Posted by on September 19, 2012

“China was in a bubble and their bubble’s bursting”.

That is not me talking, although I have been saying that for a long time.  That is Ray Dalio, founder of the world’s largest hedge fund, Bridgewater, as quoted in today’s Financial Times.

I cannot claim to be a close follower of China’s economy.  All my comments come from 30,000 feet.  I just know that the following is a combination sure to produce a disaster:

  • a manipulated foreign exchange that forces the Chinese government to give up control over its domestic money supply,
  • negative real rates interest (and this over a very long period of time),
  • a incompetent and inexperienced banking sector that is firmly under the boot of the government and that practises accounting fraud with the creativity and enthusiasm of its Spanish counterpart,
  • a corrupt, inefficient and autocratic central government, with basically no experience of a market economy, central command instincts, and limited and falsified economic information, and
  • local governments that have been issued growth targets that will be met, no matter how much lying and mis-investing it takes.

We have seen this movie before; it always ends in tears.

The West had a consumption bubble.  It is very clear to me that China is in the middle of an investment bubble.  Investment accounts for over 50% of the Chinese GDP, an extraordinary figure.  We all know how the national accounts work: a yuan invested in an airport today – and China is building 10 massive new airports per annum, as well as expanding others  – will pump up today’s GDP figures even if the airport never sees a single plane or traveller.  GDP accounts do not immediately distinguish between good investment and bad, which only shows up over time.  If you don’t believe me, ask the Japanese.

Why are people in the West so reluctant to grasp this reality?  Apart from the usual wishful thinking, I have noticed three China-specific reasons for this blindness.

The first is a form of reverse racism, a variant on the “inscrutable Oriental”.  The best example of this is a story that I read in the FT a couple of years ago.  When Kissinger first went to China in the early 1970s, he asked Zhou Enlai his opinion of the French Revolution (of 1789).  This was mistranslated as a reference to the French student riots (of 1968).  Zhou responded that it was “too early to tell”.  Kissinger, not the most credulous of people, went back to Washington with gushing tales of the incredibly long and strategic vision of the Chinese.  He would never have been so gullible if the man in front of him had looked less like Mr. Miyagi from The Karate Kid.

The same thing continues today.  Sophisticated investors in the West regularly disparage the economic incompetence of their governments, but somehow think that a corrupt and misinformed gerontocracy will do a better job.  In the same article in today’s FT,  Fraser Howie, author of Red Capitalism, says that the Western belief that the Chinese government is “all powerful, that they somehow are better stewards of the economy than in the west” is a “misconception”.  Now, there’s an understatement.

It is all very reminiscent of the awed discussions in the early 1980s of Japan’s Ministry of International Trade and Industry (MITI), the supposed geniuses who were guiding Japan to economic supremacy.  You don’t hear much about MITI anymore.

The next argument is that, although some acknowledge that China clearly has problems, its financial resources are great enough to overcome any hiccups.  This comment is usually followed by a reference to China’s vast foreign exchange hoard or some other measure of financial solidity.  These people need a little history lesson.  You would have made exactly the same statements about Japan in the early 1980s, when it too was predicted to take over the world; in fact, economies never seem more dominent than when they are in the middle of a bubble.  And that foreign exchange hoard?   Last time I checked, Japan was number two in the world on this parameter, with about 40% of the Chinese total.  On a per capita basis, that means that Japan is way ahead of China.  How much good has it done them?

Government finances look a lot better when you can get your lapdog banking sector to do your dirty stimulus work for you.  When the Great Recession hit China, the banks were brought in and instructed to shovel loans out the door to revive the economy.   This they dutifully did, to the tune of $1.4 trillion of new lending in 2009, double the previous year and much more than the “official” stimulus spending.  2009 was a time when every other banking sector in the world was seeing week demand for borrowing, so no prizes for guessing the quality of these loans.  We will see how good China’s finances look when these loans go bad and the government is forced to bail out the banks and their borrowers (many of which were state-supported enterprises or local governmental entities).

(As an aside, anybody who invests in these Chinese banks, most of which have a partial public float, should have their head examined.)

The final argument is – and I have heard this more times than I care to remember – is the ultimate China trump card: they have over a billion people!   How this is supposed to help them avoid bubbles and lead to economic success is never explained.  How a billion people in China can be an unvarnished benefit, while an even bigger number in Indian is usually seen as a problem, is never explained.  How being the most populous country in the world didn’t help China over most of its modern history, but which is now its insuperable advantage, is also never explained.  The benefits of a number with 10 digits in it are just so self-evident that only an imbecile, and an impolite one at that, would question them.

China is the last, great bubble and I think that its time has come, although predicting when is always more problematic than if.  I write this sentence with mixed emotions.  On the one hand, I will take great pleasure in watching one of the most disgusting and arrogant regimes on the planet be humbled.  On the other hand, when China does finally blow, the collateral damage will be great and no place will be entirely spared.

Be warned.

Roger Barris, Switzerland

PS.  This article is entitled “Part 1” because China is one of my betes noires and it will re-appear in this blog with frequency, although maybe not immediately.

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Posted in: Finance

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