Effect of a Chinese bubble burst

I can see that my last post about the building Chinese asset bubble has caused some alarm.  To allay those fears let me first start by saying that I think the effect of the asset bubble bursting in China will be much less pronounced on the rest of the world’s economies when compared to the asset bubbles bursting in the United States and Europe during the Great Recession.  Here’s why…

• First let’s recall why the asset bubble bursting was so rough in the First World.  It involved whole, huge sectors of the economy.  There were construction firms, cement companies, lumber companies, hardware suppliers, local lenders, national lenders, investment banks, realtors, and especially, consumers.  So when the bubble burst it took down the values of most investment asset classes (stocks, bonds, commodities and real estate).

The value of all of these assets was denominated in the U.S. dollar or in the Euro.  These two currencies also happen to be the global currencies for trade and commerce.  So that meant that the value of trade was effected globally.

The First World’s economies are largely consumer spending driven (usually around 2/3 of total GDP).  Consumers happened to be the hardest hit by the Great Recession.  They were invested in a primary residence, secondary residences (and others), in the stock market, and many folks had jobs directly or indirectly tied to real estate in some fashion.  When the net worth of consumers fell they stopped spending which led to a vicious circle that I have talked about many times on the blog, that included declining asset prices, lower corporate profits, and job layoffs.

So for any decline in China to have the same affect, similar causal structures have to be in place.

• Any effect of the Chinese asset bubble bursting would have to come from the interlinking of the Chinese economy with the rest of the world’s economies.  During the Great Recession 5 of the 6 most important world economies were affected simultaneously.  This is because of the high degree of interdependency.  The Chinese economy is not that integrated with the economies of the rest of the world.

If you treat an asset bubble bursting as a contagion then you have to look at in what ways that contagion would spread to the rest of the world.  Yes, the Chinese have the second largest economy on the planet.  But its exports to the rest of the world amount to only $1.58 trillion on a global economy that is ~ $74.3 trillion (source: CIA World Factbook) in size.  This amounts to a meager 2.1% of total worldwide economic output.

Even if the bubble bursts and it is horrible for the Chinese, their exports would likely not drop that much.  In fact, if the asset bubble bursts in China it would lower the price level throughout China, which would make their exports cheaper.  That might even spur demand in the First World for additional Chinese goods.  But to be conservative, let’s assume that China’s exports fell by 25% (a highly unlikely scenario).  That would amount to $395 billion in lost economic output.  While large that represents only 0.5% of total worldwide GDP.

Of course the Chinese themselves buy foreign goods which also interlinks them to the rest of the planet.  Last year, Chinese imports of goods amounted to a meager$1.39 trillion – or about the same as their exports.  So imagine the Chinese are so shut down that they stopped all importing (that would never happen), that would amount to a paltry 1.9% of total worldwide GDP.  Not fun, but not scary, either.

But exports and imports are not the only way that China integrates with the rest of the world, there is also the direct investments made in China by foreigners.

• The Chinese have severely limited the amount of foreign direct investment in China.  In fact, in 2009, the latest year for which statistics are available, foreign direct investment was estimated at ~$90 billion by all foreign investors (source: The U.S.-China Business Council).

If the bubble burst let’s imagine a disaster scenario: the value of investment falls by 50% (highly unlikely).  If that situation unfolded we would be talking about a $45 billion loss.  Again, not fun, but not even close to catastrophic.  That loss would represent a loss of global gross domestic product of only 0.06%!

• You see almost all investment in China is still overwhelmingly done by the Chinese government itself.  In fact, investment in China last year was $4.2 trillion and was equivalent to 69.9% of all economic activity in China last year.  This is a massive percentage.  That is another way of saying that the Chinese government is to the Chinese economy, what the First World’s consumers are to their economies.

• Trade throughout the world is largely denominated in the U.S. dollar.

The U.S. dollar and the Eurozone’s euro are the dominant world currencies.  In fact, almost all trade in the world is conducted in these two currencies.  During the Great Recession that meant that the contagion affecting the U.S. and Europe spread throughout the world.  The Chinese currency, the yuan, is not a global currency for transacting business.  So a decline in the value of assets denominated in the Yuan will not spread much beyond the reaches of the yuan currency’s power.  In other words, the damage will largely stay in China.

• Chinese banking is insular and not that connected to the rest of the world.

The Chinese are an insular people even despite their huge and successful record as exporters.  That means that what is raised in China, stays in China.  That includes capital.  China has six very large banks whose sole purposes are the full-employment of the Chinese people and the full-deployment of Chinese capital.  They do this with massive inefficiency; hence, the Chinese asset bubble.  These banks therefore, are not big investors in projects outside of China.  The most important exception is Chinese purchases of foreign government debt.

• It is well known that the Chinese purchase large amounts of foreign government debt.  What is not well known is just how much they hold.  To me this would be the largest effect on the global economy when the Chinese asset bubble bursts.

The Chinese will have to look inward if there is a bubble burst, ergo their ability to finance government deficits around the world will be reduced.  That may drive up lending costs in the First World as the demand for their debts declines, prices (i.e. interest rates) will have to go up.  It is difficult to say just how much damage this would do.  Some estimates place Chinese holdings of foreign debt at around ~$2.5 trillion.  That equates to approximately 3.4% of total worldwide gross domestic product.

The Chinese will in all likelihood not sell their holdings of foreign debts to raise capital.  Why?  Doing so would drive down the price of these assets which would only hurt the value of these holdings for the Chinese.  So the primary effect would be to raise interest rates on new debt issues.

• Commodities prices will collapse.

The Chinese are voracious consumers of the world’s commodities, ranging from gold to oil to lumber to cement.  In fact, the Chinese have single-handedly led to a bull market in commodities prices for the last decade.  That demand has also attracted huge amounts of speculative investment.  Expect the prices of these goods to rapidly fall.  To my way of thinking, the lowering of the price of these goods and services is a good thing for the worldwide economy, in general.

• Psychological impact.

Of course there is the psychological impact of a Chinese recession on the world’s citizenry.  Clearly this is a matter of timing.  If the asset bubble bursts in China in the next year, my feeling is that the psychological effects would rank a 6 on a scale of 1 to 10, with 10 being very bad effects.  However, once news spread that the effects of the collapse were largely contained to China, I think the psychological impact would dissipate fairly rapidly.

So to sum it all up, the Chinese asset bubble is likely to burst sometime soon.  The primary economic effect will be a pressure on global interest rates to rise and a collapse in commodities prices.  The psychological effect will actually probably be the largest effect (the only thing we have to fear is fear itself).  What is not easy to predict is just when this will all happen.  Furthermore, it may be the case that the Chinese find a way to rein in the lending of its banks and mitigate the crisis entirely.

Jason

Notes:

Here is a breakdown of the latest Chinese economic data:

Total gross domestic product: 39,798.3 billion yuan, up 10.3% y/y (this year compared to last year)

Industrial production: 3,882.8 billion yuan, up 49.4%

Investment in fixed assets: 27,814.0 billion yuan, up 23.8%

Consumption: 15,455.4 billion yuan, up 14.8%

Exports: 10,387.8 billion yuan, up 31.3%

Imports: 9,182.4 billion yuan, up 38.7%

Net exports (exports – imports): 1,205.4 billion yuan