By Jesse Colombo (This article is frequently updated)
All great bubbles start out as legitimate and compelling economic growth booms. The U.S.’ Roaring Twenties bubble started as a growth boom based on the commercialization of radio, automobiles and mass production. Japan’s 1980s bubble grew out of their post-war economic miracle that was spurred by ground-breaking advances in electronic technology and manufacturing. The Dot-com bubble evolved out of the Information Age boom that revolutionized society in an incomprehensible number of ways. The fact that all of these booms started out legitimately didn’t prevent them from developing into bubbles that popped disastrously in the end. The China Bubble is no exception to this pattern, starting out as a boom based on successful economic reforms and modernization that helped to lift hundreds of millions out of poverty, while eventually devolving into an orgy of wild real estate speculation, reckless construction of empty cities to create economic growth and materialism mania. Even if China’s long-term growth thesis remains intact, the same was also true of the US in 1929; China could conceivably experience a Great Depression of its very own when its bubble pops.
After suffering for three decades under Mao Zedong’s disastrous economic policies, China embarked on the path of gradual free market reform in 1978, led by Deng Xiaoping. Capitalist “baby steps” such as farm privatization, legalization of free enterprise and opening up to foreign investment helped China’s economy grow heartily in the 1980s, emboldening the country in its pursuit of further economic liberalization. The early 1990s saw the start of banking reforms and the early development of capital markets, including the opening of the Shanghai and Shenzhen Stock Exchanges. China’s growing desire to be communist in name only led to large-scale privatization of state-owned enterprises (SOEs) beginning in the late 1990s, with the number of SOEs decreasing an astounding 48% between 2001 and 2004 . After reducing tariffs, trade barriers, regulations and radically scaling-back the Mao-era welfare system , China joined the World Trade Organization in 2001.
Having a vast army of highly industrious workers and low wages helped China to become the world’s preeminent manufacturing powerhouse, while pursuing an export-led growth strategy similar to its Asian neighbors. China rapidly urbanized as several hundred million people moved from impoverished farm villages to scores of newly-built cities in pursuit of factory and construction work and better living standards. The strategy of economic liberalization, modernization and infrastructure development has paid off handsomely with an unprecedented yearly GDP growth rate of 9.5% from 1978 to 2010, helping to lift hundreds of millions of Chinese out of poverty. Though China had already been growing at a high rate for over two decades, it was only in the mid-2000s that it entered the ranks of the world’s largest economies and started generating attention as a potential consumer market, investment destination and emerging superpower. China’s economy leapfrogged past the UK in 2005, Germany in 2009 and Japan in 2010 to become the world’s second largest economy, behind only the U.S.
After three decades of breakneck economic growth, China’s economy began overheating in 2007 and signs of speculation and over-exuberance started to appear, such as a brief stock bubble that year and a housing bubble in 2008. The 2008 global financial crisis caused China’s exports to plunge, forcing China’s leaders to abruptly refocus their worries from overheating to a potential domestic economic crisis and its very realistic threat to social stability. In November 2008, China launched a massive $586 billion economic stimulus program that was primarily invested in public infrastructure projects, housing, rural development and the rebuilding of areas hit by the 2008 Sichuan earthquake. China’s stimulus plan was successful at staving off a recession and social crisis – so successful that inflation, overheating and overbuilding quickly became a concern again as the newly printed stimulus money sloshed around the economy, creating very alarming distortions and speculative activity.
Economic stimulus, in the form of literally freshly-created money, is the quickest (and dirtiest!) way to create immediate economic growth. A stimulus program’s funds are typically used to create large scale construction projects that put unemployed people back to work, generate demand for raw materials and act as a conduit for new money to enter into and reinvigorate the overall economy. The problem with stimulus programs is that the creation of new money causes existing money to be devalued, leading to inflation and, in essence, stealthily taxing savers and wage earners to fund the stimulus program. The other problem with stimulus programs is that they very often led to the undertaking of extraordinarily wasteful projects that would never been attempted if natural market forces were in control. Capital that is wasted or destroyed in stimulus-fueled investment booms is called “malinvestment.” While stimulus programs do create some form of immediate economic growth, it is largely artificial and temporary as larger and larger injections of newly printed money are required for the growth to be sustained.
China’s growth in the past decade has been overwhelmingly fueled by fixed asset investment (such as infrastructure development), which has further exploded since the launch of the 2008 stimulus program, accounting for more than 90% of economic growth in 2009. Over 100 extremely ambitious infrastructure mega-projects are currently being undertaken. Chinese cement consumption and construction spending has soared to truly bubble-like proportions as scores of extravagant and massive government buildings are being built in outer China, roads are dug up and rebuilt just to generate economic activity and cities binge on debt to build jaw-dropping infrastructure projects at all costs. China’s mad rush to build infrastructure projects has led to cut corners and shoddy workmanship, such as on the world’s longest sea bridge that was closed one week after opening due to safety problems, the much-publicized high-speed train’s disastrous crash and electrical problems and a new highway that collapsed after a test run.
A particularly strange and somewhat eery phenomenon has arose as a result of China’s building purely for the sake of creating economic growth – completely uninhabited “ghost cities,” such as Ordos in Inner Mongolia and many other empty full-size cities filled with apartment buildings and skyscrapers that can be seen in great detail via satellite imagery. Even the world’s largest mall, the New South China Mall, has been (link has an excellent video) 99% vacant since it opening in 2005 – malinvestment at its finest. There are now 70 billion sq. feet worth of buildings of all types under construction and enough new office space to give every person in China a 5′x5′ cubicle. Then there is another class of projects that can only be ascribed to “bubble drunk” decision making, such as the new government pharmaceutical plant that looks just like a palace, the wildly expensive stadium being built in the middle of nowhere and the railway bridge that was built by a chef. The latest bizarre Chinese construction fad is the replication of entire Western towns, such as Hallstatt, Austria, Greenwich, Connecticut and an English village. A Chinese billionaire’s plans to buy seventy-five thousand acres of Iceland to build an eco-resort is reminiscent of the late 1980s Japanese bubble, in which Japanese interests purchased Pebble Beach, Rockefeller Center and Columbia Pictures, while Nomura Securities proposed Japanese-American “joint ownership” of California. Most worrisome is the fact that five of the world’s ten largest buildings are now under construction in China, as skyscraper construction is a historically reliable indicator of economic bubbles, having marked the tops of the Roaring Twenties bubble in 1929 and the Asian Tigers bubble in 1997.
Economic bubbles and reckless credit booms go hand in hand and the China Bubble is no exception in this regard. A chart of Hong Kong banks’ exposure to Mainland Chinese debt displays the truly parabolic nature of China’s credit bubble that started in 2009. China’s local governments have financed their ridiculously extravagant construction projects via a $1.7 trillion “subprime” credit bubble, of which $540 billion is likely bad debt, according to Moody’s. Fitch has also warned about Chinese local government debt saying, “credit risk has risen from an over-extension of loans to local governments and property.” As the IMF sounded an alarm over the Chinese banking system’s vulnerability to heavy losses, an influential Chinese finance professor said that the Chinese banking system was “on the brink of bankruptcy” and that “every province in China is Greece.” To make matters worse, Société Générale has warned that China’s massive and largely unregulated shadow banking system may need to be rescued, no small feat considering how pervasive this type of banking is in China. In the city of Wenzhou, an incredible 90% of families are involved in the underground banking business, which includes loan sharking and pawnshops.
China’s blazingly fast economic growth coupled with an expanding credit bubble and fresh sloshing stimulus money created the perfect conditions for inflation, which has manifested in the form of soaring rents, food prices and wages. High inflation, negative real interest rates and limited investment options encouraged many Chinese to buy real estate to protect their savings from the ravages of inflation, helping to reinflate the housing bubble that first reared its ugly head in 2008. Housing prices soared 140% higher nationwide from 2007 to 2011 with Beijing housing up 800% since 2003. Clearly having learned nothing from the disastrous US housing bubble, real estate speculators or “flippers” have taken China by storm, buying “real estate as if they were buying vegetables,” such as the housewife who bought 10 properties within 30 minutes and the college student who flipped an astounding 680 flats.
China Property Price Index:
Chart Source: GlobalPropertyGuide.com
While the IMF warns that China is “vulnerable to asset bubbles,” local governments encourage real estate speculation due to their reliance on land sales taxes to pay their mounting debts. Wild speculation has sent Chinese housing prices to unaffordably high levels, hitting a globally unprecedented 27:1 price to income ratio in Beijing. China’s overly-inflated housing prices have brought about strong social costs, as young men find themselves unable to get married without owning an apartment for example. A young architect even resorted to building and living in a small egg-shaped pod to escape the high cost of housing. High prices have sparked a building boom, with housing construction rising 41% in 2010 alone, helping to create an estimated supply of a 64 million empty apartments. Most alarming is the fact that China’s residential property investment as a share of its economy has reached the same level that the US housing bubble did at before its crash, while approaching levels hit during the epic Japanese housing bubble that resulted in a 20 year (and counting) bear market. Chinese investors’ rampant speculative fervor has even resulted in property bubbles outside of China, with Chinese real estate flippers driving Vancouver, Canada property prices far higher than locals can afford, while wealthy Chinese snap up luxury apartments in Manhattan.
A giddy social mood, soaring real estate prices and plenty of “funny money” flowing around the Chinese economy has created a strong appetite for all things luxury – the more frivolous and ostentatious, the better. Luxury booms have a strong tendency of coinciding with economic bubbles, as seen during the late 1980s Japanese bubble and the mid-2000s bubble in the US. Income generated during a period of false prosperity is far more likely to be spent on pricey luxury goods and other extravagances versus wealth accumulated through hard work, sacrifice and thrift. An excellent article titled “Paper Money Wears Prada” directly links the booming sales of high-end luxury goods in the Greater China region to excess central bank liquidity (aka “sloshing” new money). Explosive demand for luxury goods has The Economist calling China “The Middle Blingdom,” which is entirely true now that the Chinese spend more money on luxury goods than Europe and the US combined. It’s no surprise that big-spending Chinese tourists have become the “Dream Consumers” for NYC’s Fifth Avenue luxury retailers, especially now that soaring demand is causing massive price inflation for luxury goods within China.
Extremely conspicuous consumption is the name of the game now that China has entered the “show off” stage of luxury evolution, where the flaunting of luxury goods has become the de rigueur way of proving one’s social status. China’s conspicuous consumption mania has created a market for $315,000 wedding cakes, decked-out custom yachts and department stores with lavatories that cost nearly $800 to use. Marketers are falling over themselves to market high-end products to successful Chinese women who have recently begun splurging and buying Maseratis and Ferraris “like Italian pastries.” The China Bubble has proven to be an absolute goldmine for BMW, Mercedes and Audi as well.
“Bubble drunk” wealthy Chinese collectors are fueling a wine bubble, as they buy $69,000 cases of Burgundy, with one Chinese buyer paying $539,280 for a lot (300 bottles) of Château Lafite-Rothschild at a Christie’s auction, the most expensive lot of wine sold in 2011. A Chinese businessman even paid nearly $200,000 for a bottle of rare whiskey in an airport duty-free shop in Singapore .
Wealthy Chinese speculators are also driving an art bubble that is drawing serious comparisons to the late 1980′s art bubble that was dominated by Japanese speculators before Japan’s economic bubble popped, crashing the global art market with it. Chinese art collectors are breaking auction price records on a weekly basis, such as the Ming vase that sold for $21.6 million. There is much reason for worry given that Sotheby’s stock price, a strong indicator of economic bubbles (like skyscraper construction), is flashing a major “China Bubble Alert” right now.
China is displaying numerous signs of being infected with the kind of frivolous “bubble drunk” social mood that is common during society-wide economic bubbles, as stripper-style pole dancing has become the latest craze among young women and Macau, China’s Las Vegas, saw its gambling revenues boom 57% in 2011 thanks to Chinese who literally “see gambling as an investment.”
From early to mid-2011, the Chinese government raised interest rates and pursued other tightening measures to cool the overheating economy and tame the real estate bubble. By the fall of 2011, the combination of the Chinese tightening measures, the US debt downgrade shock and the European sovereign debt crisis caused Chinese real estate prices to start falling, prompting a government economist to say that “tightening is crashing the economy.” Though the nascent popping of the Chinese real estate bubble is in its very early stages, there are reports of property developers dropping prices significantly, with one developer dropping prices 22% overnight and causing earlier property buyers to riot and smash the developer’s showroom. Developers dropping prices to move inventory in the face of a property glut has become such a problem that Shanghai has even banned the discounting of properties by 20% or more.
A credit crisis began to develop by late 2011, with a spate of business owners in Wenzhou (the city where 90% of families are involved in underground banking) defaulting on their loans at an alarming rate, liquidating properties, with many skipping-town and disappearing altogether. Other struggling Wenzhou business owners have commit suicide or offered to have their fingers cut off to appease their thuggish loan-shark creditors. The problem of disappearing business owners has spread to Shenzhen, where an owner of a well-respected LED manufacturer fled with his family and all relatives who worked for the company.
There are many other reasons to believe that China’s boom isn’t as impressive as it appears, despite the heaps of praise placed upon it by Westerners desperately hoping for a new global growth engine for the 21st century. A full 60% of China’s wealthiest citizens are looking to emigrate out of China, hardly a vote of confidence for the future by the country’s elite. What do these “insiders” know that outside observers don’t? The elites’ strong fear of an uprising and revolution due to soaring inequality certainly doesn’t help. Some of China’s worst enemies are found within the Chinese government as corrupt officials have pilfered $123 billion and started new lives overseas, mainly in the United States. Corruption appears to be endemic within China, as Chinese firms are among the most corrupt in the world, behind only Russian firms. Chinese corporate culture has a very long way to improve before producing reputable world-class companies like Apple, Siemens and Toyota.
One of China’s best advantages, having massive quantities of cheap labor, is becoming a thing of the past as wages soar at the same time that there are many more low-wage countries that are eager to compete against China, such as Indonesia and the Philippines. The days are also numbered for China’s export-boosting unfair advantage conferred by their artificially-weak Yuan currency as U.S. officials become increasingly assertive in their demands for revaluation. The Yuan’s eventual revaluation higher, even if gradual, will make Chinese exports more expensive and less competitive with those of other exporting countries. There is also the strong risk associated with being an exporter that is levered to financial health of over-indebted, belt-tightening American consumers who are struggling with chronic near-10% unemployment and a flagging economic recovery.
Another major risk is that China may “grow old before it grows rich” as it enters a One Child Policy-exacerbated demographic decline around 2014 that will be similar to the demographic decline that slammed Japan in the late 1980s, popped its economic bubble and contributed to its two-decade long struggle with deflation (Deutsche Bank has published an excellent report on the topic of demographics and its forecasted effect economic growth of the world’s economies, including China, on pages 59-79). There are other ways that the China Bubble is similar to Japan’s bubble, such as the explosive growth of fixed investment (mainly in real estate) and credit, along with the blind faith that was and is placed in the abilities of both countries’ leaders to successfully guide their economies. There are also many ways that the China Bubble resembles the U.S. Roaring Twenties bubble that led to the Great Depression, namely the extreme wealth disparity, massive build-up of financial leverage, bubbles in real estate and fixed asset investment and poor financial market transparency.
China has clearly veered off of its successful original path of reform and modernization, while large parts of their economy have devolved into a classic bubble. China will soon face the terrible consequences that inevitably come when bubbles of this magnitude pop. The popping of China’s bubble will also pop bubbles that are derivatives of it, primarily the bubbles in commodities, emerging markets, Canada and Australia. While China’s economy may very well have a bright long-term future, the same could be said about the U.S. economy in 1929 before it plunged into the Great Depression. Hopefully, China will do everything in its power to mitigate the aftermath of the bubble’s popping and quickly steer back on to a course of sustainable development and further liberalization of its economy and society.
Other China Bubble-Related Resources:
List of China Bubble Articles (on TheBubbleBubble.com)
The Also Sprach Analyst Blog – Blog covering the China & Hong Kong economies with a strong focus on the China Bubble.
China Bubble Watch – Blog covering the China Bubble & exposing the downsides of state capitalism.
Wikipedia: The Chinese Property Bubble – Comprehensive resource about the Chinese property bubble.
Professor Patrick Chovanec’s Blog – Blog covering the Chinese economy with good discussion of the China Bubble.
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