Brian Fallow: Danger signs all too real for China

Should we worry that China is a bubble economy, bound at some point to go messily pop?

The Reserve Bank thinks not.

Deputy Governor Grant Spencer said yesterday, at the release of the bank's financial stability report, that not only China but other countries in the region had concerns about rising property prices in particular and were using a variety of tools to prevent a boom turning into a bubble.

He is "pretty confident" they will succeed.

Premier Wen Jiabao said last Saturday the Chinese Government would "decisively" contain excessive increases in housing prices in some cities and curb the growth of industries with overcapacity.

But among those with a less sanguine view is Edward Chancellor, an economic historian who has made a study of financial bubbles and who is a member of the asset allocation committee of the big US fund manager GMO.

In a widely cited paper, "China's Red Flags", he argued that it "exhibits many of the characteristics of great speculative manias".

One is a compelling growth story. China's compound growth rate of 10 per cent over the past 30 years means its economy doubles in size every seven years. But how long can it keep playing a double-or-quits game with fate and winning?

It is just trivially true that what cannot continue indefinitely, won't.

The supply of people ready to migrate from the rural hinterland to burgeoning industrial cities, keeping marginal labour costs low in the process, may still be very large but it is not infinite.

Then there are the implications of the one-child policy. At some point its initially favourable effect on the dependency ratio (the number of children and elderly divided by the working-age population) will flip, when for every only child entering the workforce four grandparents exit.

When will the tipping point between labour abundance and labour scarcity come? I don't know, but come it will.

Another concern is the nature and quality of the economic growth.

It is in a sense top-heavy, with spending on investment contributing twice as much as consumption to growth in demand.

Investment in physical assets is one of those good things you can have too much of, if is undertaken for the sake of it, to meet officials' per capita growth targets rather than to enable a subsequent rise in living standards.

"China has procured much wonderful new infrastructure during this period," Chancellor said, "but economic development has been accompanied by rising income inequality [and] a fall in consumption's share of GDP."

The extraordinary growth in credit China has seen since it eased in response to the global financial crisis has likewise raised concerns about the quality of the lending going on.

Rampant credit growth is another of Chancellor's "red flags", in fact he called it the most important leading indicator of financial instability.

The People's Bank of China reports year-on-year credit growth, by one measure, is running at 24 per cent.

You can either be alarmed at how high that number is (credit growth peaked in New Zealand at 15 per cent in 2007, by which time Governor Alan Bollard was standing on the brake pedal) or impressed it has come down from 31 per cent three months ago.

In this country we are concerned the last housing boom pushed average house prices to six times average disposable income, and household debt to more than 1.5 times income.

China-wide the price-to-income multiple is reportedly eight, and well into double digits in some of the bigger cities. Chancellor noted that that ratio hit nine times in Tokyo just before Japan's property bubble burst in 1989 and its lost decade began.

It is dangerous, however, to interpret Chinese numbers as if they applied to a Western market economy. There are all sorts of differences that make a difference, such as home-ownership rates and the much higher loan-to-value ratios banks require.

But the vulnerability to a serious property market correction must be high.

The construction sector is a large part of the economy, representing about 8 per cent of output, and vital to such heavy industries as cement and steel.

In addition local governments in China get a lot - often half - of their revenue from selling land into booming property sectors.

The comparative lack of social safety nets means households need high rates of precautionary saving out of their incomes. But interest rates are low.

The need for a rebalancing of the economy towards more domestic consumption and less reliance on investment and exports - the mirror image of what is required here and in other Anglo countries - is acknowledged at the highest levels of the Chinese Government.

But in making that happen they face some serious structural impediments.

One springs from yet another of the factors Chancellor cited in his bubble thesis, the fixed exchange rate.

It is, if not impossible, very difficult for monetary authorities to simultaneously manage the internal and external value of a currency, especially for a country running such large trade surpluses as China.

The risk is high that the large numbers of extra renminbi that need to be created to maintain an artificially low exchange rate with the US dollar will inflate the domestic money supply and enable asset bubbles to form.

Bloomberg reports property prices last month were 12.8 per cent higher than a year ago, while consumer price inflation at 2.8 per cent is at its highest for 18 months, even after the Government has three times raised the amount of reserves that banks have to hold and increased equity infrastructure for home buyers.

The flipside of China's mercantilist exchange rate policy has been the build-up of prodigiously large holdings of foreign exchange reserves, much of it held in the form of government debt.

Chancellor drily noted that "the only two countries to have accumulated such large foreign exchange reserves, relative to global GDP, were the United States in 1929 and Japan in 1989".

Oh dear.

Two other risk factors he cited were moral hazard - the danger that some enterprises are too big, or too state-owned, to be allowed to fail - and corruption.

On the latter measure, China does not score well. It ranked 79th, between Bukina Faso and Swaziland, in Transparency International's corruption perception index last year. New Zealand was No 1.