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Saturday, 16 January 2010
When a bear starts eyeing you up, be very concerned
When one of the financial world’s most successful bears starts casting his eye over a market looking for ways to sell it short, you might think the bulls would begin to get a bit nervous.
When a bear starts eyeing you up, be very concerned
Tom Holland 15 January 2010
When one of the financial world’s most successful bears starts casting his eye over a market looking for ways to sell it short, you might think the bulls would begin to get a bit nervous.
You might think that, but when the market in question is China, you would be wrong.
The majority of investors think the mainland is poised on the threshold of multi-year bull trend. Few if any have been put off their view by an article in The New York Times last week describing how professional short-seller James Chanos believes China is one enormous bubble waiting to burst.
Chanos has a track record that commands attention. As manager of the multi-billion US dollar hedge fund Kynikos Associates, he specialises in spotting assets that are fundamentally overpriced and selling them short in anticipation of a big correction. Some of his more famous bear calls over the last 10 years include fraudulent energy company Enron, scandal-plagued conglomerate Tyco International, and much of Britain’s banking sector.
Now he thinks China is heading for a fall. According to The New York Times, he believes massive over-investment fuelled by the recent credit explosion is creating a huge excess of industrial capacity and inflating a real estate bubble equal to “Dubai times 1,000 - or worse”.
This is hardly a popular view, and in the last few days Chanos has attracted howls of derision from China bulls, who typically argue that there can be no bubble on the mainland because levels of leverage remain low. New York Times columnist Thomas Friedman even devoted a whole article this week to ridiculing Chanos, offering him “a simple rule of investment that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”
No doubt Friedman’s tip raised some appreciative laughs, but his advice is absurd. China was sitting on US$1.5 trillion of foreign reserves at the end of October 2007, but that didn’t stop the domestic stock market from crashing by 72 per cent over the next 12 months.
So it’s worth having a look at Chanos’s concerns. Clearly China has seen an unprecedented credit boom over the last 12 months, with bank loans increasing by around 30 per cent of gross domestic product.
That expansion has kept growth above the government’s 8 per cent comfort level, but it has also fuelled an uncomfortably sharp rebound in the property market, with new house prices shooting up 9.1 per cent over 2009.
Even worse, it has pushed consumer prices higher, propelling an abrupt swing from deflation back to inflation. That’s especially worrying for the authorities, because rising inflation threatens to push real deposit rates into negative territory. And as the first chart below shows, when that has happened before, savers have taken their money out of the bank to invest it in new properties, sending real estate prices soaring to bubble levels.
Aware of the danger, the government has introduced a swathe of administrative measures designed to clamp down on leverage and dampen property speculation.
That might blow some froth off the real estate market, but whether Beijing can successfully prevent the bust that Chanos expects is debatable.
That’s because China’s real problem is not so much a bubbly property market, but the underlying misallocation of capital.
Over recent years China’s rapid growth has been powered above all by massive investment. Now however, Beijing is bumping up against the law of diminishing returns. Each extra yuan invested yields a little bit less in additional output. In economists’ speak, China’s marginal product of capital is declining (see the second chart). In ordinary language, the more Beijing invests, the more money gets sunk into wasteful, unproductive assets like empty office buildings and deserted shopping malls.
Sooner or later that’s going to become a problem. Borrowing to invest is fine as long as the growth procured by that investment remains high, because high growth shrinks your debts relative to the size of your overall economy.
But when your returns begin to decline, either you must incur more and more debt to maintain the same growth rate, or your economy must slow. And if your economy slows, suddenly servicing all those debts becomes a lot more difficult and your bubble bursts.
Most investors dismiss these concerns, arguing China’s unique qualities mean it will continue generating high returns for years to come. But then, that’s what they thought about Enron.
2 comments:
When a bear starts eyeing you up, be very concerned
Tom Holland
15 January 2010
When one of the financial world’s most successful bears starts casting his eye over a market looking for ways to sell it short, you might think the bulls would begin to get a bit nervous.
You might think that, but when the market in question is China, you would be wrong.
The majority of investors think the mainland is poised on the threshold of multi-year bull trend. Few if any have been put off their view by an article in The New York Times last week describing how professional short-seller James Chanos believes China is one enormous bubble waiting to burst.
Chanos has a track record that commands attention. As manager of the multi-billion US dollar hedge fund Kynikos Associates, he specialises in spotting assets that are fundamentally overpriced and selling them short in anticipation of a big correction. Some of his more famous bear calls over the last 10 years include fraudulent energy company Enron, scandal-plagued conglomerate Tyco International, and much of Britain’s banking sector.
Now he thinks China is heading for a fall. According to The New York Times, he believes massive over-investment fuelled by the recent credit explosion is creating a huge excess of industrial capacity and inflating a real estate bubble equal to “Dubai times 1,000 - or worse”.
This is hardly a popular view, and in the last few days Chanos has attracted howls of derision from China bulls, who typically argue that there can be no bubble on the mainland because levels of leverage remain low. New York Times columnist Thomas Friedman even devoted a whole article this week to ridiculing Chanos, offering him “a simple rule of investment that has always served me well: Never short a country with US$2 trillion in foreign currency reserves.”
No doubt Friedman’s tip raised some appreciative laughs, but his advice is absurd. China was sitting on US$1.5 trillion of foreign reserves at the end of October 2007, but that didn’t stop the domestic stock market from crashing by 72 per cent over the next 12 months.
So it’s worth having a look at Chanos’s concerns. Clearly China has seen an unprecedented credit boom over the last 12 months, with bank loans increasing by around 30 per cent of gross domestic product.
That expansion has kept growth above the government’s 8 per cent comfort level, but it has also fuelled an uncomfortably sharp rebound in the property market, with new house prices shooting up 9.1 per cent over 2009.
Even worse, it has pushed consumer prices higher, propelling an abrupt swing from deflation back to inflation. That’s especially worrying for the authorities, because rising inflation threatens to push real deposit rates into negative territory. And as the first chart below shows, when that has happened before, savers have taken their money out of the bank to invest it in new properties, sending real estate prices soaring to bubble levels.
Aware of the danger, the government has introduced a swathe of administrative measures designed to clamp down on leverage and dampen property speculation.
That might blow some froth off the real estate market, but whether Beijing can successfully prevent the bust that Chanos expects is debatable.
That’s because China’s real problem is not so much a bubbly property market, but the underlying misallocation of capital.
Over recent years China’s rapid growth has been powered above all by massive investment. Now however, Beijing is bumping up against the law of diminishing returns. Each extra yuan invested yields a little bit less in additional output. In economists’ speak, China’s marginal product of capital is declining (see the second chart). In ordinary language, the more Beijing invests, the more money gets sunk into wasteful, unproductive assets like empty office buildings and deserted shopping malls.
Sooner or later that’s going to become a problem. Borrowing to invest is fine as long as the growth procured by that investment remains high, because high growth shrinks your debts relative to the size of your overall economy.
But when your returns begin to decline, either you must incur more and more debt to maintain the same growth rate, or your economy must slow. And if your economy slows, suddenly servicing all those debts becomes a lot more difficult and your bubble bursts.
Most investors dismiss these concerns, arguing China’s unique qualities mean it will continue generating high returns for years to come. But then, that’s what they thought about Enron.
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