By Tom Bradley

I am not an economist and have never been to China.

But I am an investor and a student of market cycles, and as such, I’m always wary when something that is far from certain starts being assumed as part of the foundation of the capital markets. Today China is one of those ‘uncertain assumptions’. While investors worry about Greece, the housing market and corruption on Wall Street, they are counting on China being immune to an economic downturn – 8-10% growth will continue uninterrupted. This is a particularly important assumption for Canadian investors because our market has so much pinned on the China miracle.

I bring this up again now because I came across a couple of excellent pieces over the last week. While flopped on the couch at the cabin, I watched a Charlie Rose interview with James Chanos, who is a famous and controversial short seller. In the course of making his clients gobs of money on Enron, he built his reputation as a thoughtful and savvy investor. Mr. Chanos is shorting China.

His argument focuses on China’s dependence on construction (56% of GDP) and investment spending. He provides some color on how the property markets work and the degree to which speculators are involved. If you watch it, remember that he is talking his book (i.e. he has a vested interest in viewers turning against China.)

I also read a White Paper by Edward Chancellor from GMO (you have to register on their website to read the article). Mr. Chancellor is a more learned student of cycles and bubbles than I am, and GMO, under the leadership of Jeremy Grantham, has proven in the past to be astute at flagging market extremes.

For those who are keen on China, the GMO piece will provide a dose of reality. It methodically goes through ten aspects of the bubbles of the last three centuries and then discusses how China measures up. Needless to say, Mr. Chancellor scores it high on all ten measures.

The Chanos interview and GMO paper include and add to the concerns that I have about the China assumption. In no particular order they are:

  • Abnormally high rates of capital spending are good at fueling economic booms and setting up subsequent busts. The GMO piece refers to an IMF World Economic Outlook which points out that countries with a high investment share of GDP (China is off the scale on this measure, as was Japan in the 80’s) tend to suffer the steepest and most prolonged economic downturns.
  • Governments are poor capital allocators and China’s central authority is calling all the shots. Both Chanos and Chancellor have some sobering tales about how uneconomic much of the stimulative spending has been.
  • Cheap money and undervalued currencies also lead to poor capital allocation.
  • Aggressive growth targets and poor transparency are a bad combination. I liken China to a company that shows a rapid and consistent rate of growth, even though the underlying business is far from steady and predictable. As Mr. Chancellor points out, “whenever an economic indicator is made a target for conducting policy, then it loses the information content that would qualify it to play such a role.” When non-transparent companies finally miss their target, they always ‘blow up real good’. That’s because we find out that they were stretching and straining to keep up appearances such that by the end the cupboard is bare. In the case of China, we already know what we’ll be reading about when the downturn hits – empty factories, apartment buildings and highways; an over-levered and overbuilt housing market; insolvent banks and a poor demographic profile.

China is going to grow rapidly. It will become an ever increasing force in the world economy. That we can assume. But we have to be less definitive about the path the country will take to get there and how much of that success is factored into asset prices around the world.

Related reading:
China Inc. - Buy, Hold or Sell
China Uninterrupted