A Cautionary Fable

ONCE UPON a time, Western opinion leaders found themselves both impressed and frightened by the extraordinary growth rates achieved by a set of Eastern economies. Although those economies were still substantially poorer and smaller than those of the West, the speed with which they had transformed themselves from peasant societies into industrial powerhouses, their continuing ability to achieve growth rates several times higher than the advanced nations, and their increasing ability to challenge or even surpass American and European technology in certain areas seemed to call into question the dominance not only of Western power but of Western ideology. The leaders of those nations did not share our faith in free markets or unlimited civil liberties. They asserted with increasing self confidence that their system was superior: societies that accepted strong, even authoritarian governments and were willing to limit individual liberties in the interest of the common good, take charge of their economics, and sacrifice short-run consumer interests for the sake of long-run growth would eventually outperform the increasingly chaotic societies of the West. And a growing minority of Western intellectuals agreed.

The gap between Western and Eastern economic performance eventually became a political issue. The Democrats recaptured the White House under the leadership of a young, energetic new president who pledged to “get the country moving again”–a pledge that, to him and his closest advisers, meant accelerating America’s economic growth to meet the Eastern challenge.

The time, of course, was the early 1960s. The dynamic young president was John F. Kennedy. The technological feats that so alarmed the West were the launch of Sputnik and the early Soviet lead in space. And the rapidly growing Eastern economies were those of the Soviet Union and its satellite nations.

While the growth of communist economics was the subject of innumerable alarmist books and polemical articles in the 1950s, Some economists who looked seriously at the roots of that growth were putting together a picture that differed substantially from most popular assumptions. Communist growth rates were certainly impressive, but not magical. The rapid growth in output could be fully explained by rapid growth in inputs: expansion of employment, increases in education levels, and, above all, massive investment in physical capital. Once those inputs were taken into account, the growth in output was unsurprising–or, to put it differently, the big surprise about Soviet growth was that when closely examined it posed no mystery.

The source of the cautionary fable outlined above is Paul Krugman’s 1994 essay titled The Myth of Asia’s Miracle. While we applaud Morgan Stanley’s Stephen Roach for his plea to take a baseball bat to Krugman for “giving Washington very, very bad advice,” we can’t help but think that the Nobel Laureate got this one right.  A few short years following the publication of this essay, the Asian Crisis proved that trees don’t grow to the sky.

Consequently, it is important for investors (and politicians) to understand that the concerns surrounding the rise of China today are not new.  In fact, they are quite similar to past threats faced by our great nation – the Soviet Union in the 60s, Japanese Superiority of the 80s, and the Asian Tigers in the 90s.  The lessons learned, from an investment perspective, are no different than the countless experiences of bubbles past – if something can’t go on forever, it won’t.  If it seems too good to be true, it probably is.  More often than not, investors are rightly focused on the odds that circumstances turn negative.  But every so often, it is much more important to consider the consequences of these low probability events.  With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial.

There is no such thing as a bad investment; only a bad price.  We were constructive on Chinese equity markets early last year, as we discussed in the First Quarter 2009 Broyhill Letter.  We still believe that Blowing Bubbles in emerging markets may well develop into the next Financial Mania.  But after triple digit percentage increases from the panic lows reached one year ago, investor fear has been quickly replaced with greed.  And greed has an unfortunate habit of making investors blind to risks.  We’d encourage China bulls to consider the following:

  • Chinese leading economic indicators are stalling and topping out, whereas they were recovering from depressed levels last year.

  • Chinese Fixed Asset Investment as a per cent of GDP is massive and unprecedented in history.  See Krugman’s essay for implications.

  • Chinese Real Estate is a bubble.  Period.  A recent NYT article notes that apartment prices in Shanghai have reached up to $200K where most residents earn less than $5K annually.

Can the Chinese economy and risk assets continue their relentless march higher?  Sure.  Forecasting the timing of such trend changes is always a challenging (and frustrating) exercise.  But just because the timing is questionable, doesn’t mean the risks should be ignored.  GMOs Edward Chancellor outlines many of China’s Red Flags in a recent white paper.  I’d hope we’ve learned at least that much from our own domestic housing bubble which defied gravity for longer than most anyone expected.  We wonder how industrial commodity prices would fair if the Chinese decided that 30 billion square feet of office space is probably enough for now . . .

Disclosure: At the time of publication, the author was short iShares FTSE/XINHUA China 25, although positions may change at any time.