the highest in the world.
  
  As far as I can tell, a lot of properties can't be rented at all, and those that are rented bring a 3 percent yield, barely compensating for depreciation. The average yield from rentals, including those that can't be rented out, is probably negligible. China's property prices don't make sense from affordability or yield perspectives. Some argue that China's property is always like this: Appreciation is the return. This is not true. The property market fell dramatically from 1995 to 2001 during a strong dollar period.
  
  A special facet of China's property bubble is its role in local government finance. As land sales and taxes from property sales account for a big portion of local government revenues, governments have powerful incentive to pump up the property market. Land sales are often carefully managed to spike expectation. For example, those who bid extraordinarily high prices for land are laurelled as land kings. Of late, land kings are often state-owned enterprises. When SOEs borrow from state-owned banks and give the money to local governments at land auctions, why should the prices be meaningful? The money circulates in the government's big pocket. Tomorrow's non-performing loans, if land prices collapse, are just today's fiscal revenues. By chasing the skyrocketing land market, private developers that follow the SOEs' lead could be committing suicide.
  
  The stock market is again in a final frenzy. The most ignorant retail investors, dreaming of overnight riches, are being sucked in by the rising momentum. But retail investors usually lose, as the ones jumping in now will learn. A final frenzy usually doesn't last. Turning points in China are often linked to the political calendar; a popular belief among retail investors is that the government won't let the market fall before October 1, which is the 60th anniversary of the People's Republic of China. The last time this reasoning influenced the market was before the 17th Communist Party Congress in October 2007. This sort of belief is self-fulfilling in the short term, and the market tends to roll over on time. So if the past can provide meaningful guidance, the current wave will taper off before October.
  
  The idea that the government will not let the market fall is rooted in Chinese market psychology. In financial jargon, it is called a put option. During the era of Fed chairman Alan Greenspan, financial markets thought he would always bail out the markets in a crisis. That was the so-called Greenspan put. A parallel belief in China should be called the Panda put. However, in reality, the government can't reverse a market trend after it turns. The Chinese stock market has had big ups and downs in the past, which shows the government is unable to prevent a market fall. Nevertheless, this imaginary put option remains deeply rooted in popular psychology.
  
  Many policy thinkers think bubbles are not that harmful. One popular theory is that money passes from one person to another in a bubble and, as long as it remains in China, there is no permanent harm. Hence, if people are happy now and unhappy tomorrow, they just cancel out each other. But they should look at Japan and Hong Kong to see how much damage a bubble can do, even if money does not leak from a country.
  
  In a bubble, resources are diverted to bubble-making activities. These resources will be permanently wasted. For example, businesses in China are reluctant to focus on real economic activities and are devoting time and energy to market speculation. It means China may not have many globally competitive companies in the future. Even though China has had three decades of high growth, few companies are globally competitive, and serial bubble-making in the Chinese economy may be the reason.
  
  The current generation of young people includes many who are not interested in real jobs. Rather, they are addicted to stock market speculation. They see they value of their holdings change more in one day than they earn in one month, and have illusions of making a lot of money in the market. Of course, most will lose everything and may take extreme action afterward. The social consequences could be quite serious.
  
  A property bubble usually leads to overbuilding, and empty buildings represent permanent losses. Most people would laugh at such a possibility in China. After all, 1.3 billion people should need an unlimited amount of property. The reality is quite different. China's urban living space is 28 square meters per person, quite high by international standards. China's urbanization is about 50 percent, and could rise to 75 percent. Afterward, the rural population would decline on its own due to ageing. So China's urban population may rise by another 300 million people. If we assume that all can afford property (a laughable notion at today's prices), Chinese cities may need an additional 8.4 billion square meters of space. China's works-in-progress covers more than 2 billion square meters. There is enough land out there for another 2 billion. The construction industry has production capacity of about 1.5 billion square meters per annum. Absolute oversupply – not enough people for all the buildings -- could happen quite soon. When that happens, the consequences may be quite severe. Property prices could fall precipitously, as Japan experienced in the past two decades, destroying the banking system.
  
  The most serious damage that a property bubble inflicts is that it changes demographics. High property prices bring down birth rates. When property prices recede after a bubble bursts, a low birth rate culture cannot be changed. Hong Kong, Japan, Korea and Taiwan all went through property bubbles during their development periods. Their birth rates fell during bubbles and didn't recover afterward, despite government incentives. China's one-child policy alone will lead to a demographic catastrophe in two decades. The property bubble makes the trend irreversible: When the government abandons the one-child policy, the birth rate will not see a meaningful impact. In two decades, China's population could be very old and declining. Of course, property prices would be very low and declining also.
  
  In addition to net losses, the bubble's redistribution aspect has serious social consequences. In a stock market bubble, most households lose and a few win big. China's wealth inequality is already very high, and bubbles make it worse. A sizable population in China -- even a majority -- may not have meaningful wealth even after urbanization is complete. This would lead to social instability. A market economy is stable and efficient when most a majority has meaningful wealth and, hence, a stake in the system.
  
  Today's market frenzy won't last long. The correction may happen in the fourth quarter. There could be another frenetic wave next year as China releases more liquidity. When the dollar recovers, possibly in 2012, China's property and stock markets could experience the kind of collapse seen during the Asian Financial Crisis.

ps: on the issue of overbuilding and empty buildings, do see the following posting from Prof. Pettis: Notes on a real estate trip in China