Exclusively from Michael Pettis’ newsletter.
We are beginning to see an increasing reluctance to respond to evidence of bubble-like behavior in China with explanations of how these things don’t mean the same thing in China as they do in other countries. Our normal understanding of economics doesn’t apply to China, we are earnestly told by the China bulls, because either:
1) China has a different set of economic rules under which it operates, and so the economic processes that have adverse consequences in other countries are unlikely to have the same consequences in China (how many times, for example, have we heard someone say that China cannot have a real estate bubble because, unlike in the US, surging real estate prices have not been fueled by a deregulated mortgage bubble?), or
2) China’s very wise policymakers have invented a new and brilliant form of economics that isn’t understood in the “West”, although strangely enough it seems well-understood by the many Westerners who regularly proffer up this explanation. (For an especially hard-hitting counterargument to this kind of claim, much beloved of China bulls, check out this article by Minxin Pei.)
We still hear the China’s-economy-is-different nonsense from non-economists, but among the many academic economists and research analysts who used to trot out these arguments regularly even two or three years ago, there is a growing awareness, I think, that they are starting to wear thin. There is no such thing as a different kind of economics, and even a very cursory glance at Chinese economic history should have made clear that if China really does exist in a different economic universe, with its own set of rules, then this has been a fairly new phenomenon. For most of its history the same old set of rules seemed to apply to China that applied everywhere else.
The massive credit expansion in China, with its associated problems of overinvestment and asset price bubbles, is no different than any other credit bubble. I mention this because until recently it was not just China that was supposedly following a new set of economic rules, and I was reminded of this after reading an article in the Financial Times about the Spanish bank Bankia. According to the article:
During Spain’s housing boom, mortgage lending at Caja Madrid, the largest of the savings banks that formed Bankia, started to grow so quickly that, by 2007, some executives were trying to slow things down. After its mortgage book expanded by 25 per cent in 2006, Carlos Stilianopoulos, Caja Madrid’s then head of capital markets and later Bankia’s chief financial officer, said: “We don’t want to grow this fast. We are a savings bank so we don’t have to keep shareholders happy. We prefer to have a solid institution.”
At the same time, warnings from abroad about the overheating of Spain’s property market were dismissed. “Perhaps in other countries this pace of growth would be seen as a bubble,” he told Euromoney. “But not in Spain.”
“Perhaps in other countries…but not in Spain.” This statement alone should have been a warning signal. We know why it is impossible for property prices ever to become unsustainable in China – actually I don’t know, but I have been told that it is because of the immutable urbanization process, of which more later – but why is that the case in Spain?
This, it turns out, I can explain. I remember in 2003 my mother had a New Year’s Eve party at our family home in Málaga, in southern Spain, at which over 80 people sat for dinner, including most of my old friends still around from high school days. That night I had one of those epiphanies (as you often do on New Year’s Eve, I guess) about the real estate market when I suddenly realized that nearly every one at the party was involved in one way or the other in real estate. Most of the people there (including my Persian sister-in-law) were real estate developers, real estate agents, real estate lawyers, architects, or owners of building and construction companies. All of them lived off (and had prospered mightily from) the real estate boom in southern Spain.
But this cannot be, I thought in my naiveté. If the only industry around is real estate, then we must be living through a real estate bubble of enormous proportions.
Later that night I spoke to one of my old high-school friends, Andy, who was at the time a prosperous real estate agent with houses in Marbella (purchased on borrowed money, naturally), a Mercedes, and all the trappings that accrue to an immensely charming and self-confident real estate agent during a real estate boom. In our conversations, and ones that took place subsequently over the next few years, I warned him that the property market in the south of Spain looked out of control, and it would be a good idea from him to diversify his savings out of real estate.
Same old same old
Of course Andy didn’t. He explained to me that what we were seeing in southern Spain was not a bubble because there were very strong reasons to believe that real estate prices were undervalued and were going to rise a lot more. Europe, he told me, is aging rapidly, and old people, as everyone knows, like nothing better than to retire in some warm and sunny place, preferably on the beach. With an infinite supply of European old people and limited European beachfront property, mostly in Spain, Italy, and Greece, where in addition you had great food, warm-hearted people, and plenty of immigrants to keep the prices of services (and servants) down, it was certain, Andy explained, that real estate prices would not decline. The demand was insatiable at almost any price.
This seemed like a perfectly reasonable argument on the face of it, and it was widely proposed to justify ever-soaring Spanish real estate prices for many years, not just on the Spanish coast but also, perhaps a little bizarrely, in every nook and cranny of the country, including some pretty gray and inaccessible building projects outside cold, northern industrial cities.
The weakness in the argument, of course, was that although there might have been near-infinite demand, this could not justify near-infinite increases in prices, especially since the demand itself was likely to be highly pro-cyclical because the Spanish economy had itself become dependent on real estate development. As long as the economies of the cold northern European countries were booming, in other words, the demand from retirees for beach houses would stay high, but any slowdown in the economy would reduce demand in Spain at the worst possible time.
And as Spanish real estate slowed, the impact would be exacerbated by a much sharper slowdown in the Spanish economy caused by the slowdown in real estate, which had become a major driver of the economy. If a substantial portion of the Spanish workforce depends on a booming real estate market – and not just those directly dependent, but also those indirectly dependent, like bankers, restaurateurs, retailers, travel agents, and so on – then any slowdown in the real estate sector is itself seriously self-reinforcing.
We have now seen how this works in Spain, but in China we are still using a similar argument to explain why real estate prices cannot drop significantly. Our Chinese version of the old-people-love-to-live-on-the-beach argument is the urbanization argument. As long as Chinese workers continue to move from the country to the cities – and urbanization has been one of the most dramatic consequences of Chinese growth in the past three decades – then there is likely to be a near infinite demand for city property, and so prices can only go up. And because prices can only go up, speculative demand for real estate is not speculative, it is precautionary.
This claim seems at least as plausible as the Spanish argument justifying infinite price increases, and was probably true a decade ago, but it runs into the same problem that the Spanish story ran into (and indeed that nearly every previous case in history of a real estate bubble, which has always started with a plausible story). First, no matter how much demand we can project into the future, rising prices can nonetheless outpace rising demand because rising prices can themselves stimulate further demand, in which case rising prices are unsustainable. This should be obvious, but the point is often lost in the giddiness that accompanies rapidly rising prices.
Second, and this is key, the rising demand is itself pro-cyclical. This is the most dangerous part of the process and perhaps the least well understood. Rising demand driven by the urbanization process is itself subject to underlying growth in the economy, since it is growth in turn that drives the urbanization process.
What’s more, when we reach the point as we did in Spain several years ago, and have reached in China too, in which a substantial part of the growth that drives the urbanization process is itself created by real estate development, then any slowdown in underlying growth is likely to be seriously exacerbated by a corresponding slowdown in real estate development. This is because the economy is caught in the reverse side of the feedback loop that helped drive prices on the way up – slowing growth leads to slower demand for urban real estate, which leads to slower real estate development, which itself leads to slower growth.
This is part of the reason why declining real estate prices and slowing sales, which Beijing has insisted for years it wanted to see, is causing so much worry. It is both a consequence and cause of economic slowing, and these kinds of self-reinforcing relationships always lead to unexpectedly sharp outcomes, both on the way up and on the way down.
Minsky on balance sheets
Without wanting to sound obsessive I want to re-emphasize this idea. In trying to judge the probability of a crisis we need to think not just about the probability and impact of positive or negative events in and of themselves. It is extremely important that we also understand the balance sheet mechanics that force the system into self-reinforcing behavior. The structure of the balance sheet itself, in other words, is as important in determining the impact of adverse events as the direct impact of those events on the asset side of the balance sheet.
This is, of course, one of Hyman Minsky’s key insights, and in that light I thought I would pass on part of a lecture by James Galbraith on Keynes which Galbraith gave at the 5th annual “Dijon” conference on Post Keynesian economics, delivered in Copenhagen in May last year. In the lecture Galbraith made a brief detour on the subject of Minsky in which he said:
Hyman Minsky developed an economics of financial instability, of instability bred by stability itself…Minsky’s approach, very different from Godley’s, is conceptual rather than statistical. A key virtue is that it puts finance at the center of economic analysis, analytically inseparable from what is sometimes called real economic activity, for the simple reason that capitalistic economies are run by banks. And, of course, his second great insight is into the dynamics of phase transitions: the famous movement from the hedge position to the speculative position to the intrinsically unsustainable, doomed to collapse ponzi position which arises from within the system and is subject actually to formalization in the endogenous instabilities of non-linear dynamical models.
To grasp what Minsky is about, it seems to me, is to go immediately beyond the coarse notion of the “Minsky moment,” a concept which implies falsely that there are also non-Minsky moments. It is to recognize that the financial system is both necessary and dangerous, that strict financial regulation is both indispensable and imperfect.
Any attempt to predict the likelihood and extent of a breakdown in an economic system – country, region, or company – that starts only from the asset/operational side of the economic entity (what Galbraith refers to above as real economic activity), without taking into account the feedback mechanisms inherent in the relationship between the asset and liability sides, is pretty useless.
What’s more, the recent history of disturbances in that economic entity tells us nothing about the future impact of similar disturbances – as long as the balance sheet structure is changing, and as Galbraith reminds us, the lack of instability during previous disturbances will itself change the structure of the balance sheet. Stability is itself destabilizing, as Minsky warned us, because it changes the nature of the relationship between the two sides of the balance sheet.
Commodities and growth
Volatility, in other words, is a function not just of volatility in real economic factors, but also, and perhaps even more so, of the structure of the balance sheet. The structure of the balance sheet can either smooth out normal economic fluctuations or it can turn them into highly destabilizing events.
One example of a destabilizing feedback mechanism worth pondering is the relationship between commodity prices and Chinese growth. Here is a very interesting article from last week’s Financial Times:
Chang Zhenming, chairman of Citic Pacific, is unambiguous about the significance of his company’s Sino Iron mine in the desolate, red-soiled Pilbara region of Western Australia. “The whole of China is watching this project,” he says.
More to the point, China is watching with some trepidation as his Hong Kong-listed company faces increasing cost overruns and delays. The stakes are high. Mr Chang says Sino Iron is four times bigger than any iron ore project at home.
While outside observers often fear Chinese companies are unstoppable juggernauts in their ravenous pursuit of the world’s minerals, much of this perception is inaccurate. China’s international resource expansion is not running smoothly. The world’s second-biggest economy had hoped it would more easily control its economic destiny by taking huge mineral stakes, robbing companies such as BHP Billiton, Vale and Rio Tinto of the ability to dictate commodity prices.
But the Sino Iron project, far from being a showcase for China’s might, has become instead a cautionary tale of the difficulties Chinese enterprises face as they seek to expand abroad. When it was first conceived in 2006, the total cost was estimated at under $2bn. By now, it has already cost Citic Pacific $7.1bn. Analysts at Citigroup calculate the bill could swell to a possible $9.3bn, while others say they expect the ultimate bill will be closer to $10bn. The mine is at least two years behind schedule.
“This is no longer about commercial goals,” says a senior executive at one leading Asian trading company with extensive sourcing operations in Australia. “It is about Chinese machismo. They have plonked down too much money to pull out now.”
Leaving aside that rather interesting and even surprising last paragraph, one obvious comment on this article is that vastly overspending on a project of this nature is not at all surprising in a system in which privileged operators have near infinite access to cheap funding, little accountability, and no budget constraints for any project that can be proposed as being of national importance (and it is astonishing how many projects fit under that category). But the lesson I want to draw is a very different one – a balance sheet lesson.
In projects like this, and in the extent of commodity stockpiling we have seen more generally, China has taken a huge long position. Some analysts argue that China, by buying far more in the way of commodities and commodity producing companies than it requires for its immediate needs, is hedging its future demand.
Others make an even stronger case. Dambisa Moyo, a former investment banker turned economic writer, has argued in her book Winner Take All that the world is facing a crisis in the form of a commodity shortage. According to a recent review in the Guardian:
If Moyo’s calculations are correct, we are in big trouble – which makes the central premise of her book, Winner Takes All, all the more arresting. Governments across the world, she writes, have singularly failed to grasp what’s coming – with one sensational exception. “Simply put, the Chinese are on a global shopping spree.” State-sponsored Chinese corporations are busy buying up commodities across Africa, North America, the Middle East, South America – anywhere they can – in a concerted strategy to seize control of resources before the rest of the world wakes up to the looming crisis.
They’re striking deals with what she calls the “axis of the unloved” – developing countries rich in commodities but poor in political and economic capital – in return for much needed investment, employment and infrastructure. Extravagant shoppers, the Chinese are happy to pay over the odds, treating their trading partners not as poverty-ridden charity cases nor political pariahs but valued commercial equals.
But when the resources begin to run dry, the consequences will be catastrophic. Already, since 1990 at least 18 violent conflicts worldwide have been triggered by competition for resources. If nothing is done now, warns Moyo, commodity wars on a terrifying scale are all but inevitable.
Inverted balance sheets
Perhaps it is my natural skepticism, but we have heard warnings like these many times before, and they have usually proven to be spectacularly wrong largely because they are based on projections of recent trends that are clearly unsustainable. In my opinion the next few years are not going to see soaring commodity prices but rather collapsing commodity prices, in large part because it has been China’s unsustainable investment boom that has both driven demand up ferociously (accounting for only 10% of global GDP China nonetheless absorbs roughly 40% of global copper production and nearly 60% of global iron ore and cement production) and driven up investment in extractive industries.
Once China brings down its infrastructure investment rate, the combination of declining demand (in fact China has stockpiled so much that it will soon turn from importing copper, iron ore, and other commodities to exporting them) and expanding supply is likely to have a very deleterious effect on prices. In my opinion China is paying overly high prices in a market in which prices are likely to drop sharply.
But reasonable people can differ on whether or not commodity prices are going to rise substantially. What reasonable can never do is place too much confidence in their predictions. Dambisa Moyo may be right that commodity prices will soar, and remain permanently high. I doubt it, but the real reason I think China is making a mistake in stockpiling commodities is not because I think prices will inevitably decline, but rather because it is a risky balance sheet strategy for China. It exacerbates the volatility impact of commodity prices, which are already very volatile, and this brings us back full circle to Hyman Minsky.
Why is stockpiling a bad strategy for China? It is risky because of the inverted relationship between Chinese growth and commodity prices. It is widely agreed in the commodity industry that the biggest cause of rising commodity prices in the past decade has been the ferocious growth in Chinese demand, and this growth has been primarily a consequence of Chinese investment growth. If China keeps growing rapidly, of course, we may very well see higher commodity prices in the future, but – and this is the problem – if China slows significantly, the price of commodities is likely to decline, at least in the next few years.
So China has effectively made a big bet on commodity prices, and it “wins” the bet if it continues to grow quickly. It “loses” the bet, however, if its growth rate slows sharply. This is what I referred to as an “inverted” capital structure in my 2002 book, The Volatility Machine. An inverted structure is the opposite of a hedged structure – when the asset/operational side of your balance sheet does well, your liability side also does well, but when the asset/operational side does badly, the liability side does too.
Inverted balance sheets exacerbate volatility – good times are automatically better than they otherwise would have been and bad times are automatically worse. Countries (or companies) with inverted balance sheets are more volatile than countries with hedged balance sheets, and unless you can get all your speculative bets right, this higher volatility lowers growth over the long term. Inverted balance sheets, I argued in my book, are one of the key differences between countries that are able to recover successfully from crisis and countries that aren’t, and I would propose that this may be one of the differences between countries that can escape the middle income trap and countries that can’t.
Of course a country’s balance sheet is affected by a lot more than just commodity stockpiling. There are many other aspects of China’s balance sheet that matter, but I would argue that good liability management consists of eliminating sources of volatility in the balance sheet by structuring it in ways that cause the performance of the liability side and the asset side (or, to put it another way, the structure of expenses and the structure of revenues) to move in opposite ways, not in the same way.
This isn’t happening – in at least one aspect of the national balance sheet, commodity stockpiling. To take another example, hot money flows are automatically volatility enhancers – when the economy is growing quickly, money pours into the country and causes even more growth, but when the economy gets into any trouble, money flees and so causes even more contraction.
China in principle has capital controls, which should prevent this from happening, but in practice Chinese capital controls are extremely porous, and as Chinese prospects have gotten worse in the past two years, we have seen what is clearly a surge in capital flight. If China is serious about internationalizing the renminbi and relaxing capital controls it will only increase the balance sheet inversion (which is why I think we are going to see a reversal of RMB internationalization in the next few years).
Or to take two more obvious examples, first, asset based lending – for example against real estate – is also a source of balance sheet inversion. When asset prices rise, the value of debt collateralizing the assets also rises, but when asset prices drop the debt becomes less credible and its implicit cost to the economy rises. Second, borrowing short term, or borrowing in a foreign currency, has the same risk profile. When the country is doing well, the real cost of short-term or foreign currency debt declines, only to surge when the economy gets into trouble.
Sometimes inverted capital structures are inevitable, but liability management consists, in my opinion, of identifying ways of eliminating inversion when you can and embedding as much hedged liability structures as you can, so as to make the overall economy less, not more, volatile. In the case of China, stockpiling commodities is exactly the wrong thing to do – but of course it is hard to convince anyone that this is the case when we are in the “good” part of the volatility cycle.
