Peter T Treadway, PhD
Historical Analytics LLC
THE DISMAL OPTIMIST
June 18, 2010
“Because of statistics
I can dig out the deepest secrets
Because of statistics
I am not alone any more, I can play in the numbers
Because of statistics
I can re-arrange the stars in the sky”
– Love the Motherland, Love Statistics
by Wang Jiaowei, a statistician in Shandong Province
The Global Bears on the Hunt
Several prominent global bears – hedge fund managers Jim Chanos and Hugh Hendry among them – have concluded that China is engaging in a major misallocation of capital that will not have a happy ending. Overinvestment in basic materials and infrastructure, lack of profitability of the state owned companies that dominate the economy, death of the export model, and a major real estate bubble are among their concerns.
Frankly, they offer a compelling case. But unfortunately they have to be guessing, perhaps more than normal. China is a country like no other. Being half-capitalist, half -socialist, it fits no conventional model. China’s statistics, as compared with those released by say the United States, are sparse, manipulated and unreliable. Moreover, the country operates in a language the rest of the world can neither read nor speak. It is said John Paulson knew the mortgages in the portfolios he shorted right down to their zip codes. Macro economist-bears like Gary Shilling had been able to analyze American mortgages in great detail for years prior to the 2007 crisis. Available data on Chinese mortgages isn’t remotely comparable.
At the same time they are groping with less than adequate statistics, the global bears may be underrating the some things that cannot be modeled: The singular desire of China’s citizens to work hard and their obsession with improving their material lot. And, to use the terminology of Martin Jacques in his marvelous book When China Rules the World, the fact that China is a unique civilization state which in my opinion gives it tremendous advantages at this stage of its economic development.
Excepting the Tibetans and the Uyghurs, absent are the racial, religious, regional, caste and language differences that complicate economic decision making and upset public order in countries such as India (although the Indians might argue their diversity is a source of strength.) China, contrary to the views of some skeptics, is not about to disintegrate. Han China, so its own mythology teaches, has a five thousand year history as a civilization. Periods of order have been punctuated by periods of disorder. China is just emerging from a two hundred year period of disorder. A relapse to disorder will not be tolerated by its populace or its rulers.
Confucianism, Legalism, Daoism, Buddhism and Communism have each inserted themselves into the Chinese DNA over the centuries, each building on its predecessors. The intellectual giants who shaped the West, be they Aristotle, Adam Smith or Thomas Jefferson, don’t figure at all in this process. No Chinese emperor, and there have been emperors for thousands of years, would have sided with Google.
But luckily for investors and the world there is the global consumer culture. China may have missed Aristotle, Smith and Jefferson but it has not escaped from Louis Vuitton and the whole phalanx of global consumer brands. The most important “ism” infiltrating the Chinese mind today is consumerism. The current Chinese fascination with and knowledge of European luxury brands – which never ceases to amaze Western observers –is indicative of an overwhelming desire to become rich and enjoy the “benefits” of modern civilization regardless of the costs. The Chinese government’s claim on legitimacy rests on its ability to bring these benefits to its people. If authoritarianism serves this end, that trumps all. The government’s decisions will be guided by this fact and its mistakes, including those pointed out by Western observers, will be corrected. Consumerism, not Soviet style overinvestment in heavy industry or Communist propaganda, is what the rulers must deliver. Luckily, that is just what the world wants out of China as the export model is dead. The current American obsession with doing more with less – a product of debt deflation – is regarded with pity and a sign of weakness by the average Chinese.
The bulls’ answer to the global bears is that hard working, materialistic China will quickly grow into its excesses in housing and infrastructure. And that the government will have to make the necessary policy adjustments. Buildings empty today will not be tomorrow. Unfortunately, the bulls cannot model or offer the usual quantitative evidence for their case.
My own view is that these positive long run socioeconomic factors will cushion the blow of asset misallocation that the global bears have correctly identified. The Chinese short trade —which is already underway – may not be wrong but it may not be as rewarding as was shorting subprime mortgages and lenders in 2007. The Chinese stock market will not decouple if the US and Europe relapse into a double dip. But rather than play the short side, in my opinion investors should be doing their due diligence now on Chinese stocks that will prove to be great long term investments once the non-Chinese global problems cease to worsen and China has made some important macro changes including that relating to its currency and resource allocation. To be rich is still glorious in China.
Chinese Banks-Buy, Sell or Hold?
In the United States, Japan and other Western countries, governments inject liquidity and capital into their banking systems, and hope that the banks will start lending and their money supplies will grow as a result. Often they don’t as for example in the United States bank loans have been declining since mid-2009. Partly as a result money growth has been tepid. The US government does not force banks to lend (not yet anyway!). Fannie and Freddie, now both under government control and no longer with any pretence of trying to earn a reasonable risk adjusted return or indeed any money at all, are the only exceptions to this.
In China it’s the other way around, at least in 2009-2010. The government said “lend” and the banks, largely government owned, complied. Yoy bank loans grew at 31.7% in 2009. As of April 2010 the yoy growth rate had slowed only moderately to 24.11%.
Such a rapid acceleration of lending will inevitably bring with it a rise in non-performing loans. The only question is how much. It’s taken as a given that the government will bail out the banks as it has done before. China has its own version of moral hazard. Still this, along with recent government measures to limit house price appreciation and possibly impose a national real estate tax, makes for a bumpy future for Chinese banks. The government bailout may only cover part of the problem and it may not come until after some period of time. Hence Chinese bank stocks, including those trading in Shanghai and Hong Kong, have suffered some 20 percent decline in prices since November 2009. Property stocks have declined even further.
In response to this lend first, worry later policy, the Chinese banks are now coming to the market to raise more capital to support the lending they have already done. They have been coming to a less than friendly market. For example, the Bank for Communications or BOCOM (HK: 3328) has announced a rights offering which already has been scaled back. The Agricultural Bank of China (ABC Bank) has apparently also scaled back its dual offering in Hong Kong and Shanghai to $23 billion. Still a huge offering by any standard, one would think this would be a tough sell. One would think investors will be unenthused about buying shares in banks that have made a substantial but unknown amount of potentially non-performing loans, some of which will probably be bailed out by the government. And in banks that are run as instruments of government policy rather than seeking to earn a competitive risk adjusted return.
But there’s more here than meets the eye. Reportedly, two legendary Hong Kong tycoons and property developers, Li Ka-shing and Lee Shau-kee, have signed on as “cornerstone” investors in the ABC issue. Other Chinese heavyweights and some sovereign wealth funds have also been reported as having interest in cornerstone positions. Do they know something the short sellers don’t ?
The Renminbi Should Float
For the last year and a half I have argued that the renminbi was undervalued against the dollar. This may still be true but the case may not be as compelling as before. First, easy Chinese monetary policy as described above has unleashed inflation in China. The currency has been revalued in real terms as the China price is not as competitive as it used to be. Evidence of this is coming in from all sides, viz., the steadily upward creep in the CPI, the pickup in house prices and the continuous reports of labor unrest and wage increases in Chinese factories. I expect to see the Chinese trade surplus diminish and see May jump in this number as an anomaly.
A second reason for doubting the overvaluation of the renminbi is the fact that, being pegged to the dollar, it has significantly appreciated along with the dollar against the euro.
In my opinion, the Chinese authorities should have as an objective that the renminbi would float against the dollar. In the post-Bretton Woods world of floating fiat currencies which have no intrinsic value, it makes sense for the market to determine the value of the major currencies like the dollar, the yen, the pound and the renminbi. Even the Indian rupee floats to some extent. Major countries have floating currencies. Small fry like Hong Kong dollar can be pegged to the major currencies. China by pegging to the dollar is not behaving like the major economic power it has become and is offering itself as a target to its political critics in the US and elsewhere. Stuck as it is with the US dollar, it is also stuck with Ben Bernanke’s zero interest monetary policy. Raising Chinese interest rates – which is a good idea –will bring in a flood of unwanted dollars. The US is bordering on deflation. China is not.
Does the Minsky/ Kindleberger Debt Deflation Model Apply to China?
The general pattern of real estate bubbles has been one of a rapid rise in real estate values financed by bank debt. When the asset values reach extreme values, the bubble pops perhaps due to some government action to restrain the process and asset values plunge. Borrowers suffer financial distress as they find themselves in a negative equity position as the value of their mortgages begins to substantially exceed the value of their houses. Banks in turn experience rising non-performing loans and in many cases, since the bulk of their loans are secured by real estate, become insolvent. A significant recession always ensues.
Versions of this model have been put forth by economist Hyman Minsky and financial historian Charles Kindleberger. Further research summarized in a recent book by Kenneth Rogoff and Carmen Reinhart provides examples of this boom-bust bank insolvency recession cycle for a number of countries. The model would appear to describe very well the experience of the US from 1998 through the current real estate bust. Likewise, it would describe the Japanese real estate boom bust which commenced in 1985 and peaked in 1990.
Does this model fit what is happening in China? In the US the available data clearly showed that a substantial portion of the population had mortgages with very high loan to value ratios, mortgages with disguised and unaffordable interest rates and low credit quality. Good statistics on delinquencies, vacancy rates and house prices enabled the markets to monitor the progress of these loans. This isn’t possible in China, especially for commercial real estate, but also even in the residential sector.
Cultural differences may confuse things further. Traditionally Chinese only paid cash for home purchases although that clearly has changed. Moreover, it is often said today that when couples purchase their first home that six people are buying, i.e. the couple (who are only-children) plus their parents. Also it is also said that wealthy Chinese, with limited investment alternatives, real negative bank deposit rates, and low carrying costs on residential property (including no property taxes), buy condos like they would buy gold. By this reasoning the incredible 40% or so high-end vacancy rates that one hears for cities like Shanghai and Beijing are less serious.
Is Chinese residential real estate so wildly overvalued and overleveraged that it will send middle class Chinese consumers into a debt deflation downward spiral and concomitantly render the banks insolvent? Frankly I’m skeptical of such a conclusion. Certainly not yet. In terms of the Minsky/Kindleberger model it still may be early days in China. It is unlikely that the average Chinese middle class consumer is over his or her head in mortgage debt as was (and is) his American counterpart. For one thing, the Chinese real estate bubble only really got going in 2009. China like the rest of the world suffered from the global financial meltdown in 2008. Prior to that there were two events which served to temper Chinese real estate enthusiasm. In 2003-2004 the Chinese market suffered from the SARs outbreak and in 1997 from the Asian crisis. According to the Case- Shiller Index, American house prices started accelerating in 1998 and moved continuously upward until 2006. Finally, contrasting with Allen Greenspan’s indifference, the Chinese government has moved to put a halt to the high end residential bubble.
But there is one major qualification. Professor Victor Shih of Northwestern University has alleged that in the last two years substantial bank loans have been going to special entities owned by the local governments. Shih’s number is RMB 11 trillion ($1.4 trillion). These entities according to Shih have redirected the money into real estate and infrastructure projects and are of themselves of dubious credit quality. The government has now conceded Shih is on to something although it says his numbers are too high. But if Shih is anywhere near right, China is a more indebted country than many have thought.
Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
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