The China bubble
Last Updated: Tuesday, December 22, 2009 | 2:07 PM ET Comments2Recommend6
By Gady Epstein, Forbes.com
China's big developers are highly leveraged and dependent on low interest rates and rising prices. China's big developers are highly leveraged and dependent on low interest rates and rising prices. (Greg Baker/Associated Press)China's economy is the envy of the world. As developed nations struggle to eke out a bit of growth and to get unemployment rates out of double digits, Chinese output gallops ahead at an 8 per cent annual rate. This $4.7 trillion US economy, it seems, is the world's dynamo and the prototype for the future.
Take a close look, however, and you may come away thinking China resembles nothing so much as Japan shortly before its stock and property markets melted down two decades ago. A speculative frenzy of borrowing and bidding up is at work. If and when prices crash, there will be hell to pay.
Signs of the times: government bureaucracies funding themselves by foisting debt on state-owned business enterprises; local governments raising capital by selling land at sky-high prices to corporations they own; and a People's Bank of China lavishing liquidity on the entire system in a way that makes Federal Reserve Chairman Ben Bernanke look downright stingy.
"It's a Ponzi scheme whose head is the central bank, and it can print money," says Victor Shih, a China expert at Northwestern University.
The U.S. government's $7.2 trillion in debt at the end of June represented 50 per cent of gross domestic product. The Chinese government's officially disclosed $840 billion in public debt represents less than 20 per cent of GDP. But the People's Bank of China and the treasury are also on the hook for potentially $1.5 trillion in off-balance-sheet debt owed by cities and provinces and entities they control. They're also implicitly obliged to backstop $1 trillion, both in loans that "policy banks" were directed to issue, even when they made no economic sense, and nonperforming loans that the government removed from the books of state-owned commercial banks over the past decade.
Add it up and the national government is responsible for debt equal to over 70 per cent of 2009 GDP. That doesn't count any loans generated this year that might go sour amid a 30 per cent increase in debt balances nationwide. (The U.S. government, in addition to its direct debt equal to 50 per cent of GDP, is responsible for cosigning of mortgage borrowers' obligations equal to another 18 per cent of GDP.)
Like the U.S. housing industry a few years ago, China's big developers are highly leveraged and dependent on low interest rates and rising prices. Municipal governments are knee-deep in this asset swamp. They use land sales as a means of funding themselves.
As fast as China is growing and urbanizing, its cities are churning out more office towers and luxury malls than can be leased for years to come. Tianjin, a gritty metropolis not far from Beijing, will soon have more prime office space than will be filled in a quarter-century at the current absorption rate. Shunyi County, in the capital's suburbs, sold a residential plot last month for $400 per square foot, a new national record. The bidders were mostly state-owned companies and the winner none other than a developer owned by Shunyi County. Where the developer came up with the money for the purchase is unclear, but the county will nevertheless book $740 million as revenue from the sale.
'A pure debt game'
China's mercantilist trade policy is another contributor to its asset bubble. By artificially depressing the value of its currency and making it difficult for locals to invest abroad, China has forced an artificially large amount of capital to chase after domestic investments, inflating property and stock prices. It's the same scenario China pursued in late 2007, before its stock market lost two-thirds of its value, but that era was characterized by monetary restraint compared with today.
'The more debt that's on the balance sheets, whether you see it or not, the more vulnerable borrowing entities become to shocks.'—Michael Pettis, Peking University
"It's a pure debt game," says Andy Xie, an economist who advises private investors and sees the current bubble as "much worse than previous ones."
In late November China's ruling Politburo declared that the nation's monetary and fiscal promiscuity will continue into 2010. The markets, predictably, were overjoyed. Economists who see parallels to the Russian and Brazilian financial crises a dozen years ago are less sanguine.
"The more debt that's on the balance sheets, whether you see it or not, the more vulnerable borrowing entities become to shocks," warns Michael Pettis, a finance professor at Peking University and expert on China's economy and sovereign debt.
China naysayers have been wrong before. Gordon Chang, author of the 2001 book The Coming Collapse of China, has warned — wrongly, so far — that doom lies around the corner. Cushioning China's economy is its high growth rate, an estimated $260 billion (but declining) annual current account surplus and, at $2.3 trillion, the world's biggest foreign exchange reserve.
Bubbles, it bears noting, tend to surprise many observers with their longevity. (A Forbes cover story warned six years too early that the U.S. housing bubble threatened to tank the economy.) But when bubbles do eventually blow, it's usually with a bang.
In the first nine years of this decade China added an average of $1.50 in new credit to the economy to produce each incremental dollar of output. With so much money chasing domestic investments, that ratio has jumped to $7 of fresh credit for each additional dollar of GDP this year, estimates Pivot Capital Management, a Monaco hedge fund.
Risk of crisis grows
All told, China's ratio of outstanding credit (government and private) to annual GDP stands at 160 per cent and could approach 200 per cent by 2011, which would be similar to the 1991 level in Japan, just as that nation began tottering off the economic precipice. (U.S. ratio: 240 per cent.) "All this points to [the idea] that credit in China is not going to be able to grow much longer without risking a crisis," Pivot concludes.
Assuming China's reckoning does arrive some day, it's impossible to say whether it might presage Japan-style deflation, Russian-style hyperinflation or American-style stagnation. For now, private, semiprivate and state-owned enterprises are getting creative to keep the boom alive. Some cash-starved local governments are believed to be asking companies to prepay 2010 corporate taxes to meet this year's budgets. It's the kind of monkeyshines you might expect in New Jersey or California, not in supposedly cash-rich China.
Related-party transactions are another popular funding source. Hainan Expressway Co. in southern China is a government-owned outfit deep in hock. In the last year it has lent some $40 million to its founding shareholder, the Hainan Department of Transportation, and booked the loan due as an asset on its balance sheet. This classification provides the Hainan Expressway with additional collateral to borrow even more in new construction loans from state-owned financial institutions and increases the risk that it will eventually default, according to Northwestern's Shih.
Western and Hong Kong investors are in on the frenzy, too. Evergrande Real Estate Group, a Guangzhou developer, recently staved off a default on short-term debt by raising $800 million in a Hong Kong initial offering, which bestowed it with a $14 billion market cap. But whom is it kidding? Sixty per cent of its "profit" this year is expected to come from increasing the reported value of its properties, a ploy that is a common source of earnings for Chinese real estate developers.
As is typical in the later stages of property booms, many investors in China appear to have discarded rental yields as a measure of how much a building is worth in favor of greater-fool pricing. In downtown Beijing office towers sold this year for $400 per square foot, despite the fact that many were unleased and many more are under construction. The leading buyers: state-owned enterprises, including banks and insurers.
Warning Signs
Asset flipping can go on only so long. At some point you need paying tenants.
* Developers highly leveraged, dependent on easy credit.
* Government funding via debt and land sales to state-owned corporations, prepayment of corporate taxes.
* Total outstanding debt approaching Japan's precrash level.