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The War on Cash!

Blowing Stock and Property Market Bubbles in China

Economics / China Economy Jul 30, 2009 - 07:00 PM GMT

By: MISES

Economics

Best Financial Markets Analysis ArticleTim Swanson writes: Despite all of the shimmering skyscrapers and industrial output, unless market forces are allowed to truly dictate economic exchanges, today's Chinese megacities and their residents will merely be facades and actors within a 21st-century Potemkin village, and growth will remain stagnant for years to come. This is due in large part to continual state intervention through centrally planned investment.


Roughly eight months ago, Premier Wen Jiabao announced a $586 billion stimulus package to combat a plunge in economic activity.l/

At the time, analysts such as James Pressler noted that the stimulus might simply be a rebranding of previously known spending packages rolled into a big fancy plan.[1]

Suffice to say, this is not the case. I was wrong.

Beginning in November, lending quotas have been scrapped and interest rates have been held at a four-year low: unsurprisingly, bank lending has surged.[2] According to the People's Bank of China, for the first six months of this year, new lending amounted to more than 7.3 trillion yuan (about $1.1 trillion) — which, according to the Royal Bank of Scotland, is equivalent to two years worth of credit.

Furthermore, Wei Jianing estimates that roughly 20% of the stimulus funds have ended up in the domestic stock bourses, creating a speculative bubble much akin to the previous dotcom and housing-heavy cousins. Another 30% of the funds are believed to have been shuffled into the ailing property markets.[3] [4]

In fact, residential property rates in places like Beijing are once again climbing at a spectacular rate — 6.5% in one week alone.[5] What was intended as a means to boost infrastructure improvements has been used instead to continue erecting villas and skyscrapers — with little productive value — in an already oversaturated market created by the previous boom.

For example, at the end of last year, roughly 91 million square meters of apartment space lay empty throughout China. This figure does not include the 587 million square meters of apartment space that has been sold but left vacant over the past five years or the millions more that are built but left off the depressed market.[6] More specifically, since 2006, roughly 152 million square meters of commercial office space has been built in Beijing — more than all of the office space in Manhattan — yet 30 million square meters is still vacant.[7] And in Shanghai, the vacancy rate for commercial space is estimated to have hit 25% at the end of last year.[8]

However, as an illustration of unintended consequences, during this new real estate boom, several investigations have discovered that real estate developers, desperate to offload nonperforming properties, have dumped mortgages onto state-run banks that are "facing enormous pressure from Beijing to rapidly increase lending to boost the economy."[9]

Thus, while market forces would have reallocated unused property, pushing prices down, the stimulus has catapulted markets such as Beijing and Shanghai into the top 50 most expensive globally, despite that the average resident earns a fraction of their industrialized peers.[10]

Raw Materials

Economist Andy Xie has arguably written the most concise case as to how the stimulus money has created extremely problematic unintended consequences for a developing China.

For instance, in its objective to jumpstart or simply smooth over the plunge in economic activity (primarily exports), Chinese state-owned industries have gone on a commodity buying binge that actually has worked against them:

But China's imports are mostly for speculative inventories. Bank loans were so cheap and easy to get that many commodity distributors used financing for speculation. The first wave of purchases was to arbitrage the difference between spot and futures prices. That was smart. But now that price curves have flattened for most commodities, these imports are based on speculation that prices will increase. Demand from China's army of speculators is driving up prices, making their expectations self-fulfilling in the short term.

The failure of Chinalco's investment in Rio Tinto has been costly for China. After watching its share price triple, Rio Tinto saw it could raise money more cheaply by issuing new shares to pay down debt. The potential financial loss to Chinalco isn't the point. Rather, higher costs will stem from a further monopolization of the iron ore market because Rio Tinto, after scrapping the Chinalco deal, entered into an iron ore joint venture with BHP Billiton. Even though these two mining giants will keep separate marketing channels, joint production will allow them to collude on production levels, significantly impacting future ore prices.

While the rest of his research is worth reading in length, in a nutshell he suggests that the current commodities boom is entirely unsustainable and counterproductive. How big is this commodity boom?

The NY Times recently noted that among other imports to China, iron ore increased 33% from a year earlier, crude oil increased 14%, aluminum oxide increased 16% and refined copper increased 148%. These jumps have corresponded with similar price increases in the commodities. And as Xie, the Times and others have noted, like all artificial bubbles, it will eventually lead to an unpleasant pop.[11]

Over the past year, both Yasheng Huang and Mark DeWeaver have noted that these soon-to-be-seen ill aftereffects are directly attributed to an economy that is still heavily managed by government planners.[12] [13]

While huge swaths of state-owned enterprises have been privatized, many more are owned or operated by government officials. Still worse, many companies, while nominally private, operate in markets that are currently being politically right-sized. For instance, over the next decade Chinese policy makers aim to shrink domestic automobile manufactures by forced consolidation.[14]

Furnaces Aflame

As an economy develops and becomes more productive, DeWeaver notes that investment in fixed-capital formation typically decreases as a percentage of GDP. In China the opposite has occurred — increasing from 33% to 42% between 1981 and 2007 — creating what many commentators label as "overcapacity."

Regardless of the debate over identifying what the "proper" level should be, China makes a lot of steel. China has roughly 700 steel companies that produce at least 100 million more tons than the sum total of the United States. In fact, while steel producers in other countries like Germany and Japan have cut back 20–30% due to global stagnation, Chinese producers have turned the dial to the proverbial "eleven," increasing output by 1.2% in the first six months, and breaking the previous record, which was also held by China. Full smelting ahead![15]

This is not due to more efficient technology, creative entrepreneurship or economies of scale, in fact, it is just the opposite.

During the 1950s, as part of Mao's Great Leap Forward to out produce Western capitalists, many provinces and counties subsidized and encouraged the creation of iron smelters. According to Maharshi Patel, between 1958 and 1961, Mao oversaw a policy which encouraged "every commune and neighborhood" to build furnaces. Whereas Roman politicians promised a chicken in every pot, and modern-day American politicians promise suburban houses with white picket fences, political careers in China became intertwined with the construction of smelters and ancillary industries. As Patel noted,

Like the auto industry in North America, steel in China came to be considered an essential industry, too big to fail. It directly employs 3.58 million people. Millions more live off it in support roles. As of 2007, it contributed 4 per cent of China's gross domestic product and 9 per cent of industrial profits.

And realizing that something has to be done, as part of the never-ending crusade to right-size, Chinese planners finally announced in May that they would begin to try to shut down certain refiners and "actively guide" others into merging.

Back to the Future

While Yasheng Huang and others argue that the decentralizing reforms of mainland China in the '80s were reversed during the '90s, in the past decade Chinese policy makers have emulated many of the same export-centric programs of other "tiger" economies like Singapore, South Korea and even Japan.[16] Their neo-mercantilist, export-centered preferential policies involved three primary forces: an artificial devaluation of domestic currencies, large inflows of FDI, and most importantly, Western consumers with insatiable appetites.

Unfortunately for most of the East Asian economies, this model was unsustainable and, to paraphrase Mohd El-Erian of PIMCO, this current low is the new normalcy.[17]

Roughly 40% of China's GDP is accounted for by exports, which was not a problem during the boom years. However, in May alone, exports dropped more than 25% from the year before. This drop was not a statistical outlier, as each preceding month for nearly a year had had double-digit drops as well, including a 21% fall last month. And foreign direct investment has also dropped like a rock, nearly 18% alone in the first six months this year compared to last.[18]

Acknowledging that consumption levels in Western countries will not rebound to previously seen highs, China's policy makers have begun executing contingency plans aimed at boosting domestic demand.[19] However, these are unlikely to replace spendthrift Joneses anytime soon.

The War Chest

Surely there is a bright light on the horizon? After all, the government does sit on large holdings of foreign assets.

Nope.

Gordon Chang recently noted that unfortunately for policy makers in Beijing, the large foreign reserves that China holds cannot be used to any large degree to fend off the ill effects of the current financial order. Chinese agencies such as SAFE are at the complete mercy of the United States, because there is no exit plan with Treasuries.

Despite the recent flurry of eye-popping headlines, if the Chinese unloaded their foreign reserves, they would destroy their own currency, which is pegged to the US dollar. In the event they continue gobbling up commodities, they will simply "inflate" those asset prices too.[20] Furthermore, because their currency remains pegged to the dollar, any yuan appreciation will squeeze exporters that are already reeling from the large drop from overseas.

Thus in order for them to sell any substantial portion of the Treasuries, the Chinese will have to wait until real growth begins to take place in the United States.

Uncertainty and Unpredictability

Over the past 30 years, China has changed dramatically. Despite all of the interventions and misallocations, real, inflation-adjusted growth could still take place. [21] Areas like Yunnan and Guangxi will presumably benefit due to free-trade agreements with ASEAN participants. Previously isolated rural communities will benefit from modern infrastructure links as they can finally develop and participate in China's industrial revolution.

Low personal debt and high personal savings can also be a positive factor even if depositors receive very little in return.[22] Furthermore, if the policy makers allows land-owners to actually sell land or use it as collateral, there will be some huge dividends there as well.[23]

However it is the unseen details, the unseen consequences, the unseen opportunity costs that currently dictate and bedevil the economic growth of the world's most populous country. And despite the three decades of reforms, the effects of socialist planning, even the "lite" variety, will still generate business cycles — with prolonged corrections and purges.

Tim Swanson is a graduate of Texas A&M University and currently lives in China. Send him mail. See his article archives. He would like to thank KY Leong and Mark DeWeaver for their comments. Comment on the blog.

Notes

[1] Northern Trust, "Daily Commentary." November 10, 2008. (PDF)

[2] "China Needs Consumption for Recovery, Researcher Says" from Bloomberg.

[3] Alarm bells began to ring starting in February, when analysts in Shanghai suggested that large portions of these new bank loans were being diverted into stocks. The main Shanghai Stock index (SSE composite) bottomed in early November and has subsequently surged more than 75% since January. The 20% and 30% estimates are according to Wei Jianing, an economist with China's Development Research Center. See "China loan spree goes to stocks, property" from the Associated Press.

[4] Another odd area the stimulus is affecting is cigarette consumption. See "Chinese ordered to smoke more to boost economy" from the Telegraph.

[5] "Real estate sales up, prices soar" from China Daily.

[6] "China property prices 'likely to halve'" from the Financial Times.

[7] "Beijing Commercial Real Estate" from Paul Kedrosky.

[8] "Housing Market a Drag on into 2009 and Beyond" from ChinaStakes.

[9] "China property prices 'likely to halve'" from the Financial Times.

[10] It should be noted that much of the current real estate malinvestment will probably be more concentrated in the commercial side rather that residential, as personal credit is still very tightly controlled and the typical Chinese home buyer puts down a large percent of equity, historically 20–30% higher than he would on commercial space. "Domino or dynamo" from The Economist.

[11] Even Zhou Xiaochun, governor of China's central bank (the People's Bank of China) sees big problems ahead. See "Central banker warns of risk in stimulus push" from China Daily. Such pronouncements have stirred a debate over what exactly has happened over the last 8 months.

[12] Be sure to read "The Next Asian Miracle" from Yasheng Huang, "Can China Transform Its Mode of Growth?" from Mark DeWeaver, and "China's banks are an accident waiting to happen to every one of us" from the Telegraph.

[13] Another future problem is that, due to unintended consequences of family planning policies, in twenty years there will be more elderly dependents than children. Despite China's relatively young age today (median age is 30); by 2050 the median age will be 45. And exacerbating this issue are mandatory retirement laws, set at 50 for women and 55 for men. See "A special report on ageing populations: China's predicament" from The Economist.

[14] See "China Retools its Auto Industry to meet Global Challenges" from Xu Ping and "China's Auto Industry to Consolidate" from the WSJ.

[15] "China's runaway steel train" from Globe and Mail. Full text can be read here. See also "China First-Half Steel Production Rises to a Record" from Bloomberg; "Something's Rotten in Chinese Steel Industry" from the NY Times.

[16] "Think Again: Asia's Rise" from Foreign Policy and "Private ownership: The real source of China's economic miracle" Yasheng Huang.

[17] Regarding El-Erian's bearish-stagflation outlook see "Secular Outlook: A New Normal."

[18] For more on why a speedy recovery is unlikely for China, see "Recovery in China? Not so Fast" from Forbes. See also "Foreign direct investment in China down 6.8 pct in June for 9th month, but fall narrows" from the Associated Press.

[19] For example, according to the Wall Street Journal, "Consumers who scrap vehicles under the plan can receive a subsidy of between 3,000 yuan and 6,000 yuan, or about $450 to $900, when they purchase a new vehicle." Bloomberg notes that, "[t]he government is now giving out 5 billion yuan ($731 million) in subsidies to spur auto sales in rural areas." Unsurprisingly, this has caused a huge surge in car sales.

[20] "China's Catch-22: $2 trillion in foreign reserves" from Globe and Mail.

[21] In contrast, India is, by at least several metrics, headed in a more balanced, sustainable direction. See "India's Rising Tide" from the Wall Street Journal.

[22] While relatively minor, one other problem impeding economic growth is gambling addiction. See "Beijing losing the gambling battle" from Asia Times.

[23] "China's land-rights reform is vital but not enough" from Dragon Beat.


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