China's Bubble Economy Comes a Small Step Closer to the End of the Boom

The PboC surprised the markets on Tuesday with a small baby step rate hike of 25 basis points – alas, this has still left China's real deposit rates in negative territory, as can be seen below:



China's real interest rates: still negative – click for higher resolution.



China's bubble economy has confounded the bears for a long a time – but that is no wonder. After all, it is not only a bubble – there is surely some genuine, wealth-generating growth going on as well underneath the bubble activities. In fact, if that were not the case, then last year's 'stimulus' spending and the associated government-ordered lending spree would not have had much of an effect.

We can see in the US what happens when a country's pool of real funding is in genuine trouble after a huge credit-induced boom, with a string of capital malinvestment episodes concentrated in different sectors of the economy taking place in close succession. In the case of the now defunct housing bubble, the amount of capital that was misdirected in the end amounted to capital consumption on an unprecedented scale in the post World War 2 era – hence the inability of the Federal Reserve and the administration to  create even an illusion of recovery by means of an extremely loose monetary policy and a barrage of deficit spending initiatives.

Evidently, China's economy was still in better shape structurally, since its authorities were able to create a new boom by administering the Keynesian 'cure' when the downturn struck. This new boom however is beginning to look ever more unhealthy. Don't get us wrong, looking at 'GDP growth' you would think China is still in excellent shape.

However, it is well known from anecdotal evidence that the country is littered with empty office towers and apartment buildings (see: 'Property speculation leaves 64.5 million vacant homes in China') as China's citizens plow their savings into real estate, which is seen as offering a better return than the negative deposit rates one can get at the banks.

As our friend BC (of the 'Imperial Economics' blog) writes:


“Total Chinese money supply is up over  four times since '03, a 17%/yr. rate at a doubling time of just four years; up 66% since Jan. '08, a 19%/yr. rate at a doubling time of 43 months; and up 40% since Jan. '09, a 20%/yr. rate at a doubling time of 40 months.

This kind of money supply growth is banana republic-like, making our feeble efforts appear benign by comparison.”


With that kind of monetary growth it is fairly easy to throw a party, but it should also be quite clear that the party is at some point going to come to an unpleasant end.

China's economic planners meanwhile are confronted with the problem that prices other than those of houses and apartments are also rising , which is a great burden on the still large and poor rural population, as well as on all those cheap laborers in the cities. In the interest of preserving social harmony, they must therefore juggle several balls at once, an act that can easily go awry.

Also, as reported by Asianomics in a recent research note:


“In a presentation at last week’s Mont Pelerin Society in Sydney a Chinese presenter reported that the return on equity among China’s SOEs was 3.1% last year. He was comparing this negatively with the ROE to ‘private’ companies of 8.2%. Quite simply, both are pathetic and both are driven by a cost of capital that is frighteningly cheap.”


Well, the cost of capital in China isn't going to stay 'frighteningly cheap' forever – in all likelihood the recent rate hike was just the first step on the road to 'normalization' – but what does that imply for the bubble activities currently driving China's 'growth'? It can't mean anything good, although the bust  – when it comes – should be seen as a salutary event for genuine wealth producers , who no longer will have to compete for scarce resources with the bubble-dependents.


Ancillary Bubbles

This brings us to a related point, namely what we call the 'ancillary bubbles' in Australia and Canada. Both countries are marked by soaring real estate prices, soaring household debts, and economies that one the surface look like yet another example of ruddy health, as they rake in the dough from the boom in commodity prices that is inter alia a result of China's imbalanced growth (we would be remiss not to mention monetary inflation elsewhere – Helicopter Ben has his share of responsibility to bear as well).

Looking at Australia in more detail, we would term it a bigger version of Iceland, only with iron ore and copper instead of codfish liver and whale blubber.

We already mentioned the enormous real estate bubble (house prices have doubled in the past eight years) and the huge household debt burden – which naturally is combined with an extremely low savings rate.

Australia's economy is a classic case of the combination of over-consumption and  malinvestment in higher order goods industries that mark an unsustainable boom.

However, what is also worth noting here is that Australia's banking system is  like a powder keg in search of a lit fuse. Below is a chart of the loan-deposit ratios of Australia's four biggest banks:



Loan-deposit ratios of Australia's 'Big Four' –  ANZ National Bank, Commonwealth Bank of Australia, National Australia Bank and Westpac – click for higher resolution.



This is not exactly a confidence inspiring state of affairs. What's more,  Australia's banks are entirely dependent on offshore funding and incidentally represent some 25% of the market capitalization of Australia's 'All Ords' Index. As Mish reported in September, these banks are now offerig truly absurd terms in order to peddle ever more mortgages – exactly the type of thing that brought down the US banking system after the real estate bubble burst.

It's worth repeating the quote from the '' article 'Lenders back to throwing cash at buyers' he brought in this context:


“Next month, non-bank lender Mortgage House will offer a home loan equivalent to 105 per cent of the property's value – the most generous deal since the global financial crisis kicked in three years ago.

The company also offers a 99 per cent loan-to-value ratio loan, which it launched last month, and says applications have been flooding in.

"Demand is really strong; people are finding it difficult to save substantial deposits" Mortgage House CEO Ken Sayer said.

But it's not just the non-banks that are splashing the cash.

Last week, Westpac raised its LVR for new customers from 87 per cent to 92 per cent, reversing the cut it made back in January; while ANZ also last week raised the maximum LVRs from 95 per cent to 97 per cent for existing customers, and from 90 per cent to 92 per cent for new borrowers.

Commonwealth Bank has left its LVRs unchanged, at 97 per cent, but is trying to attract extra business by increasing its discount from 0.6 per cent to 0.7 per cent on loans taken out before the end of October.

With affordability at near-record lows, experts say banks have had to loosen their lending criteria or see potential buyers priced out of the market. "Banks need to keep on lending but, with house prices rising, they have to lend more – Westpac customers will now be able to borrow almost double what they could before," University of Western Sydney economics professor Steve Keen said.

"Little changes in LVRs have a massive impact on what you can borrow. If you need a deposit of 13 per cent and have $50,000 saved up, that cash will enable you to spend $384,000 on a property.

"But if the bank will lend 92 per cent, your $50,000 will allow you to buy a property worth $625,000."

Westpac denied it was fuelling house-price growth and said the falling unemployment and strong economy were behind its decision.

"This change reflects our growing confidence in the economic environment, reflected in the low level of delinquencies for this market segment," it said.

ANZ's motives are less clear: the company refused to comment.”


If this strikes you as an accident waiting to happen, that's because it is one.  It all hinges on an uninterrupted boom in China, since that is what fuels the boom in the large resources sector in Australia. It is all slated to come to an unhappy end – once China hikes rates far enough to stop its property boom in its tracks.

We will therefore keep a close eye on the CDS spreads of Australia's big four banks in the future:



CDS on Australia's big four banks – in basis points, color-coded. Note how the market briefly got very worried when the euro area sovereign debt crisis hit in May this year– click for higher resolution.



The global market reaction to China's small rate hike on Tuesday must be seen as a warning shot – the hike is probably not yet enough to cause any more significant wobbles in the ongoing boom. However, should China's officials continue to hike rates, then at some point the low-return bubble activities will  inevitably come to a halt, and the ensuing economic setback will be felt all over the world. It should be felt especially strongly in the countries that are indirectly partaking in China's boom by dint of being large raw materials exporters and that all have bubble economies themselves.

Australia and Canada are outwardly healthy and many laud their strong performance and allegedly strong financial systems that have weathered the 2008 crisis oh so well. However, we should not be blind to the reality that this has only brought about even bigger bubbles and distortions in these economies. None of them are sustainable – and in all likelihood it will all end in truly memorable crashes when the time comes.


Charts by: Bloomberg



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