The farce of the eurozone’s debt crisis is understandably captivating, but is an even bigger situation developing in China? Credit-fuelled gullibility lies at the heart of most bubbles, but such gullibility provides quality fodder for fraudulent schemes too. No one notices on the way up. But Charles Kindleberger showed in his seminal history of financial manias that they start emerging on the way down. In this context, China’s newsflow is worrying indeed.
So begins the latest note from SocGen’s Dylan Grice. And it’s something of a treat. He’s puzzled that so few people are forecasting a hard landing for China given the developing distress in the highly speculative (and pivotal) sector of its economy.
Grice reckons the best way to think about China is with regards to the framework provided by Charles Kindleberger in his classic text “Manias, Panics and Crashes“.
To cut a long story short, the framework has five stages, and China has just moved from Stage Three (euphoria) to Stage Four (crisis).
Grice explains:
It sees, after a levelling off of prices, an uneasy period of financial distress, often accompanied by a move to increase liquidity. As this distress persists, the rush to cash turns becomes disorderly. It may be caused by a banking failure, a sudden decline in the price of the object of speculation, or maybe – and of relevance to us now – by the revelation of spectacular fraud. The spell cast on the public’s imagination in stage one, and strengthened during stages two and three, now breaks. It paves the way for stage five: revulsion, where the former object of speculation is now derided as an embarrassment.
The evidence, says Grice, is the sudden scramble for liquidity across China’s property sector in response to credit tightening measures.
According to a recent Bloomberg article (last week), nearly 70% of property developers saw worsening cash flow positions in August relative to July. In his excellent blog, Patrick Chovanec suggests this rush for cash explains why primary real estate prices in Shanghai and Beijing (i.e. prices the developers sell at directly) are 20% lower than those in the secondary markets. Developers have been dumping their inventory. The WSJ blogged last week that Longfor Properties Co. showrooms in Shanghai were attacked by protesters – presumably recent property buyers – aggrieved at the developer’s recent 25% price cut on new deals. This sudden scramble for liquidity feels like Kindleberger-Minsky’s stage four.
And something else which feels very stage four is the recent emergence of various swindles. The sub-prime crisis ultimately unmasked Madoff, Galleon, and the Greek government, but one of the first cockroaches was Bear Stearns’ Structured Credit Fund, later found to have mismarked the valuation and liquidity of its holdings to investors.
Indeed. Think about all those Chinese reverse merger companies like Sino-Forest and Chaoda Agriculture.
In the meantime, swindles are emerging in the infrastructure sector too. Passengers have been mauled or even killed in accidents on the newly opened Shanghai metro and Beijing high speed train system and the blame is being laid at the door of engineers cutting corners to meet ambitious targets. But would you be surprised if shoddy workmanship by fraudulent workers was to blame too? I wouldn’t. According to this China Daily report, the building of bridges and tunnels is being sub-contracted out (illegally as it happens) to firms run by qualified chefs with no building experience, who believe it is an acceptable practice to use gravel in pier foundations (see last quote on front page).
And I doubt these are isolated events either. Media reports suggest that the problems go all the way to the top. For example, the wife of the deputy-chief engineer at the ministry of railways – himself recently found guilty of fraud – reportedly owns three Los Angeles mansions and offshore bank accounts worth nearly $3m. And that would be entirely in line with the estimated average theft committed by the average fleeing public official, according the PBOC at least, which recently estimated that since 1990, a total of 18,000 party officials had fled the country, taking with them a total of $120bn (around $7m per flight). Of course, the report doesn’t include any estimates of embezzlement by officials who haven’t fled and so is likely to underestimate the bezzle.
Now, Grice says we should by wary of drawing conclusions from anecdotes. After all, Japan is witnessing its own corporate scandal unfold with Olympus and no one thinks that it’s a bubble economy about to burst.
Nonetheless, he’s convinced China is now at Stage Four and heading for Stage Five.
But though anecdote is of the very lowest quality information when looked at alone, when placed in context I believe it can help contribute to the attainment of knowledge. And placing these new and various revelations of fraud in the context of the recent rush for liquidity among property developers, the aggressive and sudden credit expansion of recent years, the pervasive feeling that ‘China is different’ during the same time gives the feeling of something more tangible altogether. While its application is more art than science, I believe the Kindleberger-Minsky model is fundamentally valid and that when placed in that framework, these various anecdotes paint a telling picture. And stage five, of course, is revulsion.
Related link:
The market for honesty: Gold at $10,000 - FT Alphaville