China’s Economic Bubble is Bursting

By Chriss Street

The highly credible HSBC/Markit Purchasing Managers’ Index (PMI) of economic demand in China reported that demand in China’s factories fell for a second month in a row and hit a seven month low.  Markit Research also reported that production volume turned negative for the first time in seven months and hiring expectations fell to a five year low.      

Although the Chinese government continues to produce an array of rosy economic statistics each month, China’s industrial competitiveness is fading fast.  Coupling production contraction with banking problems and a fall in employment to a five year low, it appears that China’s economic miracle may just be a speculative bubble that is about to burst.

Markit Research compiles “flash” indicators each month for demand and operating conditions in China’s manufacturing sector.  The report is based on surveys responses from executives inside approximately 85%–90% of China’s most important factories.  A Markit flash score above 50 means that activity is expanding, whereas a score below 50 means that activity is contracting.  Although the final reports are not published for another two weeks, the Markit flash reports seldom differ from the final reports.

The Chinese Lunar New Year festival began this year on January 31 and most workers went on vacation back to their family home to celebrate for two weeks.  Consequently, the level of economic activity during the lunar holidays is an excellent indicator of the strength of domestic consumer demand.  The purchasing managers’ index falling from a weak 49.5 in January to a seven-month low of 48.3 in February is a strong warning that the accelerating contraction in demand is being driven by weak domestic consumption.

Former Chinese President Hu Jintao and Premier Wen Jiabao in 2010 published “Report on the Work of the Government” and report of the National Development and Reform Council (NDRC) that formed the basis of China’s Five Year Plan for 2011-2015.  The Plan discarded the centrally planned economic model of emphasizing export manufacturing for the past three decades.  The new Plan focused the nation’s economic and development on centrally planned efforts to build a modern consumer economy.

The main features of the new policy were converting China from being the “world’s manufacturer” to becoming the “world’s consumer”; upgrading its scientific and technological capabilities with an emphasis on innovation; expanding educational coverage; and increasing wages and living conditions in the rural areas.

Over the next five years, China’s implemented “new measures” that included widespread property tax changes that converted agricultural land into housing developments.  State-owned-banks were commanded by central planners to increase lending $15 trillion in just five years, twice the entire Chinese annual gross domestic product (GDP).  As a result, housing prices soared in major cities like Beijing from an average of $1,150 per square meter in 2005 to $11,400 per square meter by 2013.  Condos that sold for $3,500 in 1994 are now listed for sale at $833,000.

But over the last six months, real estate demand and prices have been contracting faster in cities beyond the nation’s relatively wealthy “first-tier” metropolises of Beijing and Shanghai.  According to the Securities Times newspaper, housing developers in the industrial city of Hangzhou outside of Shanghai cut prices this week by an average 19% in a scramble to sell about 120,000 newly built apartments.  The current inventory of new, unsold units in the city now exceeds the total number of housing units offered for sale in Beijing and Shanghai combined.  A study by Shanghai’s Tongji University said real estate has been especially shaky in the northeastern city of Wenzhou, where new-home prices have fallen every month for the last two years.

The borrowing binge in China was not just restricted to state-owned-banks; approximately $3.5 trillion in private loans were also made by individuals to small companies at up to three times the interest rates banks charged.  Many of these loans went to shady business operators who bought coal mines to speculate on the growth of China’s electricity demand.  But most of those loans are now insolvent as the economic slowdown has caused the price of coal to be cut in half last year.

Facing liquidity shortfalls as interest payments on long term loans have shriveled; Chinese banks over the last six months have been forced to borrow huge amounts of short-term money from foreign banks.  The Sunday edition of London’s Daily Telegraph published a story that, “Currency crisis at Chinese banks could trigger global meltdown”.  The article warned that short-term foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than $1 trillion.  “Any substantial appreciation of the US dollar – and many analysts are indeed expecting gains this year – could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders.”

According to Beijing’s State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a stunning $3.85 trillion; roughly 40% of total GDP.  The bulk of those liabilities consist of $2.32 trillion of highly illiquid foreign investments in factories and equipment.  Another $374 billion is foreign investments in China’s stock and bond markets.  Most foreigners assume they can sell and take money out of China; but the “Qualified Foreign Institutional Investor Program” strictly limits on the size and frequency of withdrawing money from China.  

The contraction of HSBC/Markit Purchasing Managers’ Index to 48.3 during China’s biggest annual holiday seems dire when coupled with the PMI’s Employment Index fall for a fourth month in a row to 46.9, its lowest point since the depth of the financial crisis in February 2009.  Over the last five years, Chinese central planners drove GDP per capita from $2,204 to $3,348, the fastest expansion of any large economy in the world.

The Chinese Communist Party leadership would obviously like to continue to inflate China’s economic bubble with more lending.  But with banks facing massive loan losses and scrambling for short-term funding just to survive, central-planners now seem powerless to prevent China’s economic bubble from bursting.

The author welcomes feedback at chriss@chrissstreetandcompany.com
Chriss Street is teaching microeconomics at University of California, Irvine this spring from March 31 – June 8, 2014.