More Evidence of a Chinese Investment Bubble

April 1, 2010 • Posted by: Charles Lewis Sizemore, CFA

In recent articles, I’ve made my position clear:  China is in the midst of a risky investment bubble (see prior post).  As we’ve written before, virtually all of China’s economic growth in 2009 was due to stimulus spending primarily related to infrastructure.  In January, citing a Pivot Capital report on China, we noted that:

• Investment accounted for 70% of Chinese GDP growth in 2008
• Investment accounting for 90% of Chinese GDP growth in the first half of 2009
• China’s investment rates far exceed those of even post-WWII Germany and Japan
• China is experiencing declining marginal returns on its investment spending (i.e. getting less “bang for the buck” for every dollar invested in capital spending). Decreasing returns are an indication of overcapacity.
• China’s urbanization rate is massively understated due to the definitions that China uses (by China’s definition Houston, Texas is not considered “urban” despite being one of the largest cities in America. Its population density is too low). Pivot estimates that China’s true urbanization rate is 20% higher than the quoted 45%. What this means is that continued urbanization will not be the economic boon that many China bulls believe it will be.

This is simply not sustainable over the long term.  As Japan proved two decades ago, the game of musical chairs can continue for much longer than anyone expects.  But when the music finally stops, the fighting over the chairs can turn into an all-out brawl.  Let us not forget how quickly the US mortgage market collapsed in 2008.

Today, I want to add a quote from the Financial Times on China’s stimulus spending.  The FT notes that grew its economy by 8.7% last year due primarily to government spending, but that officially, the country’s debt load barely budged.  China’s debt-to-GDP ratio is officially a very modest 20 percent of GDP (compared to roughly 200% in Japan).  But, the FT, writes,

“The catch is that most of China’s stimulus came not from conventional fiscal spending but from bank loans issued by state-owned financial institutions. New loans last year more than doubled to Rmb9,600bn , equivalent to nearly a third of GDP.“
Essentially, state-owned banks are lending money to local governments using “assets” like public land as collateral.   If these loans are are included in debt-to-GDP calculations, the FT estimates that China’s real ratio is over 70% and will be close to 100% by 2011.  This would make China’s government debt comparatively larger than that of the US!

I will be the first to tell you that I have no idea when the Chinese bubble will burst.  But I do know that I want to be nowhere near Chinese stocks or bonds when that happens.

That said, despite it all, I still believe that China offers potential for investors who are willing to think outside the box.  In next week’s issue of the Sizemore Investment Letter, I show investors how they can profit from the continued growth of China’s middle class without taking the risk of directly investing in risky Chinese stocks.  Don’t miss it: check out the Sizemore Investment Letter today.

Charles Lewis Sizemore, CFA

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