The China Bubble

The Chinese economy made global headlines in 2015, first with the stock market crash in China and then with the surprise devaluation of their currency, the Chinese Yuan.   It caused a mini-crash in US stocks in August of that year and then again in Jan/Feb of 2016.

But now, China is old news.  Financial commentators are speaking in past tense about the China crisis.  It was a whole bunch of worry that amounted to nothing.  The Chinese economy is going to grow at 7% forever into the future, worst case 4%-5%.  Nothing has happened, and nothing will happen. 

That analysis is totally wrong.   China is in the midst of the largest, most acute private sector debt bubble in the history of the world (and that is not an exaggeration).   China will have its “Lehman moment” at some point; it is just a matter of time. 

History tells us two things about debt bubbles: 1) They end badly.  2) They often last far longer than expected.   Debt is a game of confidence.  As long as lenders are in denial and willing to rollover bad debt, the debt bubble will continue on.  But eventually there will be a crisis of confidence.  Lenders will panic, including bank depositors. 

So how was the China crisis postponed?  More debt!  Since the headlines appeared in 2015, the China debt bubble has gone parabolic.  It is reminiscent of 2007 in the US when anybody with a pulse could get a mortgage, and that mortgage would be stamped with an AAA rating.  In China, the specifics are slightly different, but the outcome will be the same.  

Here is an excerpt from my book End Times Economics:

 

China is an extraordinary success story; unfortunately, most of their success is built on debt.  The previous chapter included a discussion of China’s slowdown resulting from an attempt to shift from an investment economy to a consumption economy.  This chapter will look at how truly fragile the situation is. 

China’s debt has exploded since 2009, going from Stockman’s “golden mean” of 150% debt/GDP to 350% by some estimates1.  That is a truly unprecedented increase in such a short time frame; never has an economy added 200% of GDP in debt in less than ten years, and this is the second largest economy in the world! 

Perhaps the best place to start is China’s construction bubble, because the entire economy is based on unsustainable construction.  The concern is not so much with real estate prices, though there is a clear real estate bubble across China; the problem is that they have already built enough apartments to house the entire population, and in order to sustain their economy, they have to keep building at an extraordinary clip. 

In describing China’s construction bubble, let’s start with a classic economic thought experiment: an island.  Back in 1980, there was a small island of one hundred families that lived in straw huts.  They were given the technology to start building a modern society, and they started modernizing rapidly.  At first, they built a modern port for ship traffic.  They also built a water tower, power plant, transmission lines, roads, a couple bridges, etc., mostly with debt.  In 1990, with all the necessary infrastructure in place, they started building modern houses. 

The economy was booming in the 1990s and 2000s.  There was almost no unemployment, and 25% of the labor force was at work building houses financed by debt.  They were very good at building houses, constructing five houses per year for the island with a hundred families.  In the year 2010, the island reached a hundred houses to house the entire island.  While the island added one new family each year, the island’s economy kept on building five houses per year.  By 2015, there were only 105 families, but there were 125 houses, and there were no signs of slowing down.  Families were putting all their savings into second homes, assuming prices would always rise.  Other families borrowed money to buy second homes.  Life was good.

But there was a problem for this island economy.  They only needed so many houses, and so much infrastructure.  It was a waste to keep building five houses per year with borrowed money, most of which would remain empty.  But construction was 25% of their economy and there were massive debts everywhere in the construction industry.  The only way to pay back that debt was to keep building unnecessary housing with more debt and hope that home prices continued to rise forever.  If they ever stopped building houses there was going to be a huge debt crisis and mass unemployment.  What were they to do? 

China today is a lot like this island.  The problems are identical.  The construction industry is a huge portion of economy, somewhere between 20%-30% when all of the sub-industries are included2. But they only need so many apartments!  

According to the world renowned expert on the topic of the Chinese construction bubble, Gillem Tulloch:

We estimate that in the ten years from 2005 to 2014, a total of 137m residential property units have been constructed (both social and private). Assuming the Chinese average of 3.1 people per apartment, this implies enough living space for 426m people, or 31% of China’s entire population.3

After this unprecedented building boom, China already has far more residential housing units than they need.  A 2014 study by Southwestern University of Finance Economics, published by the Wall Street Journal, estimated that there were 49 million vacant residential properties in China, more than one in five4. Using the average resident per unit of 3.1, China has enough vacant units to house almost half of the population of the United States.  Yet they are still building!

To take it back to the island example, the China island with one hundred families would already have 125 houses, and would be building an extra five houses per year, using debt!  This is clearly an unsustainable construction bubble. 

A look at the debt multiplier (introduced in chapter 2) in China reveals major problems.  Their massive debts are providing a diminishing return, and the amount of debt required to sustain the economic momentum is truly staggering.  Again, from Gillem Tulloch:

Essentially what the Chinese have got to do, is they have to replicate the entire US financial system in just five years to maintain growth at the current rate.  And it’s all going in to houses and cars. . . . And if you sort of adjust the numbers you realize this… they are building around six times as many houses as they should. 5

If this analyst is correct—and there is every reason to believe that he is—at some point (probably in the near future) China is going to experience an epic crisis and collapse.  In order to be sustainable, China has to cut construction by 83%, which is about 25% of their economy.  China is going to experience something far worse than a slowdown; there is going to be a collapse.  Then they are probably going to repeat all the mistakes that Japan made, resulting is a stagnant economy at best. 

Making matters even worse, the construction industry is partly funding by a “shadow banking” Ponzi scheme.  Similar to the Mortgage Backed Security phenomenon during the US housing bubble, the Chinese banking system has developed what is called Wealth Management Products (WMP).  The WMPs are short-term debt instruments that pay a few percent more than standard deposit rates.  In order to pay higher yield, the banks buy corporate bonds and other illiquid debt instruments, many from development and construction companies. 

There are a number of major problems with WMPs.  Firstly, most WMPs have durations of six months or less, while the banks buy long-term bonds.  This duration mismatch is a panic waiting to happen.  Moreover, there are asset-liability mismatches of up to 10%, meaning that the liabilities of these products are 10% more than the asset base.  And finally, like the synthetic CDOs of the subprime crisis, WMPs are now increasingly buying other WMPs to put in their portfolios, so that a panic in one will cause a chain reaction that will destroy all the rest.  It is a true Ponzi scheme that is going to come to a crashing halt. 

Texas hedge fund manager Kyle Bass, who is famous for predicting and profiting from the subprime mortgage crisis in 2008, now has his eyes set on China, and he paints an ugly picture:    

In China the credit excesses are already built. . . . They have asset-liability mismatches in their system, in Wealth Management Products, that are more than 10% of their system.  And our asset-liability mismatches were 2.5% of our system [in 2008] and you know what they did. . . . [China is] already so far ahead of the world’s excesses in prior crisis . . . that we are facing the largest macro imbalance in world history.6

That is a powerful statement.  China is the largest macro imbalance in world history.  If that is even half true, the world is in for a major economic crisis. 

But according to Bass, it is not the end of the world for China.  It will be ugly, but they will do what’s best for themselves. 

It’s not Armageddon.  They’re going to recap their banks.  They’re going to expand the PBOC’s balance sheet.  They’re going to slash the reserve requirements.  They’re going to drop the deposit rate to zero. . . .  Everything that the Chinese central bankers and central planners have to do is currency negative for them.  Everything.6

Translation: the Chinese Yuan is going to crash when the inevitable banking crisis erupts.  China is not going to be able to prop up their failing currency much longer.  And the Yuan crash is going to devastate the world. 

It is hard to quantify the magnitude of the global recession and debt crisis that will erupt from a China banking crisis and a crash in the value of the Yuan of 30%-50%.  There will be a deflationary wave emanating from China, sending commodities crashing (further), and world trade will drop like a rock.  It will be a truly global, severe economic crisis. 

And it’s inevitable. 

 

Since End Times Economics has gone to print, none of this has changed.   China is still a ticking time bomb ready to drag the world economy into a serious recession.   The only thing that has changed is the size of the debt bomb!   And the size of the real estate bubble. 

According the a recent study by the Institute of International Finance (IIF), over the past 12 months debt in China has increased by $4.5 trillion, more than 40% of their GDP!  That is truly astounding.  A lot of economic problems can be temporarily postponed by that amount of debt.   But that only makes the day of reckoning even more painful. 

When is China going to experience this inevitable crash and drag the world economy into recession?   It’s hard to say.  But with the increase in real estate prices and debt, this could be categorized as a blow off top.   Those usually end in a swift reversal.