Will China be the next Black Swan?

Evening. Sea face. Me and her, the setting sun, couples getting cozy all around us and a dangling conversation not of the superficial kind.

“You know, someone in office today was saying that China will be the next Black Swan. What is a Black Swan?” she asked.

“Well. A swan that is black in colour is a black swan,” I replied cheekily.

“Ho ho! That I know. But what is the inference being made in this case?”

“See, the term black swan has recently been made famous by Nassim Nicholas Taleb. But this was a fairly common expression even in 16th century London as a phrase describing the impossibility of an event occurring. The reason being that in those days in the western world, there were only white swans and hence, black swan was used to signify impossibility. Black swans were first discovered in Australia in 1697 by Willem de Vlamingh. Taleb essentially uses the expression to talk about events which are hard to predict and at the same time have a huge impact on the economy of a country if they occur. In the recent past, black swan has been used more often than not to signify a negative economic event.”

“Interesting. But why will China be the next black swan? What is the story there?”

“I happened to read a very interesting white paper titled China’s Red Flags written by Edward Chancellor. Chancellor points out that the continued high growth rate of China is more a function of government-directed lending through banks than the state of the economy itself. As Chancellor writes “Last year, new bank lending increased by nearly 10 trillion renminbi (the Chinese currency), equivalent to 29% of gross domestic product. These loans largely went to fund infrastructure projects, property developments… It was as if the economy had received an enormous adrenaline shot.” And all this money has helped China continue to grow at an astonishingly high rate despite the world being in the midst of what is now being called the Great Recession. Estimates suggest this government-directed investment was responsible for nearly 70% of China’s growth in 2008 and almost 90% growth in the first half of 2009.”

“But what is wrong with this strategy?”

“Well. See it like this: Botox may make an old woman look good for a while, but beyond a point, it has its side effects. So to continue to grow, China has to continue to invest more and more.”

“So?”

“Well. That is a very risky strategy to follow. Let me explain what the economists call the multiplier effect to make my point. You earn a salary of around Rs 65,000 every month. What do you do with that money?”

“First I pay my portion of the rent. And then I go in for my monthly retail therapy. Of course I also save some money every month.”

“Yup. Now, the money you spend is at some level, an income for someone else. Now the person who gets your money also goes out and spends the money he earns, which in turn is an income for someone else, and so the loop continues. This is known as the multiplier effect. The greater the multiplier effect, the greater the impact on the growth of the economy, because it basically boils down to people earning more and spending more. And the multiplier effect of this investment-led growth strategy is collapsing. As a recent note of Pivot Capital Management says, “The effectiveness of domestic credit in generating growth is collapsing. In the period from 2000 to 2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favourably with the peak $4 of credit for $1 of GDP in the USA in 2008. However in the first half of 2009 in China this ratio was already at around $7 of credit for $1 of growth.

Credit might be going into the luxury property and stock markets, but the trickle down to the real economy is very poor.” So the bottom-line is it is taking more and more money to generate the same kind of growth. And a lot of this money is being used to construct bridges and roads to nowhere.

“Also, the easy credit policy pushed by the government has “boosted construction activity and the residential real estate market”. At the same time, property prices have been on an upswing.  As Chancellor writes, “Over the course of the last decade, national home prices rose at an annual rate of 8% according to Morgan Stanley. This consistent performance has fostered a widespread belief that property prices can only go up… Last year, sales of residential properties climbed to 3.8 trillion renminbi, up 87% on 2008. Average home prices rose by 8% in 2009. Several local markets saw stronger gains, rising by 20% or more.”  

“And that is a problem?”

“Of course. Take the case of Beijing. The house price-to-income ratio is at now 15. For the period 2000-2008, it was 10. This means house prices have gone way beyond the affordability of the common man.”

“But if that’s the case, shouldn’t prices be coming down?”

“Yes, they should be. But the thing is “much of this excess supply is being held off the market by property “investors.” A recent survey found that nearly a fifth of all recently sold properties were kept vacant. Since new apartments tend to fall in price if they are rented out, many of these investor properties are kept empty.”

“I see,” she said.

“Also this easy money policy has also led to ghost towns being developed. “A news clip on YouTube (originally from Al-Jazeera) shows the newly constructed “ghost town” of Ordos. An interviewee suggested that building this empty city, with housing for a million, had let local officials meet their growth targets.” The infrastructure being created is being sponsored by local governments and financed by government-owned banks. As I mentioned earlier, a lot of this infrastructure isn’t really required. Given that, there is very little chance that these bridges, roads and railway networks that are being created will earn enough to pay back the loans that have been taken.”

“So how will these loans be repaid?”

“As Chancellor points out “If the economy continues growing at its past rate, then it’s assumed all of those new airports and toll roads will generate future revenues. Alternately, local governments could finance the loans with receipts of future land sales. The trouble is that land sales currently account for some half of local government revenue. So if the real estate market tanks, then the local authorities may have trouble fulfilling their implicit obligation to make good the infrastructure loans.” So in a way, the government has an incentive to keep the real estate bubble going and keep investing. Whether that happens or not remains to be seen.”

“And?”

“And what? That’s it.”

“You have nothing else to say?”

“Well, these white shorts you are wearing look really good on you…”

(The example is hypothetical)