Our good friend, (and meticulously dressed) Cullen Thomson, recently penned an article for GQ Magazine, I mean, Absolute Return, titled Domestic disturbance: China’s boom is more investment than consumption. Cullen consumes information as fast as anyone I’ve ever seen and is able to “put the puzzle pieces together” better than most macro thinkers we know. His thoughts are well worth the read. We think he’s spot on with this one.
Shortly after seeing Cullen’s piece, we came across this article in the FT from another friend and one of the top financial historians, Ed Chancellor – China’s bad debts a cause for concern. As always, Ed is a must read and a wealth of knowledge. After reading Ed’s piece, we tracked down the CSFB research he referenced and found it rather interesting that even their “hard landing” scenario assumes 7% real growth and a “sharp” rise in NPLs to 5-10%. Their base case is for a gradual rise in NPLs toward 2.5% through 2013. Remember, this should be measured relative to the 40% NPLS taken by Chinese banks just last decade, when loan growth wasn’t anywhere near levels seen during the past two years. And furthermore, when have you ever seen a “gradual” rise in NPLs? Cullen’s response – “kind of like “gradually” trying to let a fart out at a party. Not likely.
A few months ago, at CFA North Carolina’s Annual Forecast Dinner, Ed offered up the following Characteristics of Great Manias:
- Uncritically assumed growth story
- Overconfidence in authorities and moral hazard
- Easy money and credit expansion
- Investment boom and the misallocation of capital
- Agency issues: Don’t trust your broker
- Madness of crowds: Don’t trust your feelings
- Frauds: Galbraith’s bezzle
- Ponzi finance: Minsky’s financial instability hypothesis
- Luxury: Conspicuous consumption
- Bubble valuations: It’s all in the numbers
Cullen touched on many of these characteristics in his Unhedged Commentary, but perhaps our favorite example of Conspicuous Consumption is this Million-Pound Mutt, first highlighted in Ed’s presentation. I give you – the world’s most expensive dog!!
On a closing note, one of the best minds on China, Michael Pettis of Peking University’s Guanghua School of Management, providing the following concise analysis of “the problem” in a recent note:
“It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt . . . But dangerously high levels of municipal debt are only a manifestation of the underlying problem, not the problem itself. Even if the financial authorities intervene, unless they change the economy’s underlying dependence on accelerating investment, it won’t matter. They will simply force the debt problem elsewhere.
“In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.
“China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.
“I want to stress this point. Right now everyone is worried about municipal debt levels and wondering if Beijing’s plans to resolve the problem will work or not to clean up the municipalities. But this is the wrong focus. The problem is not whether or not the municipalities will be able to repay. Repayment simply means shifting the debt servicing to another entity, and we should be worrying not about the debt-servicing ability of specific borrowers but rather about the whole system.
“The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.”