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The Chinese Black Swan. Coming Soon To A Country Near You?

By Dan Harris on Posted in China Business

I  am not for a moment saying this is what is going to happen in China, but I am saying this is a well thought out analysis by a very thoughtful and well-respected investment advisor (not just a magazine columnist or someone claiming to be a China investment analyst simply by virtue of having lived there for a few years).

The “this” is an article entitled “The Chinese Black Swan,” written by Vitaliy Katsenelson, stating that China’s economy and real estate are on the verge of collapse. Again, I am not saying I agree with it, but it certainly is worth pondering. 

What do you think? Does anyone really know the extent of China’s bad loans? Would you buy a condo anywhere in China right now?

  • Aaron

    The last question is a bit misleading. Not wanting to buy real estate in China right now doesn’t mean much. I don’t want to buy real estate in a world wide recession in general, any where.
    Vitaliy Katsenelson, like other China doomsaying bears, make 1 critical error of assumption about China.
    “Collapse” is defined by the inability of a government to take any viable course of actions on its own resources.
    The critical error is the assumption that the Chinese government has ONLY the same set of tools of traditional market intervention that are available to Western governments.
    While China is currently using the traditional market intervention tools, they are not hesitant to use other tools. (Seriously, if Chinese government is capable of manipulating currencies, why consider them incapable of throwing their whole weight into the market, like any real merchantilistic government?)
    In short, the Western governments may be restrained by their own principles of “limited government” from putting their hands into the economies, (but that is probably not very true any more, considering the bailout of US auto industry and banks).
    China is not restrained by such principles.
    “Collapse”? China is the ultimate “Too big to fail”. Bad loans? Speculative real estate? I guess instead of buying up new US treasuries, just have to eat up the loses.

  • Hua Qiao

    Dan:
    I think there is a lot more to it than Vitaliy is saying. Read Michael Pettis’ posts on China Financial Markets or Patrick Chovanec’s blog. They go into great detail about what the issues are in the economy. Personally, I think there are problems far worse than the residential real estate market. To me, that bubble is similar to the tech bubble of the late 11990′s. Mostly equity financed. Surely value loss will be painful for many families, but that won’t cause a systemic crisis. Maybe some developers will get caught with overvalued land that have construction or development loans. But I don’t get the feeling that banks have gone wild here.
    Commercial real estate is more of a concern. You can’t rationalize see through office buildings as a store of value. Those are, by definition, income producing properties. Here, banks and developers play a game. Developers don’t cut lease rates and therefore, are slow to lease up the property. If they cut rents, then banks are required to revise the project value based on the real rent roll, leading to an underwater loan to value. If the units stay vacant, the building is still considered in leaseup mode and so the loan is still interest only. Extend and pretend.
    Secondly, there are only 2 kinds of meaningful collateral for commercial loans. Cash deposits and real estate. Chattel paper and inventory is difficult to perfect. Equipment collateral even more so. Real estate value decline, when combined with poor business performance, could trigger major problems.
    Paradoxically, systemic problems could be avoided by ignoring them. Will banks recognize their portfolio issues? Hard to say. As long as the banks stay liquid and can continue to fund themselves to make up for the “suspended” cash inflows of the problem portfolio, nothing will happen.
    But as real interest rates go further negative, there will be more and more disintermediation. Bank deposits will be pulled and diverted to other investments that have higher yields such as the trust and wealth management products or physical assets such as gold, etc.
    Vitaliy touched on a lot of the issues, but strangely (to me), he focused on the problem that, in my mind, is least likely to cause a crash. To me, loans to government investment platforms, commercial real estate, and commercial/industrial leveraged overcapacity are the big potential bombs. After all, if you own a home that you plan to live in for the next 30 years and it’s value falls, what’s the big deal? It’s a paper loss. It hurts but as long as you have a job that can pay the loan, no harm.

  • Twofish

    Yes, it’s possible to make some reasonable estimates for the amount of bad loans in the system. The numbers that Katsenelson quotes are pretty reasonable, so lets assume that China has roughly $500 billion in bad loans, which is something of a worst case scenario. With a GDP of $6 trillion, that’s not the end of the world.
    What’s going to happen is that the central government is just going to increase budget transfers to local governments to pay for the loans. Assuming that the loans went into useful things (and I think high speed rail and freeways are useful), then the central government can pay for those transfers from the extra tax revenue generated from the spending.
    One thing that you have to be careful about is something I call “Segaling” after Gerald Segal. I think $500 billion is a good number for the worst case scenario number of bad loans. What can happen is that someone takes that number, and then pads it to $800 billion for their worst case scenario, then some other author takes $800 billion and then pads it to $1.6 trillion, and pretty soon you get huge numbers for losses that are out of touch with reality.
    K: To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity).
    And then they made those off-balance sheet vehicles liabilities of the Chinese government. It’s essentially what the US government did with the latest rounds of bank bailouts.
    K: But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose.
    Sure. But it’s happened before, and I don’t think it’s likely to lead to social unrest. First of all, people lose money in the stock market and houses all of the time, and usually the attitude is that “it’s your damn fault.” If someone loses money in real estate, and then starts protesting, everyone will think he is an idiot.
    The important thing about people using cash to buy houses is that you don’t have a domino effect. What happened in the US was that house prices dropped, borrowers couldn’t pay, at that point the banks had to take a hit, and once that happened the banks couldn’t pay depositors which meant there was this mad scrabble to pull deposits into safer assets.
    What will is happening in China (house prices have gone down by 20% in major cities over the last few months) is that people that buy houses are taking the hit. The fact that they paid cash means two things. First, you don’t have the domino effect. Second, people can take the long term view. The problem with buying real estate with borrowed money is that if prices even a little, you are wiped out, you can’t pay any more so you don’t.
    [QUOTE]The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest.[/QUOTE]
    Don’t think so. If you have a 20-30% drop in real estate, that’s not that bad, and the game is rigged so that the government will step in if it’s any more than that. If people start protesting, the government will start buying houses to set a floor on the prices.
    What kills savings is high inflation. If you look at Latin America, people don’t want to save because if you put money into any sort of non-hard asset in Brazil in 1965, it would be worth nothing.
    Also one thing that is interesting about the Chinese government is that it’s not constrained by economic ideology. In the 1970′s, the Chinese government gave up on Marxist principles because they just didn’t seem to work, but the Chinese government has no particular attachment to capitalist principles, so if they don’t seem to work, the Chinese government will not use them.
    One reason that I’m a little worried about the West, is that there are a lot of people that seem to worship capitalism in the same way that some people in China worshiped Marxism in 1975, and that’s gets in the way of “doing whatever needs to be done.”

  • neil

    The thing i dont get is how it is ever in china governments interest to have these poorly built, speculative tower blocks, which are for the most part empty and not fitted out. I cannot understand how this has come to be when there is a terrible housing shortage in China. I think the gov’t will eventually have to incentivise (in one way or another) people to complete them and rent them out – there is likely to be more political pressure to do that than there is to maintain artificially high house prices, in my opinion.
    The houses will then find their true value as investments, expressed as a rental yield. this will be a major correction but as people have pointed out here, they dont have a sub prime problem in china as was the case in the USA. not sure i’m seeing a black swan then.
    China good place to buy a condo? Maybe 5, 10 years ago (although hindsight is a great thing). To me, the build quality appears to be very low and you are taking a massive risk with the land laws as a foreigner. I’d be cautious even if the yield was 10%.Maybe 20, 30% and it would be worth looking at. Not anytime soon then. Before you laugh at me, im getting 30% on an apartment i own in europe, so i do know what i’m talking about.

  • Don Clarke

    1. “Does anyone really know the extent of China’s bad loans?”
    In addition to Michael Pettis and Patrick Chovanec already noted by previous commenters, Prof. Victor Shih at Northwestern knows a lot about this. His particular contribution has been calculating local government debt. See, e.g., http://chinesepolitics.blogspot.com/2010/04/reply-to-my-critics-on-local-debt.html.
    2. Is there a Chinese Black Swan?
    No, because black swans are unexpected events. Lots of people are expecting a serious downturn. Katsenelson is not exactly a lonely voice in the wilderness here.

  • DaMn

    Just bought a new 80sqm pre-construction in China. Right next to a University.
    Everyone knew 10 years ago that China put off its troubles for another day. No one seemed to scream back then, maybe because no one saw China as integral to the world economy of politics. Well, times have changed…or have they? When people analyze China and predict a hard landing (sub 6% growth) or a Black Swan they are usually “Contrarians” who are either testing the waters or have spreads to cover. From Shiller to Chanos to this guy Katsenelson their free editorials are heavy on emotion and low on perspective, timing and fundamentals.
    The first thing Shiller says is “China is very important in the world today.” Yes. How about that for starters? Is anyone who is claiming China is exploding, imploding, swooning, or hard landing talking about what will be happening in the EU if that should happen? What exactly will the state of the world be if the engine of China collapses? What happens when they stop buying Treasuries, buying debt from Greece and other countries?
    Let’s take Vit’s paragraph here and substitute Chinese for USA and see if it reads as alarmingly shall we?
    “Let’s pause for a second. In 2008, the US banking system basically collapsed. To revive it, the Fed took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity). Banks started to function as though nothing had happened. (In fact they posted record profits and bonuses!) To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 0% or so.” In a country with a very low savings rate and 3% inflation, combined with stagnant wages, this resulted in a 4% annual loss of purchasing power.”
    So the debt in China. “According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems. The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post.”
    Moody’s just came out with pretty much the same numbers and a prediction of 8-12% default rate topping it out around $250B. That’s half of twofish’s worst case of $500B.
    “Up to about 4-5 percent NPLs is consistent with our ratings and stable outlook (for Chinese banks). If it starts rising beyond that, then that might lead to downgrades to our financial strength ratings,” Stephen Long, Moody’s managing director for Asian financial institutions, told reporters.
    “On the sovereign side. We have a positive outlook right now. That would imply there is quite a lot of buffer in the sovereign rating for China,” he added.
    Moody’s currently rates China at Aa3 with a positive outlook, which means the rating was fairly resilient even if China’s central government took on the liabilities of local governments that have been a concern of investors.
    Long’s comments came a day after China released a comprehensive review of the massive debt of its local governments and curtailed their future borrowing.
    The results of the audit showed local Chinese governments had racked up about 10.7 trillion yuan ($ 1.65 trillion) of debt as of the end of 2010.

  • Twofish

    DaMn: Let’s take Vit’s paragraph here and substitute Chinese for USA and see if it reads as alarmingly shall we?
    A lot depends on your economic beliefs. There are economists (Brad Delong and Paul Krugman) that argue that the US made and is making a very serious mistake by not doing exactly what China did and that was to rack up a ton of debt to get itself out of the economic doldrums. The argument is that by cutting spending, you are actually making the debt situation worse because cutting spending causes the economy to tank which causes tax revenues to shrink more quickly than the cuts.
    Michael Pettis and a lot of other people don’t agree with this, but the thing about economic policy is that you can’t argue endlessly. At some point a decision has to be made, and the decision that the Chinese government has made in 2008 is that Michael Pettis is wrong and Paul Krugman is right. It wasn’t that the Chinese government was particularly wise, but that if the government had followed Pettis, then it’s clear to everyone (including Pettis) that you would have riots in the streets since 10% unemployment for an extended period of time is going to cause the government to collapse. One of the major goals of the Chinese government is to keep people busy so that they don’t have demonstrations, and building shoddy apartment blocks keeps people too busy and tired to organize a demonstration.
    Also you can do the numbers, and if you look at the bill from all of this, it comes out to about $500-$1 trillion dollars which is something that China can afford. If the money goes into growth producing efforts, then it could be a good thing.
    Right now with the Chinese economy out of the recession while the US is in the doldrums, it looks very much as it they made the right decision. The people that think they made the wrong decision are forced to argue that China is going to blow up soon. This is one of the “we will see how things turn out” situations, but the longer the Chinese economy goes without a blowup, the less credibility that these people have.
    Note here that it is *essential* for a neo-liberal argument to work that the Chinese economy blow up in a big way and blow up soon. The basic idea is that “pain now is necessary to avoid greater pain later” and if you can’t show huge pain later, then the whole idea collapses.
    One other thing is that I find it odd that people are worried so much about China. Personally, I’m a *lot* more worried about the US economy than I am about the Chinese economy. The US has already entered what looks like Japanese-style stagnation.
    One thing that particularly worries me are two bad cycles:
    stagnant economy -> political gridlock and indecision -> economic stagnation.
    stagnant economy -> low capital investment -> more economic stagnation
    Also, the focus on “drama” is dangerous. People are looking for this big boom, whereas a slow fizzle can be more dangerous because people don’t react. I don’t think that there will be a moment in which we can declare the US economy to have “collapsed”, but I’m more worried about a slow fizzle in which people just get used to 10% unemployment.

  • Twofish

    One other thing. Victor Shih came up with a brilliant work on how economic policy is made in China. There are basically two groups of officials. Officials that say YES (mostly local officials) and officials that say NO (National Audit Office, People’s Bank of China, and the banking securities regulators).
    These two sets of officials are always fighting with each other, but which side has the upper hand depends on the business cycle. In 2008, the YES-officials were in the drivers seat and so they were pushing for massive spending. Times are different now, so we see the NO-officials starting to gain the upper hand. My guess is that in a year or two, the economy will have cooled enough so that the YES-officials start running things.
    Shih and I basically agree that this is how the system works. The big difference is that Shih thinks that this is a bad thing, but personally I think it’s a brilliant system (which like most brilliant systems came about by accident rather than intentional design).

  • DaMn

    twofish – I definitely agree people should be more concerned about the US economy. I expect there will be some major corrections along the road the next 3-7 years for sure in China. I just don’t think they are going to derail the country the way these pundits like to stoke. The WSJ has a decent article on how to profit from the bearish scenario because it talks not about a complete collapse but opportunities to bet on specific companies or commodities or even exchange currencies which is definitely possible.
    http://online.wsj.com/article/SB10001424052702303763404576419461948540954.html
    So what do you think about giving corps a tax free* holiday to repatriate funds? 5% instead of the 35%? I think its a loser. Corps have plenty of money, more money isn’t going to make them any more confident* to invest. I also wouldn’t trust anyone in government to know how to make sure it gets spent producing jobs let alone follow through on enforcing it. I like the idea of taxing companies world wide income just like they do citizens. Companies want to be able to spend and influence elections as thought they are individuals why not tax them the same way?
    twofish – I’m more worried about a slow fizzle in which people just get used to 10% unemployment.
    Get used it it? Get used to more unemployment. Corps are done hiring Americans. Game over. Now when they want or need to grow they will hire foreigners and expect Americans to become more productive. It’s all about getting rid of Americans, not hiring more. They won’t be done until there is wage parity with China and that’s a long ways to go.

  • HI

    If China’s exports shrink significantly, through some combination of recession and protectionism in the West, China’s hard landing will not be “growth of less than 6%” but rather negative growth for an extended period. No amount of government doping and extend-and-pretend will be able to reverse that. I’ve not seen in my lifetime the kind of grass roots populism and anti-globalization that I see now in the US and Europe. Ross Perot was nothing compared to today. The politicians in charge have covered it up so far or channeled it elsewhere (see the Tea Party), but that only works for so long. The China ads in the 2010 election were just a preview.