China series part 2: The coming crash

This is the second in a five part series on China. You can see part one here. Part three is here.

Chinese growth is steaming along.

But the thing about growth is it seems to lead to imbalances. There’s always something funny building up in the economy and/or financial system.

In 2008, it was US subprime loans that proved the spark for a big global recession.

The 1990s “recession we had to have” was also driven by an asset price bubble following the long boom of the 1980s.

In China, I’m worried about property prices.

China’s property prices have grown incredibly fast. Here’s an article reporting 20 per cent growth just last December.

If you think you can sell property at high prices, you build a lot of it. The world’s media has gone crazy for the side-effect of this: ghost cities. Vast towns where there are buildings but not enough people to live in them.

On my recent trip I was gobsmacked by the number of buildings going up in China.

Economists are trained to be cautious around their intuitions and gut feelings. The best bits of economics are, after all, counter-intuitive.

But I couldn’t help wondering what would become of all this building. A lot of old buildings are being knocked down, sure, but if the replacements for two storey courtyard houses are 20 storey apartment blocks, and there is no population boom afoot, the risk of over-building is real.

If China’s property boom turns out to be a bubble, and Chinese growth slows or reverses, the effect on Australia will be nothing short of a calamity. The mining industry and the housing market will do a simultaneous nose-dive. The biggest companies in our stock exchange will lose a lot of their value. Wealth will be crushed, spending will stop, bankruptcy will be rife, firings and downsizing will follow. In short, a recession.

(And if we have Tony Abbott and Joe Hockey in charge at the time, we are unlikely to get an adequately Keynesian response)

One closely watched canary in the coal mine is the interest rate between Chinese banks.

It spiked in June, December, and again this week. The precise meaning of that is uncertain. But it certainly looks like the central government trying to discourage cheap capital flows. So far, each spike has been short-lived.

Here’s a quote from a guy who claims not to be worried, Hermes Fund Managers Gary Greenberg.

“Yes, the property market has overheated in certain areas and yes, perhaps property prices will come down, but it won’t necessarily have a major detrimental effect on the banking system, primarily because the banking system hasn’t been the main funder of property prices.”

The thing about the Chinese financial system is that because the banks are so regulated, people lend money through the “shadow banking” system. That name sounds a little spooky, and so it should.

The Alibaba group offers a savings product that pays 6.7 per cent, compared to the official banking rate of 3 per cent. Managed funds like this have reportedly doubled inside 6 months.

That reminds me of the Pyramid Building Society, which went broke in the 80s. Crazy high rates can genuinely prove too good to be true. If Alibaba is raising capital at a high rate, and lending to property investors, it is worth asking if it could end up insolvent when property prices fall. And it is worth asking if that might spread.

Here’s Ben Bernanke earlier this month reflecting on his big mistake – being sanguine on property prices.

“[O]ur expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.”

China’s shadow banking system has helped propel the country’s debt-to-GDP ratio over 200 per cent. The biggest burst of economic growth in history stretches back to 1975. It will end one day. Probably not in 2014. But it will be worth being prepared when it happens.