Streetwise Professor

April 17, 2011

Dr. Doom’s China Skepticism

Filed under: Economics,Financial crisis,Politics — The Professor @ 7:08 pm

I’ve been a China skeptic for a while now.  Post-crisis, I referred to it as “the Michael Jackson economy,” kept going by massive doses of stimulants.  Huge sums have been directed to investment in real estate and infrastructure, and financed by a massive expansion of credit.  I am deeply skeptical that such a top down, throw money at everything, approach is a viable way to create self-sustaining growth.  Instead, it appears to be a politically-driven way to protect elite interests and avoid social unrest–for now.  The fact that people like Thomas Friedman swoon at Chinese economic policy only confirms my suspicions.

I’m not alone in those suspicions.  Some noted shorts like Jim Chanos have been sounding the alarm about China for some time.  And just the other day, Dr. Doom himself, Nouriel Roubini, added his voice to the skeptic’s chorus:

China’s economy is overheating now, but, over time, its current overinvestment will prove deflationary both domestically and globally. Once increasing fixed investment becomes impossible – most likely after 2013 – China is poised for a sharp slowdown. Instead of focusing on securing a soft landing today, Chinese policymakers should be worrying about the brick wall that economic growth may hit in the second half of the quinquennium.

Despite the rhetoric of the new Five-Year Plan – which, like the previous one, aims to increase the share of consumption in GDP – the path of least resistance is the status quo. The new plan’s details reveal continued reliance on investment, including public housing, to support growth, rather than faster currency appreciation, substantial fiscal transfers to households, taxation and/or privatization of state-owned enterprises (SOEs), liberalization of the household registration (hukou) system, or an easing of financial repression.

. . . .

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging.

. . . .

Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible. Until the change of political leadership in 2012-2013, China’s policymakers may be able to maintain high growth rates, but at a very high foreseeable cost.

Roubini, then, is all in with the Michael Jackson economy hypothesis.

The main question is how long the Chinese leadership can keep playing Dr. Feelgood.  Roubini suggests 2013.  That sounds about right, but it’s impossible to be very confident in any timing prediction.  I would say that the longer they try and succeed in this strategy, the more brutal the fall will be.  But once you start with this regimen, it’s virtually impossible to stop.

Relatedly, I’ve been reading a book on the Chinese financial system, Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl Walter and Fraser Howie.  I can’t recommend the book all that highly because it’s poorly written, and particularly poorly organized.  But if you slog through it, you can pick up some valuable insights.  One main theme is that the Chinese financial system is oriented towards supporting the enterprises of the politically powerful, and that as a result, there have been periodic episodes of malinvestment followed by bad loan problems followed by shunting these bad loans from the banks to . . . somewhere.  The shady/opaque means used to make banks appear healthy would make Andrew Fastow blush–or turn green with envy.  Just who is on the hook for these bad loans is virtually impossible to figure out.  I have little doubt that the need to resort to such chicanery will soon recur–but given the very real possibility that the looming problem dwarfs the previous ones, I do have doubts whether the same tricks will work again.

When all is said and done, one’s view on whether Chinese economic management can avoid the kind of catastrophe that Roubini and I consider to be likely depends on your view of the efficacy of centralized economic management of the type that China practices.  The Thomas Friedmans of the world, and arguably Obama, believe that such dirigisme is superior to the messy, decentralized, unplanned and non-centrally coordinated actions of greedy individuals in markets.  People like me, conversely, believe that the visible hands of greedy, largely ignorant, and short-sighted politicians and bureaucrats is likely to lead to inferior outcomes.

I know that Coase (at age 100!) has a book coming out about China’s transformation to capitalism, which argues that Chinese policy in recent years has been pragmatic and empiricist rather than ideological (“seeking truth from fact”).  But  I strongly sense they’ve gotten themselves into a major mess from which there is no pragmatic exit.

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  1. Does the elite in America not influence economic policy?

    Comment by So? — April 17, 2011 @ 7:37 pm

  2. So?–Duh. But not to the same extent as in China. And everything they do is focused on keeping it that way.

    The ProfessorComment by The Professor — April 17, 2011 @ 7:44 pm

  3. Having just finished reading “The Big Short,” my first thoughts are, how do I short the forthcoming Chinese market troubles?

    Comment by Mike Giberson — April 17, 2011 @ 11:51 pm

  4. The worst conceivable outcome is something along the lines of South Korea in 1997. A sharp dip followed by renewed growth.

    Then again I’d say Korea then was far more precarious than China is now.

    Comment by Sublime Oblivion — April 18, 2011 @ 3:51 am

  5. Hi, Mike. I was thinking about including something along those lines in the post, but I generally steer clear of making anything that could be construed as an investment recommendation. But since you asked :)–

    Google “Chanos short China” or “Hugh Hendry short China” and you’ll come up with some articles that discuss their strategies. Here’s one about Hendry.

    Commodities are an alternative. Oil and particularly copper would likely decline dramatically if the scenario plays out. Plays in those commodities also don’t require you to have any risk of capital controls or market closures or other policies in foreign markets that might make it difficult for you to get out of your trade if the call is actually a right one.

    The problem is that it is extremely difficult to predict the timing of any crash, esp. since the Chinese gov’t will try heroically to defer it as long as possible. You have to have the wherewithal and risk appetite and courage of your convictions to hang with the trade.

    The ProfessorComment by The Professor — April 18, 2011 @ 9:30 am

  6. I concur with your analysis. Ironically, there was an article a few months ago comparing the growth of India (less centrally planned and messy) to China’s. Who will win? The article said China had a massive head start, but it’s not always the hare that wins the race.

    As to the comment about how to short China, if the Chinese bubble bursts, surely the S+P will burst. Ironically, the best short of all time might be US Treasuries; after the crash of China. Picture this, China crashes, US market crashes, flight to quality in US Treasuries, but China needs to raise capital (and sells US Treasuries)-along with the fact that the inflation we have been exporting to China via our monetary policy comes home-Treasuries tumble.

    The expensive strategy is simply buy puts and keep rolling them over in the markets that you think will pop. I would not be short gold.

    Comment by Jeffrey Carter — April 20, 2011 @ 5:44 am

  7. The trouble with shorting copper and other storable commodities is that they are being used as a store of value and a means to facilitate credit instead of a “consumable good”. If access to credit (money!) now in China is capricious and tight, imagine what it will be if there is a banking system collapse? More broadly, with such little faith in fiat currencies (and by extension, any non-tangible asset denominated in those currencies) to hold real value, it is hard to imagine a commodity short would end up being profitable.

    Comment by Derek Holmes — April 20, 2011 @ 9:05 pm

  8. Even if China were to crash and not grow AT ALL, it would take India about 15 years just to catch up to where it is now.

    Comment by Sublime Oblivion — April 20, 2011 @ 10:12 pm

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