China or Bust(ed)?

(All sources can be viewed at the end of the article)

China has been in the news a lot the last several weeks, and not because of its booming economy, but because of inflation, fears of a housing bubble, corruption, and corporate espionage. Translation: It hasn’t been a good start to the new year for the budding superpower.

China’s economy has been clipping along at or near a 10% growth rate for decades now, and with a massive injection of federal funding into the economy last year it seems to have staved off, even thrived during, the current world financial crisis. Yet, three weeks ago well known hedge fund manager James S. Chanos, famous for predicting the Enron collapse, made headlines by predicting that China’s in the midst of a financial bubble that’s about to burst. Then, just one week later, Google announced that it will no longer censure its search engine to adhere to government standards after it was discovered that its China mainframe had been hacked in order to spy on political dissidents.

So, what does this all mean for China? Could it actually be vulnerable to economic and political pressures like other countries, or will it again defy the world and continue to prove that capitalism and communism can thrive in a globalized world? It’s worth a closer look.

The Bubble (Part 1 of 2)

China’s economy, more than any other world issue over the last decade, has fascinated political scientists and economists alike, not to mention just about every other news reading individual in the world. This fascination stems from China having been the proverbial international enigma rapped in a riddle over the last two decades. Why? Primarily because of the adage that capitalism does not work without democracy. Yet, based on China’s economic successes so far the adage is wrong.

China began its capitalist-leaning economic reforms in 1978 under Deng Xiaoping, and the country has prospered ever since. Yet, as the country has developed peace-meal into a market economy, lasting political reform never came. Indeed, China has often regressed politically over the last thirty years, clamping down on protests and political dissidents while becoming less and less transparent. Yet, in defiance of its many doubters, China’s economy has grown… and grown… and grown, leading many a-would-be doubter to label China “The Economic Miracle.”

And surprise! It appears China has defied its doubters once again, although fewer than in the past, by pulling through last year’s financial crisis with an 8% growth in GDP amidst the worst financial crisis since the Great Depression. But at least one analyst isn’t buying it. On January 8th The New York Times published an article about a prominent hedge fund investor who isn’t drinking the China Kool-Aid. On the contrary, James S. Chanos is betting against China Inc., and he’s laying out why in an upcoming lecture at St. Hilda’s College entitled “The China Syndrome: Warning Signs Ahead for the Global Economy.” In short, based on research conducted at his hedge fund, Kynicos Associates, Chanos believes that China’s “…surging real estate sector, buoyed by a flood of speculative capital,” could lead to “Dubai times 1000… or worse” (Barboza, B1-B4). And as The New York Times reports, “He even suspects that Beijing is cooking its books, faking, among other things, its eye-popping growth rates of more than 8 percent” (Barboza, B1-B4).

At the heart of Chanos’ argument is China’s recent $586 billion stimulus package (which in terms of GDP dwarfs America’s), increased lending (nearly $1.5 trillion worth), lowered interest rates, and encouraged spending through tax breaks and vouchers, all of which, Chanos believes, has artificially inflated prices and set the country up for a massive wave of defaults. Sound familiar (if not, think Japan 1980s and U.S., Dubai today)?

Thus, Chanos thinks investors need to take off their blinders and take a hard look at the risks that will ensue when that big fat China bubble bursts. For instance, if Chanos’ fears are true, then China is now producing far too much at a time when demand for Chinese exports, the pillar of China’s economy, has dropped 22% since the onset of the 2008 financial crisis. If that’s the case then China will be left with stockpiles of unsellable goods, or goods that could destabilize the world market by being sold at deflated prices. And if that happens, Chanos fears, we’re all in for a world of hurt.

Still, Chanos is in the minority on the issue. Whereas fifteen and twenty years ago few were reluctant to state that China’s staggering growth rates were sustainable, now few are reluctant to state they could slow anytime soon. Among the many optimists are hedge fund manager Jim Rogers and famed economist Thomas Friedman who think Chanos’ predictions are based on flawed and/or nonexistent information. Rogers flat out denies that China is in a bubble, and points out that Chanos is, in no way, a China expert. Regarding Chanos’ recent interest in China, Rogerss states, “I find it interesting that people who couldn’t spell China ten years ago are now experts on China” (Barboza, B1-B4).

Holding a similar view, Thomas Freidman offered Chanos some advice in an Op-Ed piece written in response to Chanos’ theory, “Never short a country with $2 trillion in foreign currency reserves” (Friedman, A27). Furthermore, Friedman claims that although China has problems they’re on the ball when it comes to their economy, citing, in the same article, the central bank’s recent interest rate hikes to slow lending, and it’s new requirements that banks increase their reserves in light of fears that a wave of defaults are eminent (Friedman, A27). The result of such evasive action, Friedman believes, will stave off or stymie the effects of any major bubbles bursting in China. In fact, rather than China’s economy slowing, Friedman boldly states, “It may be that we haven’t seen anything yet,” eluding to the major portions of China that have yet to be industrialized amidst the eastern boom (Friedman, A27). Simply put, Chanos’ critics think he’s full of hot air.

So then, is Chanos’ bearish view on China a bunch of bull, or is there substance to his argument? Well, Chanos does have an impressive track record, he not only predicted the Enron collapse, but also the problems that plagued Tyco and Boston Market, and he was one of the first to warn of the housing and banking crisis’ that plunged the world into its current economic state—and that is why people are listening. What’s more, mounting evidence seems to support Chanos’ theory. For instance, recent government figures indicate a 1.9% increase in inflation from a year ago in China, and the producer price index recently rose to its highest level in China since 2008, leading Arthur Kroeber of Drangonomics to state, “This is quite serious. We now know [China] poured too much money into the system” (Pearson, B1-B4).

Just how much? Nearly $1.5 trillion in 2009, and as much as $12.6 billion every working day in January 2010 (Lewis; Anderlini). And even though Chanos’ critics will point out that China has an advantage over the U.S. market because it can force banks to lend such tremendous sums, which creates an immediate and ensured stimulus to the economy, that lending is more prone to default, as loans are doled out based upon political association rather than merit. Thus, as Vitaliy Katsenelson, author and director of research at Investment Management Associates reminds us, “don’t confuse fast growth with sustainable growth”– because it’s probably artificial.

And what about Chanos’ claims that China is producing too much? Well, that’s turning out to be true as well. A new report by the European Union Chamber of Commerce in China found that only 70% of the countries available wind power is in use “aluminum factories are operating at 67% of capacity, steel at 72%, and chemicals at 80%—yet Beijing is ramping up production” (Foroohar 8-8). Not good.

And housing bubble fears? Business Week reported in January that China’s housing market is dangerously out of control, with real estate prices jumping 7.8% from a year ago and nearly 200% since 2007 (Roberts 31-34). Yet, despite signs of a bubble, new land is being cleared for housing development while at the same time entire complexes sit empty (see the empty city of Ordos). What’s more, “90% of the new construction is aimed at the luxury market, which is unaffordable to the average Chinese household” (Smith). All of this has led Business Week’s, Dexter Roberts, to report that “The real estate rush is fueling fears of a bubble that could burst later in 2010, devastating homeowners, banks, stock markets, and local governments” (Roberts 31-34). But, then again, we don’t know anything about housing bubbles and their consequences back here in America… it’s probably just hype… 

And finally, big brother himself seems to be acknowledging the reality of such fears. The New York Times reported on January 13th that “Chinese regulators ordered state owned banks on Tuesday to set aside a larger share of their deposits [0.5% increase] as a reserve against failed loans” (Wines, B6; Lewis). Regulators also raised interest rates on a key interbank loan and took steps to address housing speculation by reining in credit to property developers and requiring a 40% down payment on all people other than first time home buyers (Wines, B6; Anderlini). So, yes, Friedman is correct in stating that China is taking action, but such action also confirms fears that there is a bubble.

But what about Friedman’s advice to Chanos not to short change a country with $2 trillion in foreign currency reserves? Doesn’t that put China in the clear? Not really, because most of those reserves are in dollars so if China decides to cash them in, yes it would deflate the dollar, but it would also cause the Chinese renmimbi to skyrocket, resulting in the end of days for cheap Chinese goods and China pegging the renmimbi to the dollar—precisely what China doesn’t want since it is an export-reliant economy. What’s more, if China doesn’t continue to buy those securities then Americans won’t have the money to buy cheap Chinese goods. Thus, it would hurt China’s economy as much or more than it would hurt the rest of the world--not to mention trigger a trade war--if China suddenly demands its $2 trillion. So, $2 trillion in securities is a nice card to have, but it’s not a viable solution, nor a card China wants to play if it is in a bubble.

And as far as Chanos’ claims that China might be cooking the books, since there is zero transparency in China all we have to rely on that they aren’t is China’s word. Would you trust China?

Analysis

So who’s right and who’s wrong? Thirty years ago a country with a third of the world’s population had nowhere to go but up, and it did so with remarkably sustainable growth rates. And now that China has pulled itself out of poverty it is not going to return to the stone age, so it’s pointless to speculate on China’s demise like some China watchers have done. China is here to stay, it’s that simple. But I will say this, China is susceptible to the same economic forces that all other markets are in the world, and to think otherwise is simply foolish.

Nobody in the 80’s thought Japan was susceptible to those economic forces before it plunged into a 15 year recession, and nobody believed that a propped up U.S. economy based on 30 years of cheap oil, artificially low interest rates, and Chinese backed treasuries was susceptible to those forces either… but they were. Thus, you don’t necessarily need to be a “China expert,” as Jim Rogers indicates, to see where China’s economy is headed. You just need to understand how markets work, which James Chanos does. Still, as Katensenelson puts it, “Identifying such bubbles is a lot easier than predicting their collapse.” Thus, China’s economic bubble may not burst tomorrow, but the laws of “financial gravity,” as Katensenelson puts it, dictate that it will burst at some point.

In the end, the severity of such a burst may well depend on how well China is able to recognize bubbles and manage them incrementally, which they appear to be doing at the moment. But their recognition and action may be misguided and too late, something people like Fang Yan, a Chinese analyst at Guosen Securities agrees with, stating, “The government’s regulatory skill is not so good and they have missed the best opportunity to cool down the market. If they had begun to intervene last July they wouldn’t be facing this situation” (Anderlini). And what’s more, as Charles Hugh Smith points out, “History does not provide many examples of governments successfully deflating a speculative credit or housing bubble. Speculative excesses tend to run out of steam quickly and end in a bust.”

Something else to to consider to when pondering China's continued growth is that unless it can wean itself off of an export-reliant economy and start getting its own citizens to spend more, 8%-11% growth rates may be a thing of the past. That will be hard to do unless the government continues to pump money into the market and/or is able to create an adequate healthcare system and retirement pension plan which would allow households enough security not to save 30% of their income. Both are tall orders, and neither is going to happen overnight—especially since a disproportionate portion of China’s population is edging closer to retirement age as a result of China’s one child policy.

Still, it’s also important to note amongst all the signs of trouble ahead that China is far from done growing—even if they are in a bubble. As fast and consistently as China has grown, it is still a developing country, which means high growth rates could continue for decades before they plateau, or as Thomas Friedman points out, there is still a lot of area to develop in China, emphasizing that “In Taiwan, factories go up and out [as the country develops into a more advanced economy]. In China, they go east to west” (Friedman, A27).

This may be true, but sustained growth in the long run will also be contingent upon whether China is able to make the leap from a developing to a developed country, which in turn means that China will have to make the transition from an industrial (53% of its economy) to a post-industrial economy. Translation: At some point China will have to stop building in mass and start creating new stuff, something the country has been apprehensive to do, primarily because innovation is not conducive to China's form of government. But that brings me to China’s recent spat with Google, and part two of this article.


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