Five Perspectives on China’s “Investment Bubble”
Will investments in China continue to offer attractive returns, or have initially sound hedge investments given way to Ponzi financing run amok? In an entertaining talk at the CFA Institute Wealth Management 2012 conference, Yale lecturer Vikram Mansharamani used five different perspectives on China’s economy to argue that China’s investment-driven boom will be the next great financial bubble to burst, predicting significant drops in industrial commodity prices, commodity producers’ profitability, and even the currencies of the major commodity-producing countries.
Mansharamani began by summarizing key portions of his book, Boombustology, in which he used five analytical lenses to examine historical asset bubbles that subsequently burst. These five lenses — microeconomics, macroeconomics, psychology, politics, and biology — provide particular insights into whether an appreciating market might be considered a bubble. Viewing China through these lenses paints an interesting picture.
- The microeconomic lens concerns the price mechanism. Do prices reflect market equilibrium between supply and demand or a reflexive feedback loop in which demand increases because prices are going up?
- The macroeconomic lens examines the role of credit-fueled speculation in rising asset prices. Hyman Minsky’s financial instability hypothesis suggests that stable markets breed instability, as investment migrates from hedge investments (in which debt can be repaid through investment income) to speculative investment (in which interest can be serviced through investment income, but repayment depends upon asset appreciation) to Ponzi financing (in which even servicing interest on debt depends upon appreciating asset values).
- The psychology lens views asset prices in the context of human behavior to determine whether investors are acting rationally, or whether there is evidence of overconfidence — even hubris — in their actions.
- The politics lens focuses on the government’s role in markets and to what degree government involvement may be distorting markets. For example, government actions may be interfering with true price discovery through regulatory fiat, distorting reported data, or other disruptions.
- Finally, the biological lens explores the concepts of epidemiology and emergence, applying them to financial markets. In some ways, financial bubbles are similar to epidemics, and their trajectory will depend upon the “infection rate” among market participants, the “removal rate” among the infected population, and the number of remaining participants yet to be infected. Emergence relates to the tendency of seemingly chaotic populations to exhibit herding behavior, as individual decision making is influenced by the decisions of other individuals.
Does China exhibit bubble characteristics, according to these criteria?
- Micro lens: Are asset prices in China trending towards equilibrium or indicating a reflexive dynamic? Ten-year trends in real estate prices and the tremendous growth of both residential mortgages and developer loans indicate that a reflexive dynamic in which rising prices create additional demand.
- Macro lens: Are there signs of speculative activity in China? The documented construction of five “ghost cities” and millions of vacant square feet of mall space are signs of overinvestment in the real estate sector. This overinvestment in real estate has been commented on by others, such as Patrick Chovanec of Tsinghua University School of Economics and Management. Professor Chovanec, who will be speaking at the upcoming Asia Pacific Investment Conference, pointed out in a Seeking Alpha column that “the overhangs in China’s property market are not at all limited to first-tier cities. . . . They are the pervasive outgrowth of deeply embedded structural issues in China’s economy.”
- Psychology lens: Is there evidence of overconfidence or hubris among the business elite in China? Historically, the construction of skyscrapers has preceded severe market reversals, and no fewer than five Chinese construction projects are vying to claim the title of “world’s tallest building.” Mansharamani suggests that building skyscrapers reflects hubris, is speculative by nature, and may be evidence of overconfidence. Exorbitant prices paid by Chinese collectors for art and other collectibles provide further evidence of potential overconfidence among the Chinese elite.
- Political lens: By its very nature, the state-run economy distorts the pricing mechanism by guiding investment in order to meet its targets for gross domestic product (GDP). Increasingly, state-owned entities in China have dominated private developers at state land auctions, suggesting prices may be artificially supported for noneconomic reasons.
- Biological lens: Chinese popular culture has begun to reflect the steadily rising prices of real estate, much in the same way that U.S. television shows such as Flip This House became popular at the height of the U.S. housing bubble.
Based on his analysis, Mansharamani declared that the China boom has many of the characteristics of a bubble that is likely to burst soon. He predicted that China will deliver only a 4% compound annual growth rate over a 10-year period, starting now. He suggests that global investors consider the possible ramifications of the China bubble bursting, which could include a sharp decline in Chinese demand in industrial commodities and how that would impact emerging economies, shipping, capital goods suppliers, and many other components of the world economy.