Is China's Fast-Growing Economy Headed for a Crash?.
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In the housing boom that lasted from 2001 to 2007, highly motivated investment bankers capitalized on historically low interest rates, abundant liquidity, government- sponsored housing finance, political encouragement to make housing accessible to all, and mortgage-interest tax policies to create a securitization party of unrivaled scale and scope.
The hangover from this toxic cocktail continues to plague the global economy: The world still struggles with too much debt, the threat of deflation and the painful prospect of more deleveraging.
Similar dynamics are at work in the global food system: Forces are combining to create another dangerous bubble. This food bubble, like the housing one, has grown from a system that is focused on generating efficiencies through high volumes, which generate lower prices and increased consumption. The commoditization of loans and crops, supported by government policies to keep prices low, has led to overconsumption of credit and food — resulting in a highly leveraged society, and a national obesity epidemic.
Just as bankers created loans for standardized mortgage pools, most farmers now produce predominantly for commodity markets. And just as bankers stopped caring about their customers’ financial health, or even their ability to repay loans, farmers, under the heavy influence of government programs, have increasingly stopped growing food for the benefit of the people who eat it. In fact, industrial farming is generally not even producing “food,” but rather inputs for what author Michael Pollan calls “edible food-like substances” — processed foods.
Consider corn. While some of it is actually consumed as food (for example, “on the cob”), most is converted into animal feed, ingredients for processed food or feedstock for ethanol. The price of most corn grown in the world is based on qualitative variations from the benchmark No. 2 grade corn. By the U.S. Department of Agriculture’s definition, a bushel of No. 2 grade corn weighs about 54 pounds and contains no more than 5 percent damaged kernels and less than 3 percent broken corn and foreign materials. Just as unsophisticated buyers blindly bought AAA rated mortgage securities, so does the corn industrial complex readily accept all No. 2 grade corn. Similar dynamics exist for other commoditized crops, such as wheat and soybeans.
U.S. government policies have promoted the production of high-volume commodity foods. These policies date to the early 1970s, when poor harvests in the Soviet Union and bad weather in the American farm belt caused crop prices to skyrocket. U.S. News & World Report and Time magazines dedicated cover stories to food inflation and its social impact.
To prevent grocery prices from soaring 20 percent or more, Earl Butz, the secretary of agriculture in the Nixon and Ford administrations, made a series of policy changes designed to lower food prices. He did away with some loans to farmers, government grain purchases and incentives for leaving land idle during times of low crop prices. And he replaced them with direct payments to farmers to make up any difference between the market price and an artificial price floor.
Rather than discourage farmers from growing more crops when market prices were low, the new policy motivated them to produce more, regardless of price. The floor, which has been regularly adjusted, set a price at which farmers could effectively sell an infinite supply. Ballooning crop volumes drove prices lower, which, in turn, increased consumption.
Similarly, in 2001, when the Federal Reserve lowered short- term interest rates — to fight the deflationary forces from the popping Internet bubble — the price of money was driven lower, and that increased the use of debt.
In the past 30 years, food prices have fallen, on average, 1 percent per year, according to an analysis from the Department of Agriculture’s Economic Research Service. During the same period, the daily average calorie consumption in the U.S. has risen about by an average of about 400 calories, or about 18 percent.
There’s reason to think that the low price of food has led people to eat more of it, and especially the kinds of foods that are subsidized by U.S. agricultural policy. Consider that overconsumption is not spread evenly across food groups, but rather predominates among processed foods containing ingredients such as corn, wheat and soybeans, whose prices are heavily influenced by government policies.
Flour and cereal products account for 39 percent of the total increase in average American food consumption since 1980 – - about 155 additional calories — while whole foods not supported by agricultural subsidies are not being eaten much more today than before: The average American’s intake of fruit rose by a mere 6 calories over the past three decades, and calories from vegetables were flat.
In 2004, a dollar could buy more than 1,000 calories of cookies or potato chips, or 875 calories of soda, but only 250 calories of carrots or 170 calories of fruit juice, according to Adam Drewnowski, a professor of epidemiology at the University of Washington and director of the Center for Public Health Nutrition in Seattle. In other words, agricultural subsidies cause the least healthy calories to be the cheapest.
Given that about 3,500 calories is equivalent to a pound of body weight, it is easy to see that extra calories are a major contributor to our obesity epidemic — alongside inadequate exercise and a poor diet. Furthermore, given the strong linkages between obesity and cardiovascular disease, diabetes and other illnesses, our industrial food system appears to be no more sustainable than our pre-2008 housing-finance system.
Another unintended consequence of producing food in such large volume is that the bigger the yields per acre, the fewer nutrients the crops contain. Donald R. Davis of the Biochemical Institute at the University of Texas in Austin has looked at the evidence regarding the relationship between yield and nutrient content. The studies comparing high-yield and low-yield varieties of corn, wheat and broccoli show, in his words, “uniformly inverse associations between yield and nutrient concentrations.”
In a time of strained budgets and rising medical costs, we must think more broadly about the health effects of our food system. To ignore the connection between agricultural policy and public health would be as wrong as to ignore the link between housing policy and financial regulation. Presidential campaign debates and the renewal of the farm bill in 2012 may offer a platform for the conversation. Let us begin by redesigning agricultural policy to minimize incentives for overproduction and encourage the production of healthy calories.
Two agricultural subsidies, in particular, should be greatly reduced or eliminated: the marketing-loan program and the countercyclical-payments program. The marketing-loan program, which allows farmers to borrow using their crops as collateral, effectively enables farmers to lock in a minimum price via non-recourse loans. If market prices are lower than the government-set target price, farmers are not required to pay back the full loan amount. Yet if prices are higher than the target price, they keep the difference. Countercyclical payments act as their name suggests: When prices are lower, subsidy payments are higher — enabling farmers to again lock in minimum prices. Both subsidies focus disproportionately on commodity crops.
These programs create de facto price floors, allow farmers to ignore crop prices when deciding how to allocate land, and effectively encourage overproduction. From 1995 to 2010, the Department of Agriculture spent more than $50 billion on these programs. Eliminating them would save enough money not only to subsidize the farming of fruit, vegetables and other healthy foods, but also to sponsor education programs on how careful eating and exercise can reduce or prevent obesity. Acting now could help keep today’s cheap food and expanding waistlines from adding to tomorrow’s high health-care costs.
(Vikram Mansharamani, who teaches a seminar on financial booms and busts at Yale University, is the author of “Boombustology: Spotting Financial Bubbles Before They Burst.” The opinions expressed are his own.)
To contact the writer of this article: Vikram Mansharamani at firstname.lastname@example.org (Twitter: @mansharamani)
To contact the editor responsible for this article: Mary Duenwald at email@example.com(Originally published in Bloomberg View 2012. Reprinted with permission. The opinions expressed are those of the author)
by Vikram Mansharamani, PhD
As gold has been one of the most volatile assets in the past several weeks, with some analysts arguing for a $10,000/ounce fair value, many in the media and investment communities have asked me if gold is a bubble. To answer this very difficult question, I have chosen to apply the five-lens framework from my book Boombustology to gold today.
Let’s begin with my first lens, micro-economics. Most mainstream economic theories utilize a supply and demand driven price determination model that generally results in prices tending towards equilibrium. I say “tending” because most serious scholars admit that behavioral and informational issues can distort the price at any one point in time, but there exists an overarching philosophical belief that such distortions are rapidly ironed out. Markets are, according to this view, efficient. Higher prices dampen demand, and lower prices dis-incentivize supply.
Let us suppose for a minute, however, that higher prices increase demand. Such a dynamic might arise for many reasons, but one eloquent explanation for such an outcome in asset markets is the Theory of Reflexivity, as proposed by George Soros. Although the theory has many subtleties beyond the simplified “self-fulfilling” logic that many ascribe to it, the underlying implication of this perspective is that prices can and do tend away from equilibrium. In this case, boom and bust dynamics appear highly likely.
Turning to gold, it appears higher prices are indeed generating more demand. Might his indicate that a reflexive dynamic is underway? Are prices tending towards or away from an equilibrium level? Evidence from the Gold ETF (GLD) indicates that higher prices have correlated with higher demand for gold. The chart below shows the number of shares outstanding (i.e. a reasonable proxy for “demand”) and the price per share of GLD. The fact that these two metrics correlate indicates that both price and demand are aligning, a classic sign of bubbly conditions. Lens 1: check.
FIGURE: Gold ETF price per share vs. Gold ETF shares outstanding
My second lens is macroeconomics, with special attention to credit. In Chapter 11 of my book, I state that financial innovation that embeds or enables leverage can often provide fuel to a bubble. Indeed, rapidly rising leverage of any sort (direct or indirect) is cause for concern.
Consider the above-mentioned GLD, the gold ETF that enables individuals to purchase Gold directly in a brokerage account. Unfortunately, however, because I do not have access to aggregated brokerage account information, it’s hard to determine if GLD has been purchased on margin or financed with equity. Combine this with the double, triple and other leveraged ETFs that promise multiples of daily price moves. For good measure, add on a bit of small margin, high effective-leverage futures…and what you get is evidence of a credit fueled asset price dynamic. Consider the fact that I can today (as an individual) buy 100 ounces of gold exposure (>$150,000 at the time of this writing) through futures market by putting down less than $10,000. This enables me to have more than 15x financial leverage! Clearly, embedded and indirect leverage are clearly supporting the gold market. Lens 2: check.
Overconfidence and new era thinking are the hallmarks of my third lens, psychology. Whenever individuals develop a devout belief that “its different this time,” buyers beware. It is rarely different and asset prices generally go up and down and in this regard, gold prices too go both up and down.
So, is there a belief that gold is a “store of value” like no other? Absolutely. Is it deemed a commodity that is different than others? Perhaps it is considered protection against inflation…but others insist it is the only thing to own when facing deflation. The reality is that gold is a risk-asset like any other. Its price rises and falls. In fact, the fall is generally more frequent followed by an occasional but spectacular rise. For a concise analysis of historical gold price dynamics, read Ken Fisher’s Debunkery Bunk 35: “With Gold You’re Golden” which ends with an eloquent recommendation: “Feel free to buy gold – for earrings, necklaces, and electrical wires. But for your portfolio, gold has less luster unless you’re a super-duper timer.” Lens 3: Check.
The fourth lens of my bubble-spotting framework is politics. I tend to focus on government intervention and the distortions such actions have on market prices. This a complicated topic when it comes to gold, and one I will revisit after addressing my fifth lens.
An application of epidemic thinking to the study of financial bubbles has proven very useful in gauging the relative maturity of manias. Let us analogize an investment hysteria to a fever or flu spreading through a population. To an epidemiologist, the variables of concern include the infection rate, the removal rate, and perhaps most importantly, the percentage of the population not (yet) affected. The population of “yet to be infected” participants can be thought of as fuel that is available to keep the fire burning. Once we run out of fuel, the party’s over. Prices will fall. The investing implications of this logic can be illustrated with a simple piece of advice: Don’t buy whatever your taxicab driver is talking about. It’s too late. Widespread amateur investor participation is tell-tale sign that a bubble is in its last innings.
One way to gauge amateur participation in a financial bubble is observe media targeting everyday audiences. In this regard, gold is very concerning. While walking through the streets of NYC one recent afternoon, I saw no fewer than 14 signs offering to buy my gold, 18 signs indicated there was a willingness to sell me gold…and if I veered several blocks in the wrong direction, I’m sure there are eager individuals that would simply take my gold. Other confirmatory indicators include TV commercials, billboards, dinner party conversations, and the fact that everyone under the sun now has an opinion about gold. Gold is, in many ways, the ultimate greater fool asset. To make money investing in gold, you need someone with a belief more money is to be made to take it off your hands. Lens 5: Check.
Before concluding that gold is bubble (which I tend to believe is more likely than not), let’s revisit lens #4. While I generally do not subscribe to the many conspiracy theories arguing that governments are manipulating gold markets, the primary linkage with politics over long periods of time has been through the currency. Thus, we can ask if today’s policies are affecting currencies in a way that might be affecting gold. Given that gold is effectively an “anti-asset,” by which I mean it is the flip-side of fiat currencies, we need to evaluate what is happening in the market for fiat currencies…and in this regard, the upside pressure on gold remains. In many senses, I am therefore agreeing with Jim Grant’s point that gold’s price is an inverse indicator of investor confidence in central banks. Lens 4: half-check.
Thus, given that four and a half of my five indicators are flashing “bubble,” it is my view that gold is very bubbly. But as many bubble-watchers know all too well, the final innings of a bubble can be extremely profitable. Combine this potentially lucrative opportunity with a bit of career risk (from not-participating) and you get a very volatile situation. The gold game is not in the first innings, and in fact may be well beyond the seventh-inning stretch. When one considers the fat that gold does not generate any cash flow, costs money to protect, and is generally not consumed (i.e. 99%+ of the gold taken out of the ground in the history of the world is still around today), one must use extreme caution when dabbling in this market today.
Miss the last gains, but avoid potentially devastating losses? Or capture potentially very dramatic gains rapidly, with a known and elevated risk of big losses? Given investors are all prone to making errors, it may be more prudent at this juncture to make the error of omission (miss gains, avoid losses) than to make the error of commission (ride gains, capture losses).
Vikram Mansharamani, a Lecturer at Yale University, is the author of Boombustology: Spotting Financial Bubble Before They Burst, published by John Wiley & Sons. The book presents a multi-disciplinary method for identifying unsustainable booms in financial markets.
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.
by Vikram Mansharamani, PhD
College graduation is a time of great joy, of optimism, of forward-looking enthusiasm. Indeed, the very term “commencement” implies a positive new beginning. Unfortunately, this is not universally the case in America. Many students this year will graduate with questionable educations and mountains of debt; as more students go off to college and borrow money to do so, student loan debt in the United States is likely to top $1 trillion this year, exceeding credit card debt for the first time in history.
Might our strong belief in the value of an education be misguided? Is higher education in America a bubble about to burst? As a student of booms and busts, I have developed a framework for identifying unsustainable price dynamics, which are as applicable to higher education as they are to tulips, Japanese real estate, and Internet stocks.
Two primary dynamics seem to telegraph bubbly price action regularly through history’s great speculative eras. First, an unquestioning faith in the asset’s value leads to an ever-increasing universe of buyers, despite price increases. Second, the availability of “easy money” or “loose credit” is often driven by policies that generate significant moral hazard. Higher education in America today exhibits both of these warning signs.
The argument in favor of education is based on average salaries for differing education levels, and on the surface, the numbers are compelling. According to data from the U.S. Census Bureau, average earnings in 2008 for those with an advanced degree were ~$83,000, compared to ~$58,500 for those with a bachelor’s degree. This compares to high school graduates’ average salaries of ~$31,250.
Recent research from the Pew Research Center provides confirmatory data in the unquestioning faith in the value of an education: 94% of parents with children under the age of 17 indicate they expect their children to go to college. There is a broad universality of this view, with 93% of parents who did not graduate from college and 97% of those who did subscribing to this aspiration.
Despite these responses, only 5% of those surveyed by Pew indicated higher education provided excellent value for the money (57% say it does not even provide “good” value). Further, a college degree ranks fourth (work ethic, social skills, and technical skills all rank higher) in terms of perceived life success factors. Enrollment data does not reflect this concern.
The number of American college students has risen from approximately 9 million in 2009 to approximately 13 million over the past ten years. Enrollment in the for-profit education sector has been particularly brisk, rising at multiples of the overall higher education growth rate, with 2009 enrollment growth in the 20%-25% range. Marginal students have been wooed by this sector and have sought education in droves.
TOTAL FALL FULL-TIME COLLEGE ENROLLMENT IN AMERICA
(Source: College Board, Trends in College Pricing 2010, Figure 17a)
During that same time period, the price of a college education (i.e. tuition) has risen faster than inflation. Tuition and fees at public, four-year institutions have risen on average at 5.6% per year more than inflation over the past decade. While private college tuition has risen at a less dramatic rate (~2.5%-3.0% more than inflation), it was significantly more expensive to begin with.
Increasing participation of price- and value-insensitive buyers, check.
In its noble quest to provide educational opportunities to all Americans, the Department of Education has administered over $500bn in federal financial aid to students seeking post-secondary education over the last five years. For the academic year 2009-2010, the College Board estimated that total federal aid was approximately $147bn, a 136% increase over the past ten years, a growth rate faster than either enrollment or price increases might explain.
TOTAL FEDERAL FINANCIAL AID ($MM)
(Source: College Board, Trends in Student Aid 2010, Table 1)
The securitization market has fueled this development. Just as mortgage backed securities enabled rapid growth in housing finance, so too have student-loan asset backed securities (SLABS) enabled rapid growth in education finance. The dollar value of SLABS grew from approximately $76mm in 1990 to over $2.6 trillion by 2007. SLABS are deemed by some investors to be government sponsored securities (Sallie Mae played a major role in enabling this market) and due to the full recourse nature of student loans (i.e., filing bankruptcy does not eliminate them), many investors believe the risk of loss to be small. The rapid and brisk lending pace has enabled even marginal borrowers to obtain education loans without question.
Evidence from the for-profit sector is particularly concerning. Despite low completion rates (less than half of students who start finish their program), many for-profits receive close to 90% of their revenues from government financial aid sources. From 1987 through 2000, the industry received federal financial aid (Title IV funding) of between $2 and $4 billion per annum. In 2009, the industry received over $21 billion.
Easy money supported by moral hazard, check
One of the philosophical underpinnings behind the US housing bubble was the belief that all Americans should own their homes, even if they borrowed to do so. A similar philosophical belief has taken hold in higher education.
An increasing percentage of graduates are finding themselves burdened with student loans upon graduation; less than half of the graduates in 1993 received loan repayment coupons with their degrees. In 2008, more than two-thirds graduated with loans, having borrowed double what their 1996 counterparts did. Almost 50% of those with student loans indicate repayment makes it hard to make ends meet, and around 25% indicate student loans impact career choices and delay the purchasing of a home.
Parents, students, bankers, investors, and policymakers alike should reconsider the value of education and ask the uncomfortable but critical question: Is higher education an overvalued asset? Much of America has come to question the value of $1,000 per square foot homes. The time has come to reconsider the value of $1,000 per week education.
Vikram Mansharamani, Lecturer at Yale University, is the author of the recently released Boombustology: Spotting Financial Bubbles Before They Burst (Wiley, 2011). He has been an active participant in the education bubble, having acquired a bachelors degree from Yale University, two masters degrees from MIT, and a PhD from the Sloan School of Management.
As one who has fought with global equity markets during the past 20+ years, I remain confused by the typical value investor’s belief that “top-down” issues are not worth contemplating. Why is it that Graham and Dodd investing (as practiced by many value investors) downplays the role of context in the investment process? Wouldn’t the prudent investor want to understand risks and uncertainties relating to the environment in which he/she is investing?
Perhaps because I have spent a great deal of time investing outside of the United States, I have never had the luxury of dismissing macroeconomics, politics, or the actions of other investors. Consider Indonesia before and after the Asian Financial Crisis. Investing in the best companies at reasonable prices did not protect you. The utter bloodbath in the currency markets destroyed dollar returns. Likewise, many value investors faced steep losses during the second half of 2008 and the first quarter of 2009. Herd behavior and self-fulfilling dynamics unfortunately drive these dynamics.
Most of the time, Third Avenue’s Marty Whitman is correct that macro-factors are neither predictable nor important. However, this is not always the case, and just as extreme valuations merit attention, so too might macro extremes matter. How can we value investors effectively determine if we are at an extreme, and should therefore worry a bit more about the context? Surely it is worthwhile to know if a particular asset class is a bubble about to burst. Such an insight might allow us to tilt the balance of the errors we inevitably make towards errors of omission, rather than those of commission. While we may miss gains, we might avoid painful losses.
I have developed a five-lens framework for identifying financial bubbles before they burst. The first lens is microeconomics. In direct contrast to established economic theories of equilibrium, there are occasionally times when higher prices generate demand (rather than, or in excess of, additional supply). Such conditions are particularly prone to self-fulfilling dynamics likely to create bubbles.
The second part of my framework focuses upon credit conditions and the cost of money. While First Eagle’s Jean-Marie Eveillard has rightly highlighted the dangers of using leverage for investors, the same concern is valid for an economy in aggregate. If the foundation of prosperity is built on borrowed funds, it is only a matter of time before instability ensues. One of the primary culprits of such excessive borrowing can be found in overcapacity/malinvestment.
The third lens in my framework is psychology. We humans are unfortunately not the strict, economic-optimizing agents that social scientists might model us to be. We are plagued by cognitive biases that manifest themselves in overconfidence and anchoring upon irrelevant numbers. One of the best indicators of hubris is found in the phrase “world record price.” Whether paid for a building or a piece of art or a bottle of wine or a commodity, such prices are usually a sign of speculative juices running wild.
Fourth, political developments matter. Governments (particularly democracies) are subject to popular sentiment and as such, are willing to change the rules and/or generate moral hazard by bailing out the least prudent of market participants. Price distortion and politically motivated subsidies, handouts, and taxes can also alter incentives in a dynamic manner.
Finally, popular sentiment and herd behavior can affect securities prices more dramatically and potentially for longer than fundamental developments might. As such, understanding the actions of others and linkages to relevant markets has the potential to shed insight upon contagion risk.
In aggregate, these five lenses provide a probabilistic framework for increasing the odds of accurately identifying bubbles before they burst. Consider the case of China today. Let’s apply my five-lens framework to China.
China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. Consider property markets in which leverage and prices seem to be rising together in a highly reflexive, self-fulfilling manner. Higher prices are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity. Ghost towns and vacant malls are increasingly visible manifestations of this problem. Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption on the rise. Chinese buyers have set world record prices for art, wine, pigeons, and even dogs! Moral hazard runs rampant, and national-provincial dynamics are generating GDP growth through unnecessary construction. Perfectly usable infrastructure has been destroyed and rebuilt in pursuit of GDP. Finally, amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state.
Clearly, the ramifications of a Chinese slowdown would have material impacts upon commodity markets, emerging markets, and even the S&P 500’s business and earnings mix. In short, how China goes, so goes the world economy. It seems highly imprudent for investors to not consider the possibility of a meaningful slowdown in China’s economy.
I am not suggesting that we value investors abandon our focus upon the analysis of individual securities. We should not. Finding margins of safety from intrinsic values remains the most sensible method of investing. I am merely suggesting that when we do invest, we should be cognizant (rather than dismissive) of the environment and context in which we are operating. As eloquently summarized by Seth Klarman, we should all “invest bottom-up, but worry top-down.”
Vikram Mansharamani, PhD
Vikram Mansharamani is the author of “Boombustology: Spotting Financial Bubbles Before They Burst.” He is a lecturer on financial markets at Yale University.
Updated April 15, 2011, 7:05 PM
China today exhibits many of the tell-tale signs of a great speculative mania. Higher prices in many of its asset markets are generating demand more rapidly than supply. The cost of money is inappropriately cheap, driving mal-investment and creating overcapacity.
The ripple effects of a real estate slowdown in China will be felt in commodity markets around the world.
Confidence is bubbly, with skyscrapers rising, art markets booming, and conspicuous consumption galloping forward. Moral hazard runs rampant, and national-provincial dynamics are generating growth in gross domestic product through unnecessary and low return-on-investment activity. Amateur investors seem ubiquitous, and the largest developers today are state-owned enterprises using money from state-owned banks to buy land from the state. All of these indicators point to the fact that the Chinese economic story is unsustainable.
The most visible manifestation of the bubbly conditions in China can be found in the property markets of major coastal cities. A deflation of the property bubble plaguing these cities will be accompanied by a material slowdown in demand for commodities.
Consider the impact on steel, a product for which Chinese consumption accounts for almost 50 percent of global production. Approximately half of Chinese steel consumption is in construction, most of which is for property development. Any slowdown in construction would reduce global demand for steel and also for iron ore, which is used in steel production.
Likewise, given that 40 percent of the dry-bulk shipping industry is connected to moving iron ore to China, the property slowdown will be felt in Norway, Hong Kong, Singapore, Greece and other shipping centers. Because the shipyards in Korea, Singapore and China have themselves expanded to meet increased demand for ships, they too will face significant overcapacity. And on it goes. For better or worse, the Chinese property markets have a global value chain. The ripple effects of a real estate slowdown will be felt around the world.
China has been a story of investment led growth; capital expenditure as a percentage of G.D.P. remains elevated in comparison to China’s own history as well as that of other rapidly developing countries.
Many commodity markets currently reflect substantial continued investment. If property markets deflate, and overinvestment and excess capacity are revealed, Chinese growth may be 5 percent 6 percent for the next decade, an outcome for which the world and commodity markets are not prepared.