THE COMING COLLAPSE?

Sometime a month ago, my mentor wrote in his column about the impending burst of China’s asset bubble. At first glance, one would think that such an article are but one of the many China bashing articles that is popping out lately in the press but on a closer reading, one would find out that his analysis (which he got from a broker friend of his) are quite true and right on the bull’s eye. His foremost thesis is that China’s stock prices, which is a proxy for the general asset prices in China is defying gravity. Whereas the global stock market is reeling from the unraveling of the US subprime debt market, China’s stock prices continue to grow to unprecedented heights. And what make this explosive growth trend quite worrisome is that the assets are very much overvalued with some stocks commanding prices of 20 – 50 times their projected 2007 earnings compared to the typical price – earning ratio of a stock is around 12 – 15 times their projected income for the year. An inflated PE ratio signifies that intense speculations are in the works. Of course, speculations are part and parcel of any trading activities and one cannot really remove it totally. Speculation exists because there is an expectation of getting a better price from one’s asset holdings vis – a – vis from the current bid price. Therefore, because of this expectation, people hold onto their assets until the current bid prices raises to match their price expectation. Speculation becomes detrimental only when the asset owner’s price expectation becomes unreasonably high to such an extent that current market demand cannot further digest such exorbitant price. Put it in another way, if a significant percentage let us say 30 – 50% of the asset price is based on pure speculation as in there is no underlying fundamentals to back the price (the value or the worth of an asset doesn’t justify the price), then the price becomes highly unstable for it could collapse anytime at the slightest provocation just like soap bubble that continues to rise but is easily burst at the slightest touch. Prices would finally fall when the asset owners perceived that their price expectations can no longer be realize because the expected demand for their assets do not exists due to that the assets become too expensive already and they began to sell their assets, “trying to cash in” while the prices are still high. Now, if they are only seller in the market and everybody else is either buying or even waiting, it’s not a problem. However, it becomes a problem or more appropriately a crisis when everybody else began to sell and this would degenerate into a panic – selling. Now if just everybody else in the market is selling without regards to their profit or loss and nobody is buying, then we have a stampede and prices will collapse way below their fair market value. And it is this scenario which we refer to as “the bursting of the asset bubble”. Going back to the present day China, signs of an asset bubble are getting obvious. Aside from the inflated stock prices, one can also see the numerous glittering sky scrapers, the new and trendy apartment buildings in the major city centers that remained empty and unoccupied up to now. That’s not all, the explosion of new factories and new manufacturing facilities all over the country added productive capacities in their respective industries in large increments. And these newfound capacities are not backed by real demand but fuelled by easy credit and the perception that good times would last forever. However, technically speaking though, these “over investments” in assets though pointing to a possible formation of an asset bubble wouldn’t be really be considered threatening or problematic as long as the underlying “value” of the assets “could still justify” the hefty price tag. There are signs however in China that shows that asset prices are getting unstable i.e., it might collapse anytime. In Chinese cities, urban dwellers are beginning to complain loudly about stratospheric housing prices prompting government intervention. Furthermore, rate of return on investments of most Chinese companies are falling and some steeply in the last year or so. This is because of chronic over – capacities due to over investments in factories. Companies facing high fixed costs due to amortization needs would most likely shade the prices of their products just in order to incur sales and hopefully break – even. This would in turn lead to a vicious cycle of price undercutting among competition which in turn reduces profitability, and eventually, lowers the rate of return in investments. Due to this development, the Chinese government has now implementing curbs on borrowing to certain sectors of the economy as well as raising interest rates on loans. Higher interest rates tend to deter potential investments especially when the expected return of such investment cannot cover the cost of borrowing to finance the investment. Beijing is hoping that the series of economic measures would be sufficient to “neutralize” the potential threats to the continuous economic growth. In addition to that, recent developments are also threatening asset price stability in China. One such development is in the export front which up to now is China’s main engine of growth. The product quality scare though has negligible effect on the long run is likely to cause a dent in China’s sterling export in the short term. The numerous limits imposed on Chinese exports by EU and other countries. Couple this with the slowing of the US economy due to the credit crisis, China’s export would likely suffer and this would only aggravate the over capacities experienced in many industries in China. Aside from that, government investments in fixed assets such as roads, harbor, ports, airports, etc. are likely to slow down as well given the completion of the construction for the Beijing Olympic Games which is one of the largest public investments made by the government. Without government money to fuel domestic demand, there will be no alternative way out for companies facing challenges on the export front. Hence, the likelihood of an asset bubble and it’s possible bursting especially in 2008 right after the Beijing Olympics according to my mentor. Probably, this is because the Chinese government would do everything it could to present “a prosperous image to the outside world” during the Games and an economic meltdown isn’t exactly showing “a prosperous image” but the story would be different after the Games. Whether or not the economic meltdown would occur as perceived, the real question that one has to answer is what would happen next if China collapses? Well, going back to history particularly to China during the 80s and early 90s, in which China received a trade embargo after the Tienanmen Crackdown. At that time, the economy is experiencing double digit inflations. Bankruptcies was also rampant as some financially weak companies facing a crunch on their cash flow due to lower ROE fails to pay back their loans. This in turn led to the banking system saddling on a huge bad loans. A particular problem that crop up during the 1980 – 1990 economic slowdown was the Triangular Debt Problem. The triangular debt problem came to fore because the State Owned Enterprises (SOE) couldn’t pay back their loans extended to them by State Owned Financial Institutions, which in turn sourced their funds from government particularly local governments. The governments in turn owed the SOE in the form of advances from capital investments in order to fund other fixed asset investments. The result is a huge financial mess. What China did back then to solve the problem was to separate the government from businesses by handing the management of SOE and SOFI over to professional managers instead to government cadres. The government also furthermore liberalizes the economy, privatizing many SOE and allowing foreign investors into China as well as encouraging local entrepreneurs to invest. Lastly, the Chinese government also tweaks the export taxation system and devalues the Yuan. This led to the revival of the economy, which sees it expanding till now. Of course, the side effect of these series of Chinese actions was to indirectly trigger the 1997 financial crisis (though most of fault lies with the various ASEAN economies, i.e., economic mismanagement). Given that, what would one expect that if China’s bubble did get burst in the near term? Well, first of all, one have to remember that China though a market economy isn’t rule by Market Forces alone, i.e., Supply and Demand. China’s economy is very much influenced by the market forces as well as simple administrative fiat of the government. And in the imperative of protecting China’s ruling party’s interest, China wouldn’t hesitate to do whatever necessary to return the economy to growth in order to forestall unrest. And one of the most probable measures is to devalue the Yuan in order to boost exports. Second, with the devaluation of Chinese assets and the massive bankruptcy that could happen, it is also probable that China would further liberalize their economy and allow more foreign participation. As of now, China is gradually tightening it’s control over the economy by putting in place foreign investment restrictions. And these restrictions would likely be relaxed when the time comes. Furthermore, government takeovers of private enterprises particularly strategic bankrupt enterprises are also highly probable given it’s nature for administrative fiat. So as a business people, what are to expect in case of such scenarios? Well, first, expect fierce price competition from China not only due to the devalued Yuan but also to their penchant for price competition resulting from excess capacities. Second, with the Yuan devaluating, it might trigger a round of competitive currency devaluation especially with economies whose exports are in direct competition with China. As such, inflationary pressures would be pretty strong in these economies especially if they are import reliant. Thirdly, for those exporting to China, a Yuan devaluation would make their exports expensive and hence, this would stifle their export growth. On the positive side, a bubble burst of the Chinese assets has its benefits. One of the benefits is the cooling of commodity prices like metals and oil. Commodity prices are breaking record highs lately due in part to China’s surging demand. With the China factor curbed, it is only logical for commodity prices to “fall back to earth”. Another benefit is that for importers of Chinese products either for retail or for use in manufacture, abundant supply and lower Yuan means cheaper price and hence, lower input costs, which could potentially translates to better profit or larger market share in their respective markets for these importers. Still another benefit is that with high bankruptcy rates and a more liberal economy, a fire sale of repossessed assets at rock bottom prices can be expected and this would provide investors who are left out in the current China boom a chance to gain a foothold in China. All in all, whatever happened to China in the coming years, as business people, we are intricately connected to China.