Long-term Bearish on China
Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 21st March, 2010.
Excluding the people who labour under the delusion that the US is still the "land of the free" and China is still a Soviet-style basket case, most people fall into one of two groups when it comes to their views on China's economic prospects. The first group is outright bullish on China's prospects over all time periods, while the other is very optimistic on a long-term basis but is concerned about the potential for a painful 'correction' within the next couple of years. In other words, most people are long-term bullish. We, however, are not.
Our view is that China's economy looks strong right now only because its credit bubble hasn't yet burst. In terms of the way it is widely perceived, the current situation of China's economy reminds us of the US economy in 1999-2000. Recall that the US economy was thought by most pundits to be in wonderful shape at the end of the last millennium, and that phrases such as "productivity-driven growth miracle" and "King Dollar" were waved about with abandon. Recall, as well, that intelligent observers argued in all seriousness that 50-times earnings made sense for leading technology stocks and that 36,000 was fair value for the Dow Industrials Index. Interestingly, arguments of a similar flavour are being made today to justify the absurd valuations in China's stock and property markets. Even more interestingly, in some cases people who correctly diagnosed the flaws and non-sustainability of the "US growth miracle" are now failing to apply the same logic to China's "economic miracle".
There is no requirement for China's banks to mark their investments "to market" or accurately report non-performing loans, so China's credit bubble could go on longer and grow much bigger than its US counterpart. For example, China's economy began to shrink during the second half of 2008 (not according to the official stats, but according to more objective data such as power usage), which must have caused many bank loans to become "non-performing" by Western standards, and yet China's banking industry expanded its collective loan portfolio by 32% during the course of 2009. Economy-wide loan growth of this rapidity is unheard of in the US, and we reiterate that this spectacular surge in new bank lending began when the economy was shrinking. How did it happen? Simple: the government instructed the banks to make the Yuan-equivalent of 1.5 trillion US dollars of new loans within the space of 12 months, so that's what they did. Furthermore, most of these new loans must have involved the creation of new money, because China's M2 money supply and total deposits at Chinese financial institutions were both up by around 28% in 2009.
With China's banking system being slightly less transparent than the average house brick, there is no telling how big the bubble will get before it bursts. As discussed in a previous commentary, if the government doesn't deliberately deflate the bubble it could continue until the effects of the massive monetary inflation become evident in food prices. Once this happens, the political cost of not stopping the inflation will, we think, be greater than the political cost of continuing it.
It is not possible to know, in advance, when a great credit bubble will burst. Also, it is dangerous to bet against a bubble because the nature of these things is to go on for much longer than a rational observer would expect. What we do know is that when they burst the result always includes a severe economic downturn and the wiping out of much of the 'wealth' that was created during the bubble years.
But although the bursting of a credit bubble always leads to a severe economic downturn, it doesn't have to cause long-term weakness. The key to whether it does lead to long-term weakness is the government's response to the initial downturn. History and logic tell us that if the government gets out of the way and allows the economy to move back into line with reality (as opposed to the distorted perception of reality created by the preceding credit growth and inflation), the adjustment will be painful but will likely be complete within 1-3 years; however, if the government tries to soften the blow by, for example, propping up prices and supporting failed enterprises, then the adjustment process could take decades.
We think it's a good bet that China's government will make the same mistakes that were made by the US government during the 1930s, Japan's government post-1990 and the current US government, thus setting the stage for a long-term decline once the bubble eventually bursts. This is the main reason we are long-term bearish on China's economy.
As things now stand, we are inclined to give China's bubble the benefit of the doubt; meaning that we are disinclined to bet on falling Chinese asset prices at this time. It looks like China's stock market, as represented on the following chart by the Shanghai Stock Exchange Composite Index (SSEC), made a major peak in 2007 and is in the midst of a post-crash rebound, but the post-crash rebound may not be complete. A signal as to whether or not it is complete will be the direction of the breakout from the triangular pattern that the SSEC has traced out since last August. A downside breakout from this pattern could be interpreted as a warning that the credit bubble is in trouble, although it should be noted that the epicentre of China's boom is the property market, not the stock market.
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