Note: The commentary that follows has been taken from Jim Chanos’ speech to a group of investors, on the subject of China’s economy. The video of this speech can be viewed below.
Hedge fund manager Jim Chanos has generated some controversy over the past few months because he has had the temerity to argue that China is experiencing an asset bubble. Skeptics argue that he misunderstands the nature of the Chinese economy.
There are four main parts to his argument:
• GDP drives economic activity.
• Local party bosses have an incentive to game the system
• Real estate speculation
• Overbuilding of industrial and commercial real estate
Let’s take these arguments one by one.
1) GDP drives economic activity
In most industrialized countries, GDP is what Chanos calls a residual: it is the result of economic activity. But in China, GDP growth is seen as sacrosanct, and Beijing sets a GDP growth target every year. Local party bosses act to ensure that they meet this target.
2) Local party bosses have an incentive to game the system
Since GDP growth is explicitly stated as a public policy, local political bosses have an incentive to make sure that they contribute to the country’s efforts to meet the GDP target growth rate. In practice, this means that local municipalities can, for example, meet revenue targets by selling off land to developers. Party bosses have an incentive to sell as much land as possible, regardless of whether doing so creates too much supply.
3) Real estate speculation
One of the main arguments advanced against Chanos’ China thesis is that real estate speculators in China have to have more equity than do their American counterparts. The implication is that China won’t suffer from a meltdown of real estate. But this argument, while possibly correct, misses Chanos’ larger point. Speculators in Beijing buy up multiple apartments, seeing them as a store of value, akin to commodities like gold or palladium.
Implicit in this practice is the notion that there is a greater fool down the line. Treating real estate as a store of value, rather than an investment that produces real or imputed monthly cash flows in the form of rent defies economic logic.
4) Overbuilding of commercial and residential real estate
Perhaps the most interesting statistic cited by Chanos is that there is 2.6 billion square meters (30 billion square feet) of non-residential construction under development across China. To put this number in context, that is enough square feet to give every person in China a 5 foot by 5 foot cubicle. The inference here is that non-residential construction supply will outstrip demand for a very long time. Basic economics says that if supply exceeds demand, prices (rents) will trend down.
The other consideration here is the annual maintenance expense for these tens of billions of square feet. Not only will rents go down over time as demand fails to meet supply, but maintenance expenses for vacant office buildings and industrial parks very quickly adds up and acts as a drag on the economy. Capital used to maintain unoccupied buildings does not grow an economy.
What do these arguments imply?
These four arguments present a pretty compelling thesis about China, and it’s not a pretty one. Chanos notes that two very different economists, Paul Krugman and Milton Friedman (no relation to this author), have argued that economies grow over time because outputs, not inputs, increase.
But, China has thus far repeated the economic history of the Soviet Union 50 years ago: a massive infusion of capital into a previously capital-poor country has induced millions of rural citizens to move to cities, become educated, and industrialize the economy. Those are all the inputs. But the problem, according to Chanos, is the law of diminishing returns.
At some point, those inputs reach a theoretical maximum: there is only so much moving of people from rural areas to cities and educating of the citizenry to be done before real economic growth (i.e., increased output) has to occur. Else all the growth is illusory.
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