January 14, 2010

The Economist Argues Against Bubbles in China

The Economist magazine argues that similarities between China today and Japan in the 1980s may look ominous. But China’s boom is unlikely to give way to prolonged slump.

* James Chanos, a hedge-fund investor, says that China is “Dubai times 1,000, or worse
* Another hedge fund, Pivot Capital Management, argues that the chances of a hard landing, with a slump in capital spending and a banking crisis, are increasing.

The three main concerns about China
1. overvalued asset prices
2. overinvestment
3. excessive bank lending

1. Asset Prices

Chinese share prices are nowhere near as giddy as Japan’s were in the late 1980s. In 1989 Tokyo’s stockmarket had a price-earnings ratio of almost 70; today’s figure for Shanghai A shares is 28, well below its long-run average of 37. Granted, prices jumped by 80% last year, but markets in other large emerging economies went up even more: Brazil, India and Russia rose by an average of 120% in dollar terms. And Chinese profits have rebounded faster than those elsewhere. In the three months to November, industrial profits were 70% higher than a year before.

House Prices
Tao Wang, an economist at UBS, argues that average income to house prices is misleading. Chinese homebuyers do not have average incomes but come largely from the richest 20-30% of the urban population.

China's average income to home price ratio has gone down over the last decade.

Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash. The average mortgage covers only about half of a property’s value. Owner-occupiers must make a minimum deposit of 20%, investors one of 40%. Chinese households’ total debt stands at only 35% of their disposable income, compared with 130% in Japan in 1990.

2. Overinvestment

Total fixed investment jumped to an estimated 47% of GDP last year—ten points more than in Japan at its peak. Chinese investment is certainly high: in most developed countries it accounts for around 20% of GDP. Per person capital stock in China is only about 5% of what America or Japan has. China does have excess capacity in some industries, such as steel and cement, but not across the whole economy.

Mr Chanos has drawn parallels between China and the huge misallocation of resources in the Soviet Union, arguing that China is heading the same way. The best measure of efficiency is total factor productivity (TFP), the increase in output not directly accounted for by extra inputs of capital and labour. If China were as wasteful as Mr Chanos contends, its TFP growth would be negative, as the Soviet Union’s was. Yet over the past two decades China has enjoyed the fastest growth in TFP of any country in the world.

3. Excessive Bank Lending

China's total credit jumped by more than 30% last year. Even assuming that this slows to less than 20% this year, as the government has hinted, total credit outstanding could hit 135% of GDP by December. The authorities are perturbed. This week they increased banks’ reserve requirement ratio by half a percentage point. They have also raised the yield on central-bank bills.

Recent lending has been excessive; combined with overcapacity in some industries, it is likely to cause an increase in banks’ non-performing loans. Ms Wang calculates that if 20% of all new lending last year and another 10% of this year’s lending turned bad, this would create new bad loans equivalent to 5.5% of GDP by 2012, on top of 2% now. That is far from trivial, but well below the 40% of GDP that bad loans amounted to in the late 1990s.

Total government debt could be 50% of GDP. But that is well below the average ratio in rich countries, of around 90%. Moreover, the Chinese government owns lots of assets, for example shares of listed companies which are worth 35% of GDP.

Japan’s stockmarket and land-price bubbles in the early 1960s offer a better (and more cheerful) analogy to China than the 1980s bubble era does. Japan’s economy was poorer then, although relative to America its GDP per person was more than double China’s today, and its trend rate of growth was around 9%. According to HSBC, after the bubble burst in 1962-65, Japan’s annual growth rate dipped to just under 6%, but then quickly rebounded to 10% for much of the next decade.

Two important historical Japan lessons for China. First, it is better to let the exchange rate rise sooner and more gradually than to risk a much sharper appreciation later. Second, monetary policy should not be too slack.

China has 20-30 years of growth based on comparisons of current development with Japan.

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