Monday, March 11, 2013

When Will China's Bubble Burst?

China's rise to the status of economic powerhouse has been nothing short of breathtaking. For most of the past century, China was still an impoverished Third World nation.

However, the Asian giant has averaged a 10 percent growth rate over the past 30 years and it is now the world's fastest-growing major economy. In 2010, that spectacular growth culminated in China vaulting past Japan to become the world's second largest economy (by nominal GDP), behind the U.S.

In the process, China also became the world's biggest car market, which is remarkable considering that almost everyone there rode bicycles just 20 years ago. Car ownership rocketed from just 1 million in 1977 to 75 million in 2011.

China's emergence as the world's second biggest economy was a historic shift, one that can rightly be described as a sea change. From out of nowhere, China became a major player on the world stage. It's arrival was bold, rapid and pronounced.

To provide a sense of the magnitude of China's growth, consider this: In 2007, China's gross domestic product stood at $3.38 trillion. By 2010, it had reached $5.87 trillion. That's just amazing.

In 2010, China surpassed the US as the world's biggest energy consumer and, in the process, it also became the world's second biggest greenhouse gas polluter (also following the US). The UN reported that Chinese emissions nearly doubled from 1994 to 2002.

China's energy demand has increased exceptionally fast; just 10 years earlier, its energy consumption was half that of the US.

All of these developments were astonishing in their own right. But they were small in comparison to what is projected to soon occur.

The IMF dropped a major bombshell in 2011 when it forecast that China’s economy will surpass that of America in real terms in 2016.

Such an outcome would be a positively stunning development. But as amazing as China's emergence has been, it has not come without serious challenges.

China has considerable problems that it needs to confront. With a population of 1.3 billion people, the country outnumbers the US by a billion citizens. The need to provide energy for all of those people is transforming world energy markets and increasing the global demand for fossil fuels, including oil and coal. With 20 percent of the global population, China's enormous demand will continue to drive energy costs well into the future.

According to Fatih Birol, the chief economist at the IEA, China's surging appetite for energy will require a massive and rapid infrastructure build out. China will need to construct some 1,000 gigawatts of new power-generation capacity over the next 15 years — about equal to the current total electricity-generation capacity in the US.

That is simply amazing. The US achieved its current energy capacity over a period of many decades. Yet, China's growth has occurred at hyper-speed. This is already having enormous impacts on the planet, ecologically and environmentally.

Though the US has just five percent of the global population, it uses 25 percent of the world's oil. But America now has a huge competitor for vital energy resources, and one with very deep pockets. The irony is that America's robust appetite for Chinese exports helps to pay for China's massive purchases of foreign oil.

Yet, China's problems go far beyond its demand for energy resources, much of which come from foreign sources.

China needs to generate 15 million jobs needed annually—roughly the population of Ecuador or Cambodia—to employ new entrants into the national job market. That is a spectacular challenge.

China's incredibly rapid growth was built on manufacturing and exporting. But with the global economy slowing, the demand for Chinese goods has also slowed. In order to maintain its growth, China will eventually have to boost domestic demand and switch from its export-driven model to a consumption economy. That will be a challenge for a thrifty nation more inclined toward saving.

Moreover, one billion of China's citizens are still peasants. It has one-fifth of the world's population and it has to feed that mass of humanity. Yet, much of its landscape is an ecological wasteland and an environmental disaster area. That poses an enormous challenge.

Dust storms have been steadily worsening in China over recent decades due to heavy tree-cutting. The environmental damage in China is extensive. More than a quarter of the country's landmass has been turned into desert as a result of erosion and logging, and acid rain has damaged a quarter of Chinese soil.

According to the World Bank, China is home to 16 of the world's 20 most polluted cities. Three hundred thousand Chinese citizens die prematurely each year due to respiratory illness, and the life expectancy of a traffic cop in Beijing is approximately 40 years due to the horrid air quality.

These problems are poised to worsen as China attempts to provide energy to its continually developing economy and absolutely massive population.

So, while some are heralding the 21st Century as the 'Chinese Century', and predicting that China will supplant the US as the world's dominant power, I, for one, remain unconvinced.

Yes, the US has its own enormous challenges and finally appears to be bumping up against the limits to growth. While the US is the world's biggest debtor nation, China is the world's largest creditor nation and owns approximately 20.8% of all foreign-owned US Treasury securities.

Nonetheless, China will eventually face even greater environmental and agricultural challenges, which could derail all of those exuberant projections of its rise to global supremacy.

Yet, long before China is forced to fully confront its horrendous environmental degradation, which will make feeding 1.3 billion humans even harder than it would otherwise be, it will likely be derailed by the largest housing bubble in human history.

China has built entire cities with no one in them. Seriously.

According to Gillem Tulloch, a Hong Kong based financial analyst, China is building somewhere between 12 and 24 new cities every single year. We're not talking about developments, communities or neighborhoods — but entire cities. This means that 1-2 new cities are being constructed each and every month in China.

Think about that for a moment. It's hard to comprehend.

These are known as "ghost cities" and their skylines are adorned with massive apartment buildings that sit empty. The emerging Chinese middle class is buying up multiple properties — in addition to their primary residences — with the belief that real estate is the best investment. Banks offer paltry interest rates and the stock market is too volatile. Property prices, on the other hand, have always gone up and they've always beaten inflation.

Sound familiar?

Real estate has been an enormous driver of growth in recent years, accounting for as much as 20 or 30 percent of the entire economy, according to some estimates. And it's not just apartments and houses; it's shopping malls and towering office buildings. But far too many of them sit empty.

The idea seems to be, "If you build it, they will come."

But there's a big problem with that assumption: Though China has a rapidly growing middle class, one billion of its citizens still live as peasants.

The typical new Chinese condo is 1,100 square feet and costs between $100,000-$150,000. However, the typical two-income Chinese couple in their 30s makes approximately $7,000 or $8,000 a year. That just doesn't add up.

In some places, it's even worse. A typical apartment in Shanghai costs about 45 times the average resident's annual salary.

China is building the wrong kind of housing. It isn't creating affordable dwellings for its massive population of impoverished citizens. And desperately poor people don't shop at malls either. Most people in China live on about $2 a day.

When this enormous real estate bubble bursts, it will have massive reverberations throughout the world — not just in China.

About 50 million Chinese workers are employed as construction workers. When the bubble bursts, they'll all suddenly be out of work. That would pose a staggering social problem for the government.

Already, numerous construction projects throughout China have been abandoned. Many developers have run out of money and abruptly pulled out of existing ventures in midstream. That, in turn, is slowing the Chinese economy. Lots of loans are going sour. If this builds up a head of steam, it could cripple the economy.

How might this affect the US?

The Chinese government has spent some $2 trillion to build these 'ghost cities' as a means of maintaining its economic growth.

Imagine if the Chinese government has to use its US currency reserves to solve its own financial and economic crises. Imagine if it has to sell off its US Treasuries to fill the void?

If the Chinese bubble bursts, it would affect all US companies that sell commodities to China — particularly the variety that go into construction, such as steel, most of which goes to China at present.

I first wrote about the Chinese real estate bubble three years ago, when I questioned whether China's growth is an illusion. At that time, millionaire hedge fund manager James Chanos said the following about China: “Bubbles are best identified by credit excesses, not valuation excesses. And there’s no bigger credit excess than in China.”

Chanos, the founder and President of Kynikos Associates, has spent significant time evaluating and analyzing the Chinese economy and its property bubble. Back in 2010, Chanos warned that the bubble will likely burst and run its course in late 2010 or in 2011.

Because that hasn't occurred yet doesn't mean Chanos was wrong. He was just early. The pressures in the system have only grown considerably over the last two years, meaning that when this bubble does finally burst, it will be felt all around the world.

There's an awful lot of foreign investment money tied up in China. At the first outward signs of distress, everyone will want to escape intact. But with everyone simultaneously heading to the exits, not everyone will fit through the door.

The losses would be catastrophic.

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