How China Will Crash, Explained In 700 Words

17 Aug

Vitaliy Katsenelson, author of the Little Book of Sideways Markets, and Chief Investment Officer at Investment Management Associates Inc, explains simply and concisely how China will crash.

In my opinion, this is a must-read for all Australians (reproduced in full below, from Forbes magazine):

How China Will Crash And Burn

Party rulers in China are trapped in a position that chess players deeply fear — zugzwang — where any move made puts you at disadvantage. In China, the potential cost of both action and inaction is economic collapse.

China is slowly starting to face the consequences of its actions — loans grew over 30% a year over the last few years — and inflation is rising fast. Inflation in developed countries is unpleasant, but it is tolerable. For a developing country — and China, despite its size, is still a developing country — it can be catastrophic. In developed countries, we spend two or three times less on food as a percentage of our income as do people in developing countries.

Therefore, though food inflation is unpleasant, we have a much greater tolerance (margin of safety) for it. While food inflation the U.S. can mean fewer trips to restaurants or no summer vacation, food inflation in China leads to hunger.

The Chinese government is desperately trying to put the brakes on the economy. It is shutting off lending to land developers and has raised bank reserve requirements five times this year. However, its success on the inflation front will likely lead to a slowdown of the economy and high unemployment. Ironically, those were the issues party planners tried to cure when they stimulated the hell out of the economy over the last few years.

China bulls are arguing that the almighty Chinese government will be able to soft-land the economy. Unlikely, I’d say. Forced lending was at the core of Chinese economic growth. Simply put, there is too much debt to go bad. According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems. The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post.

Once lending is cut off, property prices will stop appreciating (and likely collapse — that is what usually happens in a Ponzi scheme). Also, the overcapacity in the industrial sector and commercial real estate will come to the surface. And suddenly everyone will discover that the venerable emperor has no clothes.

I often hear the argument that China will not have a real estate crisis of U.S. proportions because home and condo owners have to put 30-40% down when they buy. So where do people get the money to buy a house that costs, on average, 8 times their annual income (a figure several times higher than in the U.S.)? Some of it comes from savings, and some comes from borrowing from relatives.

Let’s pause for a second. In the 1990s, the Chinese banking system basically collapsed. To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity). Banks started to function as though nothing had happened. To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 1% or so. In a country with a very high savings rate and 5% inflation, this resulted in a 4% annual loss of purchasing power.

Chinese consumers were punished severely over the last 10 years for the banking crisis of the late ’90s. And they’ll be punished even more soon. Keeping money in the bank didn’t make that much sense, and investment alternatives were limited. However, they could invest in an asset that supposedly never declines in price – a house or condo. So they did.

As China slams the brakes on the economy and as housing prices fall, the banks will lose plenty of money. But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose. The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest. That is the Chinese blacks swan!

See also Mr Katsenelson’s excellent slide-show presentation – China: The Mother of all Grey Swans

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3 Responses to “How China Will Crash, Explained In 700 Words”

  1. Oliver K. Manuel August 17, 2011 at 1:54 pm #

    I sincerely hope that Vitaliy Katsenelson is right and I am wrong.

    The current budget stand-off, social unrest, the Tea Party movement, and the Climate scandal reflect the fact that Henry Kissinger, Chinese Chairman Mao, and Chinese Prime Minister Chou-en-lai agreed in 1971 to use anthropogenic global climate change as the “common enemy” [1] in order to:

    a.) Unite nations,
    b.) End the space race, and
    c.) Avoid the threat of nuclear annihilation.

    But failed to include two key items in their goals [2]:

    d.) Government controlled by the people being governed, and
    e.) Transparency and veracity (truth) of information provided to the public.

    References:

    1. Deep Roots of Climategate

    http://dl.dropbox.com/u/10640850/20110722_Climategate_Roots.pdf

    2. Harmony from Climategate

    http://dl.dropbox.com/u/10640850/20110815_Climategate_Harmony.pdf

    3. Background information on Chairman Mao and Prime Minister Chou-en-lai

    http://www.janetjagan.com/2009/05/22/chairman-maothunder-29-september-1962/

    With kind regards,
    Oliver K. Manuel
    Former NASA Principal
    Investigator for Apollo
    http://myprofile.cos.com/manuelo09

  2. Yodas Mentor August 18, 2011 at 11:50 am #

    I know an ex-pat who is married to a Chinese national with, let’s say, good party connections. As a result they are allowed to break the 1-child rule and have access to better housing in Shanghai. They paid (equivalent) $850,000 for a nice apartment in a development where 20,000 other people live. Think about those numbers. If there is, say, 10,000 apartments in that one development, and they all lost, say, 20% of the value, destroying most of the equity, that is a significant amount gone, even on higher LTV ratios. Roll that formula across all the developments like this that have sprung up in the last 10 years and it makes the US housing bust look like a yard sale.

    Obviously all centrally-planned economies go wrong eventually, it’s just the timeline and size of the crash that is in question. So the questions are : how many more months, years, decades has the chinese model got to run? And how big will the destruction of wealth be when it happens? And will this force a major-rerating of chinese currency? And what about Gold? The Chinese love the stuff. Anyone who has lived with a meddling government for a long time tends to develop an attachment to physical money that can’t be devalued by a central planner. Right now, the muttering is that a large percentage of the world gold supply is making it’s way into china, largely through private buying. Where will it all end up? If only we knew.

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