Is The Chinese Bubble Ready To Burst?
29 Jun 2011 - Andrew Barber
The discussion of whether or not the Chinese economy is a bubble destined to collapse, or if the recent rash of media over empty cities and spiraling food costs are merely sensationalistic hype masking an unstoppable growth story, has become a favorite Wall Street parlor game over the past year.
May trade data from China released earlier this month registered stronger growth in imports than consensus forecasts, suggesting that demand in the Middle Kingdom is remaining resilient despite the steady rounds of tightening that the People’s Bank of China policy makers began in the fourth quarter of last year. With interest rate and reserve ratio increases still failing to tame rising prices completely, some economists anticipate that currency appreciation against the dollar peg is remains a possibility. Simply put, the longer view of the situation facing Beijing is still very much a matter of debate.
One strong voice in this debate is Vikram Mansharamani, a Managing Director at Boston-based SDK Capital and a lecturer at Yale where he teaches a seminar on economic boom and bust cycles that served as the basis for his book 'BOOMBUSTOLOGY: Spotting Financial Bubbles Before They Burst' that was published earlier this year.
Mansharamani, who holds a PhD and two master’s degrees from MIT, helps oversee a long/short global equity portfolio. "I skin the cat thematically – what I look for structural long term trends on which I can bank for longs, and on the short side I look for things that fit my framework of bubbly conditions."
One example Mansharamani gives as a potential developing bubble is base metals. "The steel industry in China boomed from 5 percent of global steel production in the late 70s to almost 50 percent today; on the back of that surge was a voracious appetite for iron ore" he says. "Anticipating that Chinese growth will continue and extrapolating on past trends, the iron ore industry is now planning expansions equating to over 100 percent capacity growth in the next ten years. Well, hold on a moment: if China continues to grow at past rates, China becomes more than 90 percent of the entire global steel market – which is unlikely, and so it seems likely that the iron ore capacity may be rising just as slowing capital investments in China cools demand."
A native of western New Jersey, Mansharamani had an unlikely path to high finance. The son of an auto service technician and a dietician, he won a scholarship funded by Jack Bogle to attend Blair Academy, a private, co-ed boarding school in north-western New Jersey. Starting at the age of sixteen, Mansharamani began an unusual (for high school students) series of summers interning on the institutional equity sales and trading desk at Bear Stearns, where he reported to Mitch Jennings, a Blair alumnus, and Ricky Greenfield. After high school (and three summers at Bear), he entered Yale where he spent his summers very differently – working at the American Enterprise institute where he assisted the legendary Sinologist and diplomat James Lilley. The experience at AEI led to fieldwork in Asia (including a summer at the US Embassy in Beijing) that ultimately sealed his fate as a China focused investor.
Mansharamani recently spoke to InstitionalInvestor.com contributing editor Andrew Barber about the factors he considers when evaluating boom and bust cycles and how these stack up for China.
Institutional Investor: Your book is based on a course that you teach at Yale. Can you tell us a bit about the course and your approach?
Vikram Mansharamani: The book is based on a seminar called 'Financial Booms and Busts' which I have taught to undergraduates for the past two years. Because the course has been so oversubscribed, I have the opportunity to select students from differing majors. In the past, I have had students from history, psychology, biology, molecular biochemistry and biophysics, physics, American Studies, art history, East Asian studies, as well as the more expected economics and political science students. One of the reasons I proactively compose the class with students from different backgrounds is that I believe firmly that a multidisciplinary approach is essential for understanding booms and busts. I also sprinkle in students from all over the world to add a cultural dimension to the discussions.
I believe that problems can generally be classified along a continuum with two extremes: one extreme is a puzzle, which is a clearly defined problem for which there is an answer. When grappling with puzzles, we need to find more data. An answer exists. We need to find the needle, but because it’s buried in the haystack, we need to go through a lot of hay to find it. For puzzles, more data is helpful.
The other extreme is a mystery, which is a poorly-defined, ambiguous, uncertain and probabilistic problem. It is one for which there is no answer, so we can just gauge various scenarios. You can’t 'solve' mysteries, but you can 'understand' them.
I think of financial booms and busts as mysteries rather than puzzles. If you think of things as a mystery, the best approach to understanding various scenarios and their respective probabilities is through the use of multiple lenses.
That’s a long-winded background about the book, but the primary contribution I think I’m making is the presentation of a framework that moves beyond the use of a single lens. While reliance on one lens may work at times, it’s surely going to not work at some point. It’s not sufficient to use just microeconomics or macroeconomics, you have to think about psychology, about politics, about biology.
II: OK, so can you briefly describe each lens?
VM: Sure, as I’ve mentioned, there are five lenses that I suggest in the book. There’s no good reason why I limited it to five, other than space constraints. Frankly, in my eyes, the more the better. The five lenses presented in the book are microeconomics, macroeconomics, psychology, politics, and biology.
Lens 1 is a microeconomic lens and focuses on the concept of equilibrium. Traditional economic theory tells us that supply and demand adjust to create a stable price. But what happens if higher prices create more demand, rather than the expected supply? Bubble potential driven by self-fulfilling reflexive dynamics.
Lens 2 uses a credit framework to think about the foundation upon which asset prices have risen. The macro lens really builds on Hyman Minsky’s work related to capital structure evolution over time and the Austrian School’s beliefs in mal-investment and overconsumption as a logical consequence of inappropriately priced money.
Lens 3 is a psychological lens and takes the behavioral decision-making literature and applies selected lessons to asset markets. The insights I focus on are overconfidence and hubris and how that has the ability to really generate unwarranted convictions and whether people sufficiently adjust their expectations in light of new data.
Lens 4 is politics, and I focus upon very simple things – about price distortions via ceilings, floors and subsidies as well as tax policies that may change incentives and then the morals hazards that come from bailouts and supports and the political process of preventing failure.
Lens 5 is a biological lens, and there are two sub-topics upon which I focus. If you analogize a speculative mania to a fever transmitting itself through a population, one of the key metrics to understand is how many people are left to be infected. The lesson for investors is clear: when your taxi driver is talking to you about internet stocks, it's probably not a good time to be buying. The other topic of the biological lens is an emergence concept where I look at behaviors of ants, locusts and bees to illustrate how groups of seemingly uninformed individuals can develop conviction towards a particular path or outcome.
II: Can you apply your five-lens framework to China for us?
VM: Sure. Lens 1 finds that we have residential mortgages and loans to developers growing at the same time that property prices are rising. This is a tell-tale indicator of a reflexive, self-fulfilling dynamic at work. Bankers are lending money to buyers (and therefore creating demand) who are driving prices up (and making the bankers therefore more secure). The bankers fail to realize that they are the ultimate source of the rising prices.
Through Lens 2, are we seeing mal-investment, overinvestment, or overcapacity? This topic in China is very disturbing. There are entire 'ghost cities' today in China. My personal favorite is Kangbashi, which is a district of Ordos in Inner Mongolia. Kangbashi is a city built for 1.5 million people and, as of last year, it was housing around 20,000 people. This is a city that has museums, government offices, libraries, suburban areas, urban towers apartments, four-lane highways ... but is virtually empty. That’s a great manifestation of capital deployed towards non-economic purposes. Another example is the recently built South China Mall in Dongguan. Here, a mall was built to accommodate fifteen hundred tenants. As of last year they had around 15 or 20 tenants. That’s a 99 (ish) percent vacancy rate.
Disturbing as that may be, the mall was taken over by Beijing University who installed a new CEO and, when that new CEO was interviewed on Bloomberg earlier this year, his solution to the problem was perhaps as bad as the problem ... He is going to expand! He is going to add two hundred thousand more square meters, close to two million square feet, to help get critical mass. This is easy money at work – this is what it looks like.
When using Lens 3, we need to ask ourselves what we are seeing in terms of overconfidence. One of the most natural ways to find overconfidence in market is to look for world record prices, or any type of world record set from an asset perspective. That is usually a sign of national hubris and overconfidence being manifested in the form of buying behavior. The art market and wine market in China are spectacular cases to study – today Chinese bidders are continually setting world records at art auctions, not only ancient Chinese art finding its way home from the west but global artists as well. A Picasso was purchased last may for $110 million by a Chinese buyer. Wealthy wine enthusiasts are buying Chateau Laffite like it is going out of style. So wine and art markets are telegraphing signals of overconfidence but it doesn't stop there. ‘Mutton fat jade’ is a marbled jade variant that was historically used to fill bags to hold back flood rivers a few decades ago, but today it is selling for more than twice the US dollar price for gold. The world's most expensive dog was just purchased by a wealthy Chinese national – a Tibetan mastiff that sold at GBP1 million. The world's most expensive racing pigeon was just the subject of a bidding war between two Chinese nationals in Belgium as they were each intent on bringing pigeon racing to China. The list goes on, and on, and on.
One of my favorite indicators that combines the credit and psychological filters is the world's tallest skyscraper. Here is an indicator that, if you go back in time, you will see clearly predicts economic slowdown quite dramatically. In New York in 1929 three towers competed for the world's tallest status – 40 Wall Street, the Chrysler Building and the Empire State Building. In the early 1970s we had the World Trade Center and the Sears Tower followed by a decade of stagflation. In 1997, the completion of the Petronas towers in Malaysia came just before the currency crisis swept south-east Asia. In 1999, construction begin on Taipei 101 at the height of the tech boom. And at the height of the credit and commodity bubble of 2007/2008, Dubai took the crown with the Burj Dubai (now renamed to reflect the Abu Dhabi bailout). Today, five of the largest ten towers under construction globally are in China.
Why does this indicator work? Because the world's tallest skyscraper under construction is usually a sign of, first, speculative excesses – remember they are built by developers not the people who plan to occupy them. Second, there is no economic reason to pursue world's tallest status – that’s a simple manifestation of hubris and national overconfidence. And third, easy money – these things are never built with full equity financing – they’re they're usually built relying heavily on other people's money.
II: OK – but let's play devil's advocate. Does it matter that we are talking about a society which has suppressed built-up demand as opposed to seeing this reflected in a society that is relatively opulent to begin with? Do you think the fact that normal consumption, let alone conspicuous consumption, was not possible for Chinese citizens in years past might mark this as a more "normal" cycle of excess than a Dubai or Japan in the 80s? In other words is this celebration of new money psychologically less representative of a bubble than old money embracing excess on top of pre-existing wealth?
VM: I totally understand where you are going with that. Look, at the end of the day, private residential and commercial real estate didn't exist in china 15 years ago – this is a totally new phenomenon. But at the end the day I still stick with the conviction that this indicator is relevant because what is the purpose of having to be the world's tallest building? Why not just 100 stories? There are architects who have done analysis of structure height and economic viability and you reach a point somewhere in the process where you are realizing ever-diminishing returns on height. The optimal height is far lower than the world’s tallest towers. Consider the enormous magnitude of building going on in China and the facts presented by serious investors like Jim Chanos who said that he calculated roughly 30 billion square feet of commercial office space under construction last year in China. That equates roughly to a five by five cubicle for everyone in the country.
II: OK, now there is an overlapping observation that one could make here about what this type of consumption means for social stratification. Normally one could argue that a widening gulf between the ‘haves’ and ‘have-nots’ in any society carries negative ramifications, normally meaning in the context of a democratic or autocratic society of some sort.
In a communist society this type of disparity would appear to be toxic, potentially the most poisonous thing possible since it would appear to undermine the basic principals the Chinese government is founded on. Putin may be able to appropriate the role of Tsar in Russia, but the majority of Chinese people still seem to exhibit faith in the communist system and there is no better example than interviews of people in desperate poverty on television who still express hope that the government will fix these imbalances. Is social volatility the bigger long-term threat represented by these factors from a political standpoint?
VM: Yes. I absolutely agree. Social instability is what the communist leaders in Beijing fear the most. If there is anything that keeps them up night after night, I suspect it is the risk of revolution and popular uprisings. Social instability is the thing they will seek to avoid at all cost. Further, measuring the progress of the ‘average’ Chinese person is silly. The inequality is so large – China has one of the largest Gini co-efficients [a measurement of inequality and wealth] in the world – that averages are meaningless. It’s like placing your left foot in a bucket of ice water, your right foot in a bucket of boiling water, and saying that you are on average comfortable.
II: So the China bulls – the very committed bullish investors who are out there and advocating buying, would likely argue that all of what we have discussed is simply froth. That the excesses we have discussed are merely symptoms of pent-up demand and poor management on a micro level and that the underlying economic catalysts are so strong that the near term impact of recent cooling measures represents a buying opportunity. How do you answer this line of thinking?
VM: I have data in my book somewhere that there were 500 malls built in China over the past five years. Five hundred. There are many 'ghost cities.' Unfortunately, these aren't one offs. So the better question is are there measures that indicate the likely breadth of misallocated capital. And the answer is yes. The Capex to GDP ratio – which is running at extremely heightened levels and has for a decade, show that China is addicted to investment-led growth. We have had greater than 30 percent Capex to GDP for more than a decade. The last few times that I know of where this ratio has been that heightened for this long was Japan in the 80s and Thailand during the mid 1980s to mid 1990s. Both of those cases did not end well. There are very few examples where you have had Capex to GDP that high for sustained periods. What they are doing, and this gets to the political lens, the national priority of sustainable growth is in direct conflict with the local objectives of rapid and plentiful job creation.
The idea of sustainable growth is not part of the vocabulary at the provincial level. The way you rise in the communist party is by putting up good GDP numbers and creating lots of jobs. And so you have all sorts of irrational behavior that comes about when GDP is the target rather than the outcome measuring normal economic activity.
II: So in some ways China today is harking back to the five-year plans that were used in Russia and China during the last century. They demonstrated that a poorly chosen goal can open up a nightmare of unintended consequences.
VM: Absolutely right. Goodhart's law states that anytime you take an economic variable that has historically been used to measure a process and make that the objective of the process itself then it loses its value as a measure.
This makes a lot of sense: GDP is the target now, and it doesn't matter what you are doing, driving GDP is the sole goal – as opposed to "well we need to get higher return projects and lets add them all up and see what they generated."
Some things that have happened there make sense in light of this dynamic. You have a bridge that is seven years old – with a useful life of fifty (with proper maintenance) – [and it is] blown up and recreated. Why? Well the explosives and the clearing generate GDP, and of course the construction of the new bridge generates GDP so you get to double dip on that project while accomplishing nothing!
II: Ok so let's discuss how the Chinese consumer factors into this. If you look at the consumption patterns of rural and less affluent consumers in China it rings true with historical developing economy precedents. People are diversifying their diet, they may replace the farm automobile with tax incentives but the first thing they buy with disposable income are healthcare and education for the kids. So how you calculate GDP even suddenly becomes important – how you measure GDP can actually distort the picture, if you see what I mean?
VM: I do, I absolutely do. I think there are a whole bunch of problems that you encounter when GDP becomes the target rather than the outcome. Ultimately we are talking about a communist central planning organization. That's never been the most efficient way to deploy resources. They are very cognizant of the need to drive consumption and they are very aware of the need to establish a social safety net or else people will continue to save for that rainy day or healthcare cost.
It is a race between the inevitable falloff in investment led growth and the pickup in consumption led growth. The clock is ticking. They need to get that consumption engine really going before the investment engine peters out. Unfortunately, I think the investment engine is much closer to petering out than the consumption engine is to getting up and running.
As a side note, we spoke about social instability in the context of conspicuous consumption earlier, but I think that education in China is one of the ticking time bombs of potential social instability. They have made massive strides in the past decades and built up the university system to the point where they went from producing 800 thousand graduates in 1998 to producing roughly 7 million a year today. At the same time we have not seen comparable growth in white-collar jobs for Chinese graduates. The most disgruntled group is the most educated group, adding more fuel to the potential social instability fire.
II: So growth is the target and it’s only measured in one way, and as such provincial leaders only care about making tractors and bridges.
VM: Yes. Consider the Chinese situation through a growth accounting lens. You don't need a PhD in economics, or need to have read Solow’s work – Paul Krugman’s 1994 piece in Foreign Affairs called ‘The Myth of Asia's Miracle’ provides a very accessible and easy to understand description of growth accounting. Basically there are three effective sources of growth: you can put in capital, you can put in labor, or you can get productivity out of the existing stock of capital and labor. Those are the sources of growth. That's it. So if we look at Capex to GDP at very elevated levels we're getting lower and lower return for each dollar of investment and there is now a huge base effect that has kicked in because now we have so many dollars used for investments. A lot of these are one-off infrastructure projects – how are you going to get growth from investment next year? You are going to have to do exactly what you did this year – but that’s already a huge number. So it becomes incrementally a smaller and smaller source of growth.
What about labor? The broad population of China is going through an ageing process making the working age population smaller over time. The one-child policy created a blip, a slowdown in population growth rates. So that's not supportive of labor being a major support for growth in China going forward.
Finally, if you think of total factor productivity or the sort of combination of these – is there a way to get more out of the existing capital and labor stock? One good proxy for that factor in China is migration and/or urbanization: when we take the farmer out of the rice paddy and put him into a factory, he tends to be more productive.
Unfortunately, even here the data doesn't look good. The demographic most likely to migrate from rural to urban areas is 18 to 24 years of age. Of that population, because of the residency permit system (hukou), roughly a third has already moved to cities but they are not labeled as such. So right off the bat a big percentage of the people that we think of as rural are not rural. Roughly 230 million people between the ages of 18 and 24 were living in China in 2010, and that number is falling by roughly 25 percent over the next five years. So, many of these people have already migrated, the overall size of the age cohort is falling, and those that haven't migrated may be necessary to agricultural production. And finally, Chinese definitions of an urban area differ from ours. They define an urban area as one having population density of at least 1,500 people per square kilometer. By that definition, Houston would not be a city. So, what this means is that even if we adjust for the hukou distortions and the demographic data, we are still left with some percentage of the population that is living in areas that resemble cities, but are not classified as such. I am therefore not very optimistic that migration and urbanization will continue to be a source of meaningful growth.
Add this stuff up and it's hard to see how China's growth can be higher than around 5 percent a year for the next decade. The world is not expecting this outcome. If this scenario plays out, there will be big ramifications across many regions and sectors.
II: So we have one more lens to discuss, the biological factor driving the group dynamic.
VM: I will leave you with one thought that I think captures the essence of my concern. Today the largest buyers of land in auctions taking place on the municipal level are state-owned enterprises. So what does that mean? If we just pause for one second to think about this we realize that we have state owned banks lending money to state owned enterprises, to buy land from the state. And somehow we think there is a price mechanism at work. This is a spectacular self-dealing situation, very prone to accounting irregularities so common in transfer pricing or revenue recognition. That's not a dynamic that gives me great comfort; it indicates to me that private developers have been squeezed out, the private amateurs have been squeezed out and now we are left with professional amateurs being financed by the seller of the land. This is a 7th, 8th, or 9th inning phenomenon. We’re not at the start of the ballgame.
The ramifications are enormous, but the impact will be much more extreme in the ‘China industrial complex’ – ie, the countries and industries that have been supporting the Chinese development story, both within and outside of China. The commodity economies, the shipping industry, the suppliers of the capital goods china consumes – that’s where the pain will be felt most dramatically. In an ironic twist of fate, China may be relatively insulated against a Chinese slowdown.
II: So taken to its logical extreme, ultimately this leads us to a possible devaluation scenario.
VM: It's conceivable that there is a political game of sorts going on where the US effectively says "look, we need the jobs over here and we are going to take our currency and debase it through QE and, if you stay pegged to the dollar at the current rate we are going to create the inflation that you so desperately want to avoid because it is instability inducing – so you will be forced to appreciate your currency." If that were to happen, it would take the razor thin manufacturing margins that have existed for a long time and push them from the black into the red. In that scenario China will find itself between a rock and a hard place –between potential social instability and potential economic instability and they are not going to want either. They will eventually find that raising interest rates causes economic slowdown and hurts the growth story and possibly undermines the economic opportunity that has been the foundation of Beijing’s legitimacy in recent years. Following a material Chinese slowdown, it is not inconceivable that they will choose to devalue the Chinese currency. They’ve done it before, and my suspicion is that they may do it again. The current path of least resistance is likely for the currency to appreciate, but if the Chinese bust scenario transpires, a major devaluation may be the cards.
Andrew Barber is the director of strategic investments for Waverly Advisors, a Corning, NY based asset management firm.