Is China Facing a Boom or Bust?

Before we set about proving that Australian housing was a bubble waiting to blow up - we began making the case that the resource boom might be facing an unquestioned assumption behind its enduring boom: that China won't blow up. But what if it does?

There is emerging evidence that China has its own enormous property boom. The fortunes of provincial governments are tied to land sales. So real estate has become a real rice winner in terms of government revenues. But to be honest, that is not a story I've investigated much.

It's Australian resource stocks that are our beat here. And it seems like if China's demand for raw materials is driven by an unstainable level of fixed asset investment (short-seller Jim Chanos says China is on a "treadmill to hell" with 60 per cent of GDP derived from construction spending) then the rosy assumptions about rebounding exports (and the royalties that heal damaged federal finances) are pretty stupid and short-sighted assumptions.

Luckily while we were over in Perth talking about how to be free in an unfree Australia , our man in Sydney, Greg Canavan, had his thinking cap on. Greg's new venture, Sound Money. Sound Investments, combines a big picture perspective with a kind of a forensic analysis of the balance sheet and some time-tested methods of valuation. He sent us a note on China's perceived strengths and weaknesses over the weekend.

He writes that, "Most people point to China's huge foreign exchange reserves as a source of wealth and firepower to deal with any emerging problems. As I've stated in previous reports, I don't agree with such an assessment. Why?"

"China based economist Michael Pettis says that only twice before in history have nations built up foreign exchange reserves similar in size (as a proportion of global GDP) to China's current hoard. Those two lucky countries were the US in the late 1920s (despite Britain's attempts to stop the US accumulating gold) and Japan in the late 1980s. Pettis says rapid expansion of domestic money and credit were responsible for these two countries' subsequent malaise.

"'It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.'

"This doesn't mean China will suffer a decade or so of deflation and falling asset prices. But it does mean you should be cautious about the country's prospects and the expected impact on your investments. At a guess, I would expect China to feel the effects of much slower credit growth and lower government involvement in the economy by the final quarter of the year, if not before.

"None of this expected risk is priced into the Australia equity market at the moment. And that is not surprising. All we hear is how the Chinese are on the hunt for resource projects, and how demand for steel inputs is going through the roof. But that demand is the result of past stimulus.

"Meanwhile, inventories of most base metals are at or near their peaks (and above 2008 peaks) suggesting that basic raw material supply is more than adequate to satisfy demand. After all, the global economy is only just emerging from recession and is not expected to bounce back strongly.

"The biggest concern for Australia is that China has brought forward much of its raw material demand via the 2009 stimulus measures. When the impact wears off, commodity prices may correct and give back some of the very large gains achieved since the 2009 lows.

"For this reason I am avoiding the resource sector until prices move back to more favourable valuations. This may take months, and I may look like an idiot in the meantime, but my view preservation of capital is more important than jumping on momentum trades.