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Inquiring
minds are reading a GMO white paper on China’s Red
Flags
In
the aftermath of the credit crunch, the outlook for most developed economies appears
pretty bleak. Households need to deleverage. Western governments will have to
tighten their purse strings. Faced with such grim prospects at home, many
investors are turning their attention toward China. It’s easy to see
why they are excited. China combines size – 1.3 billion inhabitants
– with tremendous growth prospects. Current income per capita is
roughly one-tenth of U.S. levels. The People’s Republic also has a
great track record. Over the past thirty years, China’s Gross Domestic
Product has increased sixteen-fold.
So what’s the catch? The trouble is that China today exhibits many of
the characteristics of great speculative manias. The aim of this paper is to
describe the common features of some of the great historical bubbles and
outline China’s current vulnerability.
Past manias and financial crises have shared many common characteristics.
Below is an attempt to list ten aspects of great bubbles over the past three
centuries.
1. Great investment debacles generally start out with a compelling growth
story. This may be attached to some revolutionary new technology, such as
railways in the nineteenth century, radio in the 1920s, or more recently the
Internet. Even when the new technology is for real, prospective rates of
growth may beexaggerated. Early growth spurts are commonly extrapolated into
the distant future. ....
2. A blind faith in the competence of the authorities is another typical
feature of a classic mania. In the 1920s, investors believed that the
recently established Federal Reserve had brought an end to “boom and
bust.” A similar argument was trotted out in the mid-1990s when it was
widely believed that the Greenspan Fed had succeeded in taming the business
cycle. The “New Paradigm” disappeared in the bear market of the
new millennium. It was soon replaced with the “Great Moderation”
thesis of Ben Bernanke, which suggested that high levels of mortgage debt
made sense because monetary policymaking was so vastly improved. ...
3. A general increase in investment is another leading indicator of financial
distress. Capital is generally misspent during periods of euphoria. Only
during the bust does the extent of the misallocation become clear. As the
nineteenth century economist John Mills observed: “Panics do not
destroy capital; they merely reveal the extent to which it has been
previously destroyed by its betrayal in hopelessly unproductive works.”
...
4. Great booms are invariably accompanied by a surge in corruption. ...
5. Strong growth in the money supply is another robust leading indicator of
financial fragility. Easy money lies behind all great episodes of speculation
from the Tulip Mania of the 1630s – which was funded with IOUs –
onward. ...
6. Fixed currency regimes often produce inappropriately low interest rates,
which are liable to feed booms and end in busts. This lesson was ignored by
the creators
of the European Monetary Union, which brought low rates and real estate booms
to its smaller members, Spain and Ireland. ....
7. Crises generally follow a period of rampant credit growth. In the boom,
liabilities are contracted that cannot subsequently be repaid. ...
8. Moral hazard is another common feature of great speculative manias. Credit
booms are often taken to extremes due to a prevailing belief that the
authorities won’t let bad things happen to the financial system. ...
9. A rising stock of debt is not the only cause for concern. The economist
Hyman Minsky observed that during periods of prosperity, financial structures
become
precarious. Investments financed with borrowed money don’t generate
enough income to either service or repay the loan (what Minsky called
“Ponzi finance”). ...
10. Dodgy loans are generally secured against collateral, most commonly real
estate. Thus, a combination of strong credit growth and rapidly rising
property prices are a reliable leading indicator of very painful busts. ...
The
GMO article looks at each of the above points through the eyes of China.
1.
The China Dream. For centuries, foreigners have pondered how to make money
from China’s vast population. Today, the China Dream is more vivid than
ever. The People’s Republic has more than 1.3 billion citizens, making
it the world’s most populous nation. China’s rural population is
gradually moving into its cities. A further 300 million country-dwellers
– that’s roughly the same size as the U.S. population – are
expected to head toward towns and cities over the next decade. It is
generally assumed that the Chinese economy will continue to grow by around 8%
annually in the coming years. ...
2.In the Communist Party of China We Trust.
Twenty
years ago, it was argued that “Japan is different” and that
Tokyo’s economic policies were better than the West’s. A number
of best-selling books lauded the land of the rising sun. One bore the
infamous title, Japan as Number One.
Today, similar claims are made about the singularity of the Chinese economy
and the superiority of Beijing’s policies. And similar expectations are
entertained about China’s inexorable march to economic primacy.
3. Investment Boom. In a market-oriented economy, investment might be
expected to fall during a period of uncertainty and economic turbulence. Yet
in 2009, Chinese fixed asset investment climbed by 30% and contributed 90% of
last year’s economic growth. Investment rose to a record 58% of GDP.
These are remarkable figures. The key question is: how well was this money
spent? ....
4. Corruption. All great speculative manias have been accompanied by rising
levels of fraud. Only in the bust do we get to see the full extent of the
“bezzle,” as the Enrons, WorldComs, and Madoffs come to light.
The upturn in China’s property and infrastructure spending, however,
provides a cyclical spur to malfeasance. The People’s Republic recently
slipped to 79th place in Transparency International’s 2009 Corruption
Perceptions Index, just below Burkina Faso. ....
5. Easy Money. Nobel laureate Friedrich Hayek differed from his great rival
J.M. Keynes. While the latter argued that bubbles were the result of
turbulent “animal spirits,” Hayek claimed that asset price
inflation followed from excessively low interest rates. Easy money, said
Hayek, fed through to monetary and credit expansion, leading to inflation,
either in the general price level or in asset prices. ...
6. The Fixed Exchange Rate and Capital Inflows. The Chinese currency, the renminbi,
is pegged to the U.S. dollar. An undervalued exchange rate has boosted
exports and kept interest rates low. It has also encouraged massive capital
inflows, mostly in the form of foreign direct investment. Capital controls
have limited inflows of hot money, although speculative inflows have picked
up recently. ...
7. The Credit Boom. In response to the global financial crisis and the
collapse of export orders, Beijing ordered its banks to go out and lend. Last
year, new bank lending increased by nearly RMB 10 trillion, a sum equivalent
to 29% of GDP. These loans largely went to fund infrastructure projects,
property developments, and state-owned enterprises in a number of industries.
It was as if the economy had received an enormous adrenaline shot. What most
analysts fail to consider is the hangover that generally follows a credit
binge.
8. Moral Hazard. The major Chinese banks are controlled by the state. They
have a history of poor lending decisions. ...
9. Risky Lending Practices. .... No one can gauge the robustness of the
credit system since Chinese banks appear particularly reluctant to report
problematic loans. Ernst & Young published a 2006 report that estimated
non-performing loans (NPLs) at $900 billion. This report was subsequently
withdrawn. NPLs continued to decline in 2008 even as the stock market
imploded and exports crashed. Fitch has suggested Chinese banks have been
rolling over, or “ever-greening,” problematic loans. Bank employees
have their own reasons for burying bad loans. A loan officer who reports
problem debts is liable to have his salary reduced to below that of a migrant
worker. Few seem to care about the practice of concealing nonperforming loans
since it’s generally assumed that so long as the economy continues
growing quickly, bad credits will turn good over time.
10. The Bubble. Surging credit has revived the animal spirits of Chinese
investors. The Shanghai stock market recovered sharply in the first half of
last year. On a single day in late July, turnover of “A-shares”
in Shanghai exceeded the combined trading of the New York, London, and Tokyo
stock exchanges. Chinese IPOs accounted for nearly two-thirds of global
issuance by market value in the third quarter of last year. Chinese companies
accounted for seven of the ten largest IPOs in the world. New issues were
often massively oversubscribed and saw huge first day “pops.”
The
Field of Dreams
Three
years ago, Premier Wen described China’s economy as “unstable,
unbalanced, uncoordinated and unsustainable.” The Great Recession
hasn’t cured these imbalances. Rather, China’s ensuing investment
and credit booms exacerbated them. The real estate market displays the
classic symptoms of a bubble – stretched valuations, rampant speculation,
and frenzied new construction. Sooner or later, this
bubble will burst.
In the past, whenever an economy has exhibited the 10 red flags listed in
this paper there has been an unpleasant outcome. Forecasting the end game is
no easy task since speculative bubbles can run to extremes. It’s made
more difficult in this case by the fact that China is not a pure market
economy. Stateowned enterprises can be called upon to prop up markets. Losses
may be concealed or shuffled around like a shell game, as has happened in the
past. Such measures, however, won’t cure China’s problems. They
only delay the dénouement. ...
There is much
more in the article worth reading. Investigative minds will want to take a
closer look.
Global Imbalances
In case you missed them, please consider the following articles on the ever
growing global imbalances...
Spain, UK, Japan, Greece: Eurozone Structural
Problems; Spain's Economic Woes; Pain In Britain; Deflation Persists In Japan
US, Canada: California USA vs.
Ontario Canada - Which State (Province) Is In Worse Shape? Canadian Banks vs.
US Banks Comparison
Australia: Money Madness In Oz
Mish
GlobalEconomicAnalysis.blogspot.com
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