Roofs of Rome

The Chinese Black Swan

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Party rulers in China are trapped in a position that chess players deeply fear — zugzwang — where any move made puts you at disadvantage. In China, the potential cost of both action and inaction is economic collapse.

China is slowly starting to face the consequences of its actions — loans grew over 30% a year over the last few years — and inflation is rising fast.  Inflation in developed countries is unpleasant, but it is tolerable.  For a developing country — and China, despite its size, is still a developing country — it can be catastrophic.  In developed countries, we spend two or three times less on food as a percentage of our income as do people in developing countries.  Therefore, though food inflation is unpleasant, we have a much greater tolerance (margin of safety) for it.  While food inflation the US can mean fewer trips to restaurants or no summer vacation, food inflation in China leads to hunger.

The Chinese government is desperately trying to put the brakes on the economy.  It is shutting off lending to land developers and has raised bank reserve requirements five times this year.  However, its success on the inflation front will likely lead to a slowdown of the economy and high unemployment.  Ironically, those were the issues party planners tried to cure when they stimulated the hell out of the economy over the last few years.

China bulls are arguing that the almighty Chinese government will be able to soft-land the economy. Unlikely, I’d say.  Forced lending was at the core of Chinese economic growth. Simply put, there is too much debt to go bad.   According to Ernst and Young, one-third of the $700 billion in loans taken out by local governments may face repayment problems.  The People’s Bank of China estimates that Chinese banks’ exposure to local government loans is 14 trillion yuan ($2.2 trillion), according to the June 17 South China Morning Post.  Once lending is cut off, property prices will stop appreciating (and likely collapse — that is what usually happens in a Ponzi scheme). Also, the overcapacity in the industrial sector and commercial real estate will come to the surface. And suddenly everyone will discover that the venerable emperor has no clothes.

I often hear the argument that China will not have a real estate crisis of US proportions because home and condo owners have to put 30-40% down when they buy.  So where do people get the money to buy a house that costs, on average, 8 times their annual income (a figure several times higher than in the US)?  Some of it comes from savings, and some comes from borrowing from relatives.

Let’s pause for a second.  In the 1990s, the Chinese banking system basically collapsed.  To revive it, the Chinese government took bad loans from banks’ balance sheets and put them into off-balance-sheet vehicles (Enron would be proud of that financial ingenuity).  Banks started to function as though nothing had happened. To finance the off-balance-sheet assets, the government set deposit interest rates at very low levels: 1% or so.  In a country with a very high savings rate and 5% inflation, this resulted in a 4% annual loss of purchasing power.

Chinese consumers were punished severely over the last 10 years for the banking crisis of the late ’90s.  And they’ll be punished even more soon.  Keeping money in the bank didn’t make that much sense, and investment alternatives were limited. However, they could invest in an asset that supposedly never declines in price – a house or condo.  So they did.  As China slams the brakes on the economy and as housing prices fall, the banks will lose plenty of money. But more importantly, it is the people who bought tremendously overpriced houses, and their relatives who lent them money, who will lose.  The wealth and hard work of more than one generation will be lost, and this kind of pain leads to political unrest.  That is the Chinese Black Swan!

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here or read his articles here.

Investment Management Associates Inc. is a value investing firm based in Denver, Colorado.  Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.

Copyright Vitaliy N. Katsenelson 2011.  This article may  be republished only in its entirety and without modifications.




  1. Isn’t the logic that in China 2+2 doesn’t have to equal 4 the same that the Chinese RTO’s have been using? You might want to look a little harder at the track record in China when 2+2 doesn’t add up to 4.

  2. Dear  Vitaliy N. Katsenelson ,

    I am simply very wondering in what basis can you say that Chinese banking system basically collapsed during 90’s ?

    I know that they allowed countless non performing loans to state-run companies.
    And yes their 70% of the economic growth is made from the fixed asset like mega project or real estate bubble.

    But do  you have any related datas on it that can prove they collapsed during 90’s ?

    and would you please explain the principle based on this data ?

    Thank you.

  3. at least they are slamming on the brakes. the US didn’t do that in 2007-2008…
    looking forward, I think if there’s a qe3, in the US… chinese stocks are a buy

  4. Jim Rogers should read this.  The basic problem of the Chinese economy is that the Chinese government is still trying to manage the economy.  Managed economies never survive.  The US economy is dying from government management.  France and the UK have collapsing economies due to government mismanagement.  Germany is doing well because it is being bolstered by the rest of the European Union, but when the EU crashes, Germany will fall with it.  But the Chinese economy is worst of all.  Labor problems are still coming as a result of China’s former one-child policy.  Swaths of real estate remains vacant simply because the Chinese deemed it more important to employ people than to have them produce things that will be used.  China has immense environmental problems.  The Chinese are making token efforts to deal with their environmental problems, but the problems are bigger than the Chinese gov’t is willing to confront.  Hello to Jim Rogers!

  5. However, for the last so many years, the very USA has been on its very knees begging for mercy from Communist China, right? While at the same time, the USA  having Communist China, as one of its favored bankers!  In reality, shame to America for not beeing the true example it was supposed to be for all times, as per the Founding Fathers! Now the most horrendous and evil Empire of all times with its Militarism circling the globe and fighting bogus wars after bogus wars and ever deeper in bankrupt condition. If the Founding Fathers were to rise they would immediately wish to go back to their graves seeing their nation, in reality in the hands of other than God Almigthy and creating more and more suffering at home and abroad. So, here my reaction to your otherwise complicated article!

  6. While I am not a china bull myself, I do have to wonder about these China bears like Vitaliy Katsenelson.  He has been saying for quite a while that the economy is going to crash soon.  Well…when?  Like, next year?  50 years?  What are we looking at here?

    Without a time frame on such an apocalyptic prediction, being a china bear is pretty useless for the rest of us mere mortals.  It’s like what they say: when you end up being 10 years early, you’re not actually early…You’re wrong.

    P.S.  I predict that some time within the next 100 years some economy will experience a massive decrease in their equity index.  You heard it here first.

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