Hold On To Your (Made-In-China) Hats

The Bubble Has Burst

The Bubble in China has burst. We just haven't felt the ramifications of it yet because the process has only really begun this June when the equities market in China blew a gasket and went down from its bubbly heights. Make no mistake, that collapse in the equities market we witnessed in June was the point at which the Chinese economy hit its Minsky Moment. Yesterday's falls are merely the logical continuation of the spiral down. In September during the G-20, the head of POBC made comments to the effect that the market moved as if a bubble popped. Thus, we have to acknowledge the moment that we feared has in fact arrived.

The news in December was how China opened up a bond market for international investors, but somehow managed not to drum up good business. The tricky thing here is that like Japan, China's government debt is mostly held within China. There's very little debt owed to international markets. The complicating factor is how the Yuan/Renminbi is still tied to the US dollar in some way through a red - but if December was anything to go by, China has been devaluing the Yuan as quickly as it can. The long and short of it is that there won't be new money going into China from international markets. And if debt has reached saturation then, there's no inflating the sagging asset prices any more.

While China is too big to fail as an economy, it still has to navigate some kind of landing as it moves into a developed world, low-growth sort of economy. The long wished-for soft landing is looking less likely by the day, and instead it is looking more and more likely that China is headed for a solidly hard landing. A lot of this has to do with the inherent contradictions of containing an (ostensibly) market economy inside a pretty rigidly controlled economy. So on the one hand there is market competition, with say, many firms in any one area. But the prices of their output are still rigidly controlled, and so are wages. This leads to a situation where the central government demands 15% wage increases while not allowing for prices to go up because they're trying to control inflation.  The apparent growth that they report, is conjured from stealing from the margins of companies.

Under this arrangement, wages have exploded roughly 500% in the last decade, all of which was absorbed by the companies operating in China. Indications are now coming out of China that many foreign firms are retreating out of manufacturing in China, moving factories to Vietnam, Cambodia and even on to Myanmar and Ethiopia. Because the Yuan is pegged to the US Dollar, it also creates inflexibilities that result in phenomena where goods and services work out to be cheaper in Tokyo than Shanghai.

And that's just the framework showing signs of heavy contradictions between a market economy and a controlled economy.

Where Did Their Bubble Come From?

As it turns out, the single area where the government did not exert the usual controls turns out to be real estate. Technically, all of China's property belongs to the state, and farmers are leasing their land from the state. This has made it very easy to take the land from farmers in rural communities. Local municipal governments have paid a laughably small amount of money to remove the farming communities off the land, hand it to developers, and by the time they lease it out as commercial property, they are able to put a price tag on the same land that is 50 to a 100 times what they paid.

This magically large margin has gone into local municipalities as income; so much so that there are many municipalities that have anywhere between a third and a half of their revenue based on this mechanism. It means the municipalities don't have to raise taxes to find money to invest in infrastructure projects. The developers profit, the politicians profit, the bureaucrats arranging these deals profit form kickbacks, everybody involved gets a piece of the action.

Which illustrates why the Chinese government essentially let the property prices skyrocket. Of course, it is easy for the wants of the many to outweigh the needs of the few, but at a certain point the real estate prices became so unrealistic the whole market came off the boil. This led to sagging prices as well as people carrying enormous debt, sliding backwards and out of the market, putting even more pressure on property prices. In response the Chinese government stopped lending money for property and instead encouraged people to take out loans and buy financial products. In 24months, the Chinese equities market went up 250% and then this June, tumbled down 30% from its peak.

The thing to keep an eye on is the surge of money that flooded out of China, that financed other property bubbles around the globe. At the heart of it is the flipping of farm land into commercial land with no consideration for demand. If you were in a part of the chain that profited from this activity, you would have looked upon all this a once in a lifetime opportunity and really, there is nothing to do but take your money and run.

But consider this for a moment. The building of the massive ghost towns in China comes from this process of price controls and pegs on the one hand and abject profiteering off the land irrespective of demand on the other. Nobody wants to move to the ghost towns, certainly not at the prices being asked for, which means all of those developments are forces in asset price deflation waiting to be unleashed but for the moment are included in property prices in China. To some extent, there needs to be price discovery, but there are so many mitigating factors stopping that from happening, most of which are the state controls.

If China commits to moving to a market economy, then it effectively lets go of the controls it has been exercising for a long time. It's hard to imagine they'll do so. Instead, they are likely to keep applying controls in a bid to sustain the asset prices. You wonder how that scenario is going to play out. It can't be good - but the bubble has collapsed. Whatever kind of landing they can engineer, the landing gears are about to hit the tarmac.

How Much Of Our Bubble Is Their Bubble?

It's hard to say just how much of Australia's property bubble is directly because of China's bubble getting exported. It's not all of it, because Australian households themselves are carrying all-time debt. The private sector debt has been record high since well before the GFC. This suggests strongly that our bubble is not their bubble. That being said a few things come to mind. The recent growth in house prices coincided with the rise in revenue from high commodity prices. Those factors have all but disappeared with commodity prices hitting unthinkable lows and revenue dropping substantially. China's simply not going to buy iron ore and coking coal at the volumes and prices it did a few years ago. China's bubble bursting will hit our revenue even harder.

The other thing we learned this year was that even though Australia's economy is greatly dependent on growth in China, our economy is relatively unaffected by the daily gyrations of the Chinese Market. This is because not only is the Chinese market not really connected to the global financial markets, it doesn't seem to be connected to its own domestic economy. There are simply too many state run businesses lined up in the Chinese bourse, and everybody knows they are of some kind value, but they can't be understood from reading the balance sheets because nobody seems to be in the transparency business when it comes to business in China. And this means things take a long time to work their way out of the Chinese financial markets and affect the global financial markets. Add in the fact that most of Chinese government debt is held domestically by these state owned businesses, it gets very opaque as to how things might play out and at what rate.

We do, however know a few things. The real estate market in China had its Minsky moment in 2014. The state intervened to coerce investments into the equities market and this led to even more loans being made out to buy these assets to inflate. The bubble came undone in June this year. Commodity prices for things Australia has been selling China, have collapsed. There are serious signs the crunch is now on, but no indication for how this will spill out of China. But you have to say, when (not if) it happens there'll have to be a great readjustment of Australian asset prices, up to and including real estate.

Where To Now?

The new movement out of China is this Asia Infrastructure Investment Bank. All these nations signed up to go with an institution that is designed to be a vehicle for Chinese construction firms to go around the place and build stuff. The AIIB is meant to be China's response to the US influence over the IMF, but closer examination reveals it is some kind of investment vehicle designed to carry out a kind of economic colonialism on unsuspecting Asian countries. This isn't small potatoes because there are something like 100 steel manufacturers alone that have basically hit the limit and are desperately undercutting one another. All this Chinese capacity for processing raw materials and constructing infrastructure is looking for somewhere to go and keep doing its thing. You can bet your bottom dollar we are going to see some extraordinary things as a result of this movement.

Thus, if the AIIB ploy of building a modern day Silk Road transpires and all those companies somehow manage not to go broke when China has its hard landing, then a commodity-driven country like Australia might be able to keep supplying that process. If the AIIB fails to deliver, then we're going to see big wobbles up ahead. China is not only too big to fail, it's too dangerous to fail.

A Bank of America analyst thinks the possibility of a Chinese financial crisis is 100%. On the other hand, a Citigroup/Citibank analyst says it's too early to worry. The indication therefore is, soon, if not imminent.