Inquiring minds are reading a GMO white paper on China’s Red Flags



In the aftermath of the credit crunch, the outlook for most developed economies appears pretty bleak. Households need to deleverage. Western governments will have to tighten their purse strings. Faced with such grim prospects at home, many investors are turning their attention toward China. It’s easy to see why they are excited. China combines size – 1.3 billion inhabitants – with tremendous growth prospects. Current income per capita is roughly one-tenth of U.S. levels. The People’s Republic also has a great track record. Over the past thirty years, China’s Gross Domestic Product has increased sixteen-fold.



So what’s the catch? The trouble is that China today exhibits many of the characteristics of great speculative manias. The aim of this paper is to describe the common features of some of the great historical bubbles and outline China’s current vulnerability.



Past manias and financial crises have shared many common characteristics. Below is an attempt to list ten aspects of great bubbles over the past three centuries.



1. Great investment debacles generally start out with a compelling growth story. This may be attached to some revolutionary new technology, such as railways in the nineteenth century, radio in the 1920s, or more recently the Internet. Even when the new technology is for real, prospective rates of growth may beexaggerated. Early growth spurts are commonly extrapolated into the distant future. ....



2. A blind faith in the competence of the authorities is another typical feature of a classic mania. In the 1920s, investors believed that the recently established Federal Reserve had brought an end to “boom and bust.” A similar argument was trotted out in the mid-1990s when it was widely believed that the Greenspan Fed had succeeded in taming the business cycle. The “New Paradigm” disappeared in the bear market of the new millennium. It was soon replaced with the “Great Moderation” thesis of Ben Bernanke, which suggested that high levels of mortgage debt made sense because monetary policymaking was so vastly improved. ...



3. A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear. As the nineteenth century economist John Mills observed: “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal in hopelessly unproductive works.” ...



4. Great booms are invariably accompanied by a surge in corruption. ...



5. Strong growth in the money supply is another robust leading indicator of financial fragility. Easy money lies behind all great episodes of speculation from the Tulip Mania of the 1630s – which was funded with IOUs – onward. ...



6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts. This lesson was ignored by the creators

of the European Monetary Union, which brought low rates and real estate booms to its smaller members, Spain and Ireland. ....



7. Crises generally follow a period of rampant credit growth. In the boom, liabilities are contracted that cannot subsequently be repaid. ...



8. Moral hazard is another common feature of great speculative manias. Credit booms are often taken to extremes due to a prevailing belief that the authorities won’t let bad things happen to the financial system. ...



9. A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become

precarious. Investments financed with borrowed money don’t generate enough income to either service or repay the loan (what Minsky called “Ponzi finance”). ...



10. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts. ...

1. The China Dream. For centuries, foreigners have pondered how to make money from China’s vast population. Today, the China Dream is more vivid than ever. The People’s Republic has more than 1.3 billion citizens, making it the world’s most populous nation. China’s rural population is gradually moving into its cities. A further 300 million country-dwellers – that’s roughly the same size as the U.S. population – are expected to head toward towns and cities over the next decade. It is generally assumed that the Chinese economy will continue to grow by around 8% annually in the coming years. ...



2.In the Communist Party of China We Trust.



Twenty years ago, it was argued that “Japan is different” and that Tokyo’s economic policies were better than the West’s. A number of best-selling books lauded the land of the rising sun. One bore the infamous title, Japan as Number One.



Today, similar claims are made about the singularity of the Chinese economy and the superiority of Beijing’s policies. And similar expectations are entertained about China’s inexorable march to economic primacy.



3. Investment Boom. In a market-oriented economy, investment might be expected to fall during a period of uncertainty and economic turbulence. Yet in 2009, Chinese fixed asset investment climbed by 30% and contributed 90% of last year’s economic growth. Investment rose to a record 58% of GDP. These are remarkable figures. The key question is: how well was this money spent? ....



4. Corruption. All great speculative manias have been accompanied by rising levels of fraud. Only in the bust do we get to see the full extent of the “bezzle,” as the Enrons, WorldComs, and Madoffs come to light. The upturn in China’s property and infrastructure spending, however, provides a cyclical spur to malfeasance. The People’s Republic recently slipped to 79th place in Transparency International’s 2009 Corruption Perceptions Index, just below Burkina Faso. ....



5. Easy Money. Nobel laureate Friedrich Hayek differed from his great rival J.M. Keynes. While the latter argued that bubbles were the result of turbulent “animal spirits,” Hayek claimed that asset price inflation followed from excessively low interest rates. Easy money, said Hayek, fed through to monetary and credit expansion, leading to inflation, either in the general price level or in asset prices. ...



6. The Fixed Exchange Rate and Capital Inflows. The Chinese currency, the renminbi, is pegged to the U.S. dollar. An undervalued exchange rate has boosted exports and kept interest rates low. It has also encouraged massive capital inflows, mostly in the form of foreign direct investment. Capital controls have limited inflows of hot money, although speculative inflows have picked up recently. ...



7. The Credit Boom. In response to the global financial crisis and the collapse of export orders, Beijing ordered its banks to go out and lend. Last year, new bank lending increased by nearly RMB 10 trillion, a sum equivalent to 29% of GDP. These loans largely went to fund infrastructure projects, property developments, and state-owned enterprises in a number of industries. It was as if the economy had received an enormous adrenaline shot. What most analysts fail to consider is the hangover that generally follows a credit binge.







8. Moral Hazard. The major Chinese banks are controlled by the state. They have a history of poor lending decisions. ...



9. Risky Lending Practices. .... No one can gauge the robustness of the credit system since Chinese banks appear particularly reluctant to report problematic loans. Ernst & Young published a 2006 report that estimated non-performing loans (NPLs) at $900 billion. This report was subsequently withdrawn. NPLs continued to decline in 2008 even as the stock market imploded and exports crashed. Fitch has suggested Chinese banks have been rolling over, or “ever-greening,” problematic loans. Bank employees have their own reasons for burying bad loans. A loan officer who reports problem debts is liable to have his salary reduced to below that of a migrant worker. Few seem to care about the practice of concealing nonperforming loans since it’s generally assumed that so long as the economy continues growing quickly, bad credits will turn good over time.



10. The Bubble. Surging credit has revived the animal spirits of Chinese investors. The Shanghai stock market recovered sharply in the first half of last year. On a single day in late July, turnover of “A-shares” in Shanghai exceeded the combined trading of the New York, London, and Tokyo stock exchanges. Chinese IPOs accounted for nearly two-thirds of global issuance by market value in the third quarter of last year. Chinese companies accounted for seven of the ten largest IPOs in the world. New issues were often massively oversubscribed and saw huge first day “pops.”

The Field of Dreams

Three years ago, Premier Wen described China’s economy as “unstable, unbalanced, uncoordinated and unsustainable.” The Great Recession hasn’t cured these imbalances. Rather, China’s ensuing investment and credit booms exacerbated them. The real estate market displays the classic symptoms of a bubble – stretched valuations, rampant speculation, and frenzied new construction. Sooner or later, this

bubble will burst.



In the past, whenever an economy has exhibited the 10 red flags listed in this paper there has been an unpleasant outcome. Forecasting the end game is no easy task since speculative bubbles can run to extremes. It’s made more difficult in this case by the fact that China is not a pure market economy. Stateowned enterprises can be called upon to prop up markets. Losses may be concealed or shuffled around like a shell game, as has happened in the past. Such measures, however, won’t cure China’s problems. They only delay the dénouement. ...

Global Imbalances

Spain, UK, Japan, Greece

US, Canada

Australia