Deflating China

Damned if they do, damned if they donâ??t

Last year, Chinese authorities impressed Western leaders by turning China’s falling growth rate around through stimulus programs designed to boost domestic investment. However, as China’s massive monetary stimulus has led to a surge in bank lending and rapidly growing asset prices, officials in Beijing see the need to rein in the boom. The prospect of a Chinese slowdown-or, even worse, a full-blown crash-is in turn creating fears that the global economic recovery is in fact not sustainable.

Opinion is divided on how to interpret recent developments in China. As reported by the Financial Times:

While some regard China as having made forward-looking investments in infrastructure and urban planning that will lay the foundations for a new burst of growth, others fear last year’s recovery is really a mirage based on an investment bubble. It is also a crucial question for the fragile global economy. If China’s rebound were to fizzle, it could easily drag the rest of the world into a double-dip recession.”

Among those who are the most bearish is Jim Chanos, a hedge fund manager who famously saw the coming Enron collapse. Chanos thinks Chinese authorities have created “an unprecedented bubble.” China has all the symptoms of an investment bubble. Investment as a percentage of GDP is approaching 50 percent, and in some cities real estate prices have risen by more than 200 percent in one year.

According to Standard Chartered, a UK-based international bank, the average land price in China increased by 106 percent last year-including increases of more than 200 percent in Shanghai, nearly 400 percent in Guangzhou and 876 percent in Wenzhou, which is why the bank believes China’s stimulus program has created a bubble, especially in the big cities.

Other places, such as the newly constructed town of Chenggong, are totally void of inhabitants, with streets lying barren and empty, as a symbol of an investment boom gone awry.

There are some ominous parallels to earlier accounts of real estate and investment booms in other East Asian countries. A recent Financial Times analysis notes that “there is something unprecedented in China’s investment boom. Even before last year’s surge […] China’s investment-to-GDP ratio was the same as Thailand’s on the eve of the 1997-98 Asian financial crisis, or Japan’s at its peak during its high investment phase in the 1960s.”

These historical comparisons have led several investors and commentators to believe that China is facing an imminent crash sometime this year. In a recent report, the hedge fund Pivot Capital Management warns that “investment-driven growth cycles tend to overshoot and end in destructive ways,” and that “the capital spending boom in China will not be sustained at current rates,” leading them to believe that “the chances of a hard landing are increasing.”

If this happens, the world economy could experience a new downturn, and as a worst case scenario this could, according to Pivot, turn out to be “a similar watershed event for world markets as the reversal of the US subprime and housing boom.”

Jim Chanos is even more bearish, saying that China is “Dubai times 1,000 or worse,” thinking of last year’s real estate debacle rattling markets around the world. Apart from the apparent similarities with the small Arab emirate, such as the megalomaniac Chinese construction project aptly entitled The World, the most alarming fact about China during the last year has been the rapid expansion of credit. This is especially worrying, because, as Chanos points out: “Bubbles are best identified by credit excesses, not valuation excesses. And there’s no bigger credit excess than in China.”

Loosening credit was part of China’s stimulus program, but it is now seemingly spinning out of control, which is why Chinese authorities are putting the screws on banks in order to rein in the lending boom. But this is a tricky balancing act. If they tighten too fast, it could trigger a full-blown crash, as happened in the U.S. after 2006 when interest rate hikes eventually pricked the subprime bubble. If they tighten too slowly, the credit expansion could continue for some time, which would ensure a continuation of mal-investment and make the potential fall and necessary corrections even more severe.

The government’s preferred instrument to tighten monetary policy is adjusting reserve requirements for banks upwards, thereby slowly contracting credit. The higher the reserve ratios, the less the banks can lend, which will cool of the pace of credit expansion. Chinese authorities should be familiar with this kind of maneuver, which has been used on previous occasions. U.S. monetary authorities tried increasing bank reserves in the 1930s, which led to a second crash and a new severe “depression within a depression” in 1937-38. Chinese authorities seem to have learned something from history, though. Whereas the Federal Reserve in 1936 tightened policy in one big step, doubling reserve requirements overnight, the Chinese monetary authorities are tightening in small successive steps, thereby hoping to gently let the wind out of the credit balloon.

China’s monetary stimulus experiment should be a reminder of the dangers of credit and asset bubbles. The Financial Times writes:

“If there is one big idea to come out of the financial crisis, it is that monetary authorities should try to anticipate asset price bubbles, especially in property. China is now a test-case for the theory, given strong indications that the property market is getting close to bubble territory.”

Recent developments in China, and elsewhere, should also make us more wary about the potential pitfalls of stimulus programs. Governments seem to think that rising debt and mal-investment during credit booms are cured by more debt and mal-investment in the recession that follows. This is no real solution to our economic ills. What is needed to regain sustainable world economic growth in the long run is exactly the opposite: tight money to avoid credit and asset bubbles, prudent fiscal policies to avoid bloated public sectors that only crowd out private investment and economic activity, and a more balanced global economy in which the U.S. saves more and China reins in its investment boom.