Is China a classic bubble economy? Maley

As Australia gears up to meet the projected huge future demand for resources from China, the last thing anyone wants to hear is that the Chinese economy is showing all the classic symptoms of being in the late stages of a major speculative bubble.

But that’s the verdict of a recent research paper written by Edward Chancellor, a member of the asset allocation team of global investment manager GMO. He argues that past manias and financial crises have shared common characteristics, many of which are clearly evident in the Chinese economy.

In the first place, he says, you need a compelling growth story to get a bubble started. Often, this involves a revolutionary new technology, such as railways in the nineteenth century, or, more recently, the internet. In China’s case, the growth story rests on from its massive population of 1.3 billion people.

It’s widely assumed that the Chinese economy will continue to grow at an annual rate of at least 8 per cent in coming years, and that Chinese wages will tend to gravitate towards western levels. It’s also assumed that Chinese workers will continue to migrate away from the countryside and head towards the towns and cities. This massive migration to the cities is expected to fuel a surge in the demand for industrial commodities and consumer goods in China.

The problem, Chancellor argues, is that investors are adopting an uncritical attitude to China’s growth forecasts, and to the surge in demand this urban migration is likely to create. Chancellor points out that current Chinese figures likely understate the existing level of urbanisation in China – many people that already live in relatively high-density regions are supposedly about the ‘urbanise’. In addition, many new urban dwellers are migratory.

They come to the cities when there’s work, and leave when jobs vanish. In China’s case, says Chancellor, it’s misleading to equate a rising urban population with a growing middle class.

What’s more, he says, investors are overlooking the darker side of Chinese demographics. China’s population will start falling from 2015. The worker participation rate actually peaks this year, and the number of new entrants to the workforce is likely to fall off quite rapidly. Yet this is the part of the population that has tended to migrate to the cities, and provide the country with a limitless supply of cheap labour.

If the supply of rural workers drops, Chancellor says, real wages will likely rise. This will allow workers to consume more, but it could jeopardise China’s international competitiveness.

Another major feature of speculative manias is a blind faith in the competence of authorities – in this case, the reputation of Chinese policy-makers has been boosted by the country’s strong rebound in the wake of the financial crisis.

But Chancellor argues that China’s growth is decidedly lop-sided, relying too heavily on increasing exports. China, he warns, simply can’t keep increasing its trade surpluses with western countries without provoking protectionism from the US and others.

In addition, Beijing’s obsession with growth is distorting the decision-making process, as local governments are driven by the need to meet the growth targets imposed on them. “In China,” he says, “GDP growth is no longer the outcome of an economic process; it has become the object.”

In addition, Beijing is still favouring state-owned enterprises over private businesses. State-owned enterprises get preferential access to credit, and pay much lower interest rates than the private sector.

Investment booms are a third common feature of speculative bubbles. Chinese investment in fixed assets jumped by 30 per cent last year, rising to a record 58 per cent of GDP. There are signs that many industries are continuing to invest even though capacity utilisation rates were already low. China, he says, is following the pattern of the Asian Tiger economies, boosting growth through ever-increasing investment inputs. The problems inherent in this strategy were revealed in the Asian Crisis of 1997-98. Chancellor argues that China’s problems are potentially greater because its investment share of GDP is higher than any Asian economy in history.

Easy money lies behind all speculative manias. According to Chancellor, Beijing is following a deliberate strategy of keeping interest rates low to promote investment and subsidise state-owned companies. He notes that for the past 40 years, the interest rate that top US companies have borrowed at has been on average 1 percentage point higher than the rate of GDP growth. In contrast, the Chinese prime rate has been on average 9 percentage points below GDP growth over the past two decades.

What’s more, Beijing responded to the global financial crisis and the collapse in its exports by ordering its banks to lend. As a result, new bank lending grew by nearly 10 trillion renminbi ($US1.5 trillion), or around 29% of the country’s GDP. As Chancellor comments, “It beggars belief that lending could have expanded so rapidly without some decline in underwriting standards”.

Another common feature of bubble economies is the belief that authorities will protect the financial system. China’s leading banks are among the largest in the world in terms of market value, and are considered simply too big to fail. There’s also a presumption that nothing bad can happen to Chinese banks, because they represent a key instrument of Beijing’s economic policy. As Chancellor notes, similar arguments were advanced about the Japanese banks in the 1980s.

He also points to other common features of speculative manias – such as a fixed exchange rates, risky lending practices, and corruption – which are also evident in China. Bubble-like signs are evident in the Shanghai stock market, and stretched real estate prices. There is massive construction of commercial premises, even though commercial property vacancy rates are already high.

The entire edifice depends on the country’s ability to maintain a cracking pace of growth. As Chancellor argues, “China’s real estate market, and indeed its economy and financial system, have been shaped by a belief that past rates of economic growth will continue into the future. This assumption justifies more investment, which spurs the growth, leading to more investment.

“China’s current situation is reminiscent of the late stages of the dotcom bubble, when investors extrapolated past rates of growth into the future and were bedazzled by the size of the prospective market. As with the internet frenzy, a surge of investment creates a demand that appears to justify the most optimistic predictions. China has become a field of dreams; a build-and-they-will-come economy.”

This article first appeared on Business Spectator.