I’m writing from the Trans-Siberian Railroad somewhere in southern Mongolia. I left Beijing a day ago and still have more than half a day on the train before arriving in Ulaanbaatar, Mongolia’s capital. I could have saved 30-something hours by flying, but I’m here to learn more about Asia. You cannot see anything from the air. I’ve actually seen a lot in the past day to modify my perceptions of China. Businessmen in a hurry take airplanes. Whenever I can, I chose to go at a slower pace and take it all in. You never know when something will make you question your thinking. Besides, after a whirlwind trip through China, it’s nice to relax a bit. I’m surrounded by stunning scenery, close friends and all the beer I can drink. I’m a very happy hedgie.
Once you leave the more polished Beijing, you start to see the ‘other China.’ There are immense swathes of extreme poverty. There are shantytowns and mud huts along with plenty of Soviet style housing in various stages of decay. There are picturesque farming villages and noxious industrial towns. You can literally see the pollution clouds for kilometers before you can see the first buildings of the next city. If you told me that all of China qualifies for superfund status, I’d agree with you.
The pollution is intolerable. There are red, purple and green rivers. Some rivers have multiple colors depending on where the polluting factory is upriver. There are clouds of orange and purple smoke over some towns, and black smoke over others. Brand new condos are rusting from the acid rain. As I neared the Mongolian border last night, I saw a shadow creep across the dining car table. It was a bit startling. I literally have not seen the sun since I left Toronto.
Even more amazing is the blatant misallocation of capital that I see everywhere. There are thirty story office buildings in corn fields and bridges over rivers that do not link up to any roads. There are five lane highways with only a handful of cars and there are half built condos decaying next to belching smokestacks. I cannot make sense of this. You read about it and even see pictures of it, but until you see 10,000 vacant condo units in a town of 500 people, you find it difficult to believe. After nearly two decades of rampant growth, it’s inevitable that there will be misallocations of capital. The longer a boom lasts, the more bizarre these misallocations are. The Chinese system of government intervention likely has exacerbated the problem.
One of the more remarkable things about the Chinese economy is that it is nearly impossible to determine where the public sector ends and where the private sector begins. Every bureaucrat seems to have a different view on their responsibilities. The government water company may literally be in the semiconductor business and the government semiconductor business may be trying to deliver water. It’s baffling. There is a strong feeling that unless you have relatives in the government, you cannot advance economically. It seems that corruption is so ingrained in the culture that it can never be expunged. Everyone complained about how corruption stifles growth.
A lot has been written about a Chinese bubble of sorts. I’m not sure what to think. It’s hard for any Westerner to really comprehend what is going on in China as it is so different from our system of economic growth. For instance, most Chinese will readily admit to you that their banking system is insolvent, but then again, it has been insolvent for two decades now and it hasn’t really mattered. The funding mechanism for most capital projects is a Gordian knot of IOUs, state corporations and shell companies theoretically comingled with bank financing. It works until it doesn’t. Private companies are routinely cudgeled into funding projects with no economic return. Businessmen go along with it because they fear the consequences.
It’s obvious that there has been a tremendous misallocation of capital, but that is not exactly synonymous with a bubble. In an economy with double digit growth, a bit of waste is to be expected. What are a few million vacant condos in a multi-trillion dollar economy? I have always thought that to have a bubble, you need multiple layers of debt to prop it up. In China, you need a sizable down payment to buy a new condo. If you want a second or third one, you need to pay for it almost completely with cash. Property development loans have different rules—is it a corporation, a bank or an individual who is personally liable if there is a default? What if it is all three and they are all fronts for different government agencies? Is that much different from how low income housing is financed by our own government? I think it is naive to look at rampant construction or empty office towers and unilaterally declare China to be a bubble.
What is a bubble? A bubble is an economic event that overwhelms rational thinking forcing sane people to act irrational. It isn’t a few people making bad decisions. A bubble is when an economic trend pervades an economy and changes how people function within the economy. It is a level of action and thought that is all encompassing to those who are engaged in it and most of the relevant population eventually becomes swept up in it. The main thing about a bubble is that an outside observer can spend a few minutes investigating it and conclude that everyone has gone mad. There aren’t half bubbles or tame bubbles. Either it’s a full blown insanity induced bubble, or it’s not. It should be obvious.
I lived in Miami through the great property bubble of the last decade. I saw things that were stupendous. I watched banks lose all sense of restraint and offer credit to anyone. I watched as the 1,600 foot house I rented was bid up to over a million dollars by my gardener. My dog was preapproved for a HELOC by WaMu. I saw businesses form to service this insanity. At one time, there were 24 real estate brokerage offices within five blocks of my condo. I saw mortgage brokers make a million dollars a year refinancing loans to people who could not possible afford them. Across the street from me was a 24 hour mortgage refinancing outfit. I used to joke that you could swipe your deed, round the corner and pay your bar bill. Near the top, people would camp out for weeks to be first in line to buy pre-construction condos. By noon that day, they’d flip them for a $30,000 profit each. To an impartial observer, it was obvious; Miami was engaged in an epic property bubble. The people were drunk with playing the property ladder game. The economy of Miami was increasingly fake. When it all collapsed, there was quite a lot of collateral damage.
Having witnessed one bubble, I feel I can recognize another one. Strolling around downtown Beijing, I saw a single real estate office. There was no one trying to peddle no money down mortgages that reset in 18 months. I did not see real estate agent sandwich boards trying to get you to buy a unit during your lunch break. A surprising number of individuals are simply priced out of the market. Many purchases are all cash. This doesn’t feel like a bubble.
All real estate is local. It’s rare to have a national real estate bubble. It’s nearly impossible to have one without massive debt. Sure, there’s been a huge run-up. Sure there’s a lot of fluff in individual markets. I’m nearly certain that there will be a severe setback at some point. However, economic trends have a way of staying in motion for longer than anyone can imagine. I sure wouldn’t want to guess the timing of this setback. I feel confident that there eventually will be a Chinese property bubble, but it may be another decade in the future. I don’t want to be long either. China is too hard to figure out. There is clearly something wrong with the capital allocation process, but there’s so much still going right that I don’t think it will matter yet. Those who anticipate a complete collapse seem to be missing something. A setback can happen at any time, but that’s a buying opportunity. I sure wouldn’t want to short China. China will be in a bull market for decades. I want to find ways to profit as China continues to grow.