"China today has the characteristics of a truly great bubble. The value of the housing stock is set to exceed 350 per cent of GDP this year, the same level as Japan at the height of its real estate bubble. Construction accounts for around one-quarter of economic activity in China, which by coincidence is the same level that Ireland attained before its dramatic implosion."
With the world being remade around us, once unshakeable facts have to be re-assessed. I found this article's Ponzi finance view of China hard to fault. You do have to have much of a grasp of economics to wonder how long all those gleaming skyscrapers can lay empty for? Not saying it's curtains for the regime but economics makes politics. What happens when the prices of skyscrapers and those ostentatious homes fall back to earth in the Middle Kingdom...
FINANCIAL TIMES
Entranced by China’s bubbling economy
By Edward Chancellor
Published: February 6 2011 10:31 | Last updated: February 6 2011 10:31
George Orwell once accused fellow socialists of playing with fire without knowing fire was hot. The same could be said of investors who are repeatedly drawn towards speculative bubbles without understanding the risks.
Even the experience of several great bubbles over the last quarter of a century – from Japan’s bubble economy of the late 1980s through to the global credit spree of the past decade – hasn’t made them any wiser. Today, investors are entranced with China’s apparently glorious prospects. Yet they are ignoring the dangers posed by China’s overheated property market.
Bubbles can be identified before they burst using simple valuation tools. But numbers alone don’t tell the whole story. Investors also need an intellectual framework to understand the dynamics of bubbles. A new book, Boombustology (Wiley) by Vikram Mansharamani provides an excellent overview of the leading work in this field.
Mr Mansharamani starts out with George Soros’s theory of reflexivity. According to Mr Soros, markets are determined by a “two-way feedback mechanism in which reality helps shape the participants’ thinking process and the participants’ thinking helps shape reality”. Chaos rules as errors of perception feed back into reality.
The financial instability hypothesis of the late Hyman Minsky complements Mr Soros’s reflexivity. Mr Minsky’s famous “Ponzi finance” theory describes a situation in which already inflated asset prices can only be sustained by further price appreciation and ever increasing leverage. When the flow of credit dries up, Ponzi finance structures collapse.
According to Mr Minsky, when Ponzi finance is widespread the economy is likely to develop into a “deviation-amplifying system”. All great bubbles have easy money and growing leverage. Mr Mansharamani turns to Friedrich Hayek and the Austrian economists to show how inappropriately low interest rates fuel credit growth and over-investment.
Behavioural psychology also helps explain why bubbles develop. Humans have a chronic tendency to overconfidence. We underestimate the probability of events that we haven’t recently experienced (what’s known as the “availability heuristic”). For instance, in Japan in the late 1980s and again in the US in the early 2000s, it was generally believed house prices could not fall because they had been on a continuously rising trend in earlier decades.
Mr Mansharamani surveys recent research into swarm behaviour in the insect world. While ants lay and follow trails of pheromone, the speculative crowd follows a trail of recently minted money. Politics provides yet another prism for identifying bubbles. Great speculative booms are often stimulated by governments, sometimes with the intent of lining the pockets of public officials. All bubbles are accompanied by fraud.
China today has the characteristics of a truly great bubble. The value of the housing stock is set to exceed 350 per cent of GDP this year, the same level as Japan at the height of its real estate bubble. Construction accounts for around one-quarter of economic activity in China, which by coincidence is the same level that Ireland attained before its dramatic implosion.
A reflexive process appears to be at work as the anticipation of future Chinese economic growth drives new construction, while new construction drives economic growth.
Ponzi finance proliferates in China. Wasteful infrastructure projects are funded with bank loans and land grants from local governments, which themselves depend on land sales for the bulk of their income. Chinese banks bypass credit restrictions by securitising loans to developers, while state-owned enterprises boost profits by dabbling in real estate. China’s financial system has become in Mr Minsky’s phrase a “deviation-amplifying system”. When land prices stop rising and real estate credit dries up, non-performing loans are likely to surge.
China’s asset price inflation has been driven by artificially low interest rates, which is contributing to a massive misallocation of capital into investment projects with palpably low returns. This bubble is the product of government policy. The construction boom was instigated to cushion the Chinese economy from shock waves of the global financial crisis.
Because Chinese property has risen continuously over the past decade, most people assume prices will rise indefinitely. Yet the newly constructed apartments in many Chinese cities are unaffordable to anyone but the rich elite, speculators have acquired millions of apartments that are currently sitting empty, while a glut of new supply is set to hit the market this year.
Beijing is trying to control the runaway housing boom with restrictions on housing speculation and tighter credit.
Mr Soros said speculative bubbles continue until the misperceptions of investors are so glaring they can no longer be ignored. In China, we may not be far from that point.
Edward Chancellor is a member of the asset allocation team at investment manager GMO
