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GMO: Something's Fishy in China

January 17, 2012

by Robert Huebscher

Collective irrationality and herd behavior were the sixth sign of a bubble that Chancellor discussed.  As an example, he cited the Mississippi bubble of 1719, when investors poured money into a trading company based on an over-hyped value of properties in Louisiana.  Signs of similar activity in China include excessive trading – in 2009, there were days when the Shanghai exchange volume was greater than that of New York, London and Tokyo combined.

Fraud and Ponzi financing were the next indicators Chancellor cited, of which there is a long history in the US, including Enron and WorldCom.  Chancellor showed examples from China today, including Longtop and Sino-Forest, the latter of which ensnared the hedge fund investor John Paulson, who lost $100 million when the company collapsed amid questions about its finances.

Ninth on Chancellor’s list was conspicuous consumption, which in China has been most obvious in excess investment.   He said China’s fixed investment is roughly 50% of its GDP, a level that no other economy has sustained for a long period of time.  

Real estate markets are the subject that most clearly separates the optimists from the pessimists in regard to China.  Chancellor, as you might expect, said the market is vastly overbuilt, with empty apartments throughout the country.  Moreover, work on much of the construction has been shoddy, he said, including the use of cement insufficiently strong to support buildings.   Many apartments have no fixtures, electricity or bathrooms.

And the number 10 sign of a bubble…

Ultimately, what matters for investors are valuations, and Chancellor cited several examples of prices in China that increased by two or more standard deviations above their historical averages.  The most prominent illustration is in housing, where the value of China’s housing stock went from 200% to 350% of GDP from 1998 to today.  By contrast, the corresponding increase in the U.S. was from 100% to just over 150% from 1998 to 2006, and ours is now back to nearly 100% of GDP. 

China’s housing bubble more closely parallels that of Ireland in 2004 and Japan in 1990; it both cases, a collapse in housing led to severe recessions.

Chancellor said that he discussed China’s housing market with his boss, Jeremy Grantham.   Acknowledging that China’s empty apartments were primarily for trading and not for occupancy, Grantham said that they were like the sardines tins that California’s gold miners exchanged in the 1850s.  When a prospector was flush with money, they would buy a tin of sardines, and sell it when their fortunes had reversed.

One day, however, a miner opened a tin and found that the sardines were rotten – thus realizing that these tins were really for trading, not eating.

The sardine investor may still have been better off in those days than a Chinese real estate investor is today, since there was a secondary market for trading those little tins.

There is no secondary market for Chinese housing, Chancellor said.