03 January 2011

What Has Kept China’s Bubble from Popping

Several years already there have been talks about the Great Bubble in China. Starting from 2009 there are voices warning that the bubble is set to pop soon, very soon.

As an example, see the article “The Great Bubble of China?” by Vitaliy Katsenelson in 8 September 2006. What is important is that several risks and weaknesses described in there are valid today, and got worse. Most importantly, China is still growing at very fast pace and that’s why the worst hasn’t happened so far.

Or consider the warning by Colin McLean, the managing director of SVM Asset Management, published in 1 April 2010 in The Telegraph:
"With fresh memories of the recent banking crash, few investors are giving much thought to the risk of a bubble. This could come sooner than expected and China seems the likely source."
"Its recent rapid growth looks unsustainable and some of the lending practices in China should trigger alarm bells."
"Some of the biggest cities in China have taken on enormous debt that is risky despite China's high growth rate. Given the confidence in steadily rising property prices, little thought has been given to capital repayment. The overall picture looks much like the early stages of the US subprime credit bubble."

If you haven’t had the chance so far, take also a look to the almost unbelievable overinvesting and wasting described by Daily Mail: “The ghost towns of China: Amazing satellite images show cities meant to be home to millions lying deserted”. This is not about the numbers and statistics which can be manipulated or just be misleading, and as such give false sense of security. This is about the empty new buildings and towns which are very real.  

The question is: what has kept China’s bubble from popping so far? How can it possibly be that the euphoria is largely still there?

Sure, generally positive main stream media and optimistic consensus view have contributed to this. Although strains in the banking system and in regional finances tied to a volatile property sector are foreseen, GDP is still forecasted to grow by 8.4% in 2011 (Source: The Economist, The World in 2011). Often the following underlying strengths supporting this view are highlighted:
* Very favourable demographics since the mid-1970s
* The creation of a very large labour force
* The accumulation of high national savings
These are said to have resulted and continue to result in the robust growth of China’s domestic consumption that has been among the strongest of any country during the past years. Strong industrial output and investments are also stressed.

But this is not the whole story, by far.

Steadily high growth rates of the amount of money in circulation (see Figure 1 below) are not of less importance. These growth rates are explained with (hot) money flowing into the country from outside (twin surplus of current account and financial account, especially the rise in the later), but even more with lending growth which in fact is not limited by the official restrictions to new loans. Shadow lending by lightly regulated financial companies outside formal banking system is playing an increasing role (read more e.g. from The Wall Street Journal).

Combined with the low interest rate environment (illustrated by overnight interbank rates in Figure 2 that only lately have started to increase) and “innovative” CBRC (China Banking Regulatory Commission) policies designed to allow banks to reschedule or roll over loans before they become non-performing (read more about the policies from the Forbes’ website), losses are artificially kept low. This is further amplified by the activity of state-run Asset Management Companies (AMCs) that enable banks to swap their bad loans into bonds, repayment of which is avoided via government’s decisions to run them over (read more e.g. from this interesting blog post by Patrick Chovanec: “Big Losses Are Hidden on China's Bank Balance Sheets”).

So the good macro numbers have not that much to do with the country’s strong fundamentals, but with government policies and hot money of the investors who simply do not want to see the underlying risks or try to knowledgeably benefit from taking them.

Whether and when the bubble is going to pop? All bubbles pop. The timing in this case depends on when money starts flowing out of China and new lending really get constrained. According to the IMF forecast, financial account turns negative in 2011. This is of course compensated by current account surplus that may be put into risk given continued weaknesses in global economy and/or too sharp appreciation of renminbi. Because of shadow lending, government and central bank seem even not in the position to control the amount of new loans. Defaults of bad assets and the resulting erosion of confidence would quickly lead to the downward spiral; this very much depends on the restructuring practices and rolling over problem credits. All in all, in case of “proper” management of the situation and assuming at least some recovery in global economy, excesses can still be maintained for some time. This however doesn’t mean anything else  than more air being pumped into the bubble.

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