An Open and Shut Case for the Chinese Economy

The themes of World War D (our recently concluded investment conference) just keep popping up in the news. Today it’s a contingent of the People’s Liberation Army heading to China’s border with Vietnam. Troops in full combat gear, tanks, trucks and artillery are all on the move, according to locals.

The reason is that economic warfare in the region took a violent turn. Vietnamese protesters recently destroyed Chinese factories and killed Chinese workers near the border. The Chinese had moved an oil rig into disputed waters, triggering the protests.

We wish the Chinese good luck if they want to take on the Vietnamese…

But maybe a good war is just what the Chinese need at the moment. Their falling house prices are going to need a major distraction to avoid serious social unrest.

More and more cities in China are seeing house price declines, especially in the periphery. The chart below shows the percentage of cities. This has the makings of America’s house price crash of 2007.

click to enlarge
Source: Macrobusiness

The Wall Street Journal reports real estate agents are literally fighting each other for access to clients. Buyers are fighting real estate agents over the discounts they’re offering new customers. Developers can’t roll over their loans. And local governments are losing a crucial source of revenue as their land sales dry up. Meanwhile, everyone is in debt, so the banking system is in trouble too.

Forecasts of China’s doom first appeared in The Markets and Money in March 2010. Now the story is playing out before your eyes.

If you’re smirking about our predictions being ‘too early’, you should know that’s how we like it. By the time a prediction sounds plausible it’s a lot less interesting. You can read about it elsewhere.

Pointing out a bubble while it’s still inflating is of course the curse of anyone who believes in the Austrian School of Economics. The Austrian Business Cycle Theory basically blames governments and their central banks for creating the instability that triggers bubbles like the tech boom and the housing bubble.

Unfortunately, the Austrians focus on the bust that inevitably follows a boom. A more optimistic bunch, say the Bavarians, might’ve pointed out the opportunity of investing in the bubble rather than the doom that will follow. But it’s a bit depressing to think of yourself as profiting off other people’s over-optimistic fervour.

Anyway, China’s bust is the major macroeconomic prediction that Austrians would consider an open and shut case. It has all the hallmarks of what it takes to create a bubble and all the symptoms an Austrian would look for. It’s a textbook case of the Austrian Business Cycle Theory in action.

To spot a bubble, Austrians would look for a ‘misallocation of capital’. Economic activity isn’t just about quantity, it’s also about quality. Investments that aren’t useful will eventually turn into a problem. The US’ and Europe’s housing boom is a perfect example. Houses stand empty by the thousands.

In China’s economy bubble, construction also plays a key role. That’s not a surprise because construction is commonly debt financed and central banks control the price of debt — the interest rate. Get the rate wrong and you get too much construction and too much debt, also known as a bubble.

So what might hint at a misallocation of capital in the construction industry? Here’s a fun stat: In 2011 and 2012 China produced more cement than the US did in the entire 20th century. Where is the cement going? The famous Enron and China short seller Jim Chanos explained it to CNN back in 2010:

[Our analyst] said they were building 5 billion square meters of new residential and office space 2.6 billion square meters in new office space alone. I said to him, ‘You must have the decimal point in the wrong place.’ He said no, the numbers are right. So do the math: That’s almost 30 billion square feet of new construction. There are 1.3 billion people in China. [In terms of new office space alone] that amounts to about a five-by-five-foot cubicle for every man, woman, and child in the country. That’s when it dawned on me that China was embarking on something unprecedented.’

Usually anyone trying to explain the Austrian Business Cycle Theory has to resort to an alcohol analogy. When the government uses fiscal or monetary stimulus, it’s like spiking the punch bowl. The party is awesome. But then comes the hangover.

China didn’t just spike the punch bowl with some gin. It added all sorts of ‘stimulus’. Capitalism on steroids has much the same result as an Olympics on steroids would. A bundle of records would fall. And then the athletes would drop too, once everyone overdoses and  kicks the bucket.

The hair of the dog treatment is as popular with policy makers as alcoholics. So far six Chinese cities are on the record as launching some form of ‘rescue package’ for their real estate markets…last month alone.

All this is causing problems for Australia’s mining sector. Having ridden the boom of Chinese construction our iron ore miners in particular are struggling this year. We couldn’t find a digital version of the Australian Financial Review’s charts, so here is the phone camera version:

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Source: Nick’s Phone (Australian Financial Review)

Yesterday mining shares racked up $4.8 billion in losses as the iron ore price fell below $100 for the first time this year.

Diggers and Drillers editor Jason Stevenson sent over his take on the action:

There’s panic in the iron ore market at the moment. However, it’s important to realise that 1) Chinese steel production is running at record rates and 2) Chinese iron ore imports were at their second highest level on record last month (the highest level was in December 2013). I wouldn’t be selling quality iron ore stocks at the moment and am expecting a rebound in the price in the second half of the year as more – more unprofitable Chinese mines will go bankrupt and this will likely be good for the iron ore price.

Jason has taken his sieve to the Aussie iron ore miners and found one he thinks will surge from Act II of the China boom. We’re far from convinced, but the insiders agree with Jason. The Chinese are buying into and joint venturing with Aussie miners like there’s nothing to worry about. What do they know?

it’s not just iron ore that China needs. It’s also the key gas export market that Aussie extractors and export terminals are gearing up for. Nobody knows for sure just how much gas China will end up gobbling up. But it’s a lot by anyone’s standards.

It looks like the Australian mining industry might get served when it comes to gas as well. A $100 billion gas deal between China and Russia is in the works. It could undercut Aussie producers by a third.

Maybe that will solve the gas ‘shortage’ in Australia. Remember that story? The idea that Aussie gas companies will export all our gas because the international market price is so much higher than the local one. That would supposedly leave us with no gas.

So maybe we should be thanking the Russians for solving our gas shortage.


Nick Hubble+
for The Markets and Money Australia

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Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like.

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