Author: Andy Xie
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The risk of a global hard landing is rising rapidly. The trigger could be a policy action by China, a credit incident in commodity market or just the weight of the debt bubble in Australia.
Resilient consumption among Anglo-Saxon economies-the most important pillar for the global economy today-is a bubble that mirrors their property bubble. This bubble results from their household optimism that interest rate would continue to decline and income would continue to rise, which causes them to borrow quicker that their current income growth.
China's investment bubble is the other pillar for the global economy. Its cause is the 'gold rush' mentality that dominates businesses and property speculators. Massive capital inflow is supporting property demand and credit supply. China's growth essentially comes from accumulation of speculative inventory in property and excess production capacity.
The key to the twin bubbles is low US interest rate that has sparked rapid growth in household leverage in the Anglo-Saxon economies and business leverage in China. The rapid growth in debt manifests in rising consumption and property price among Anglo-Saxon economies but massive capacity increase in China.
The right way to watch the global economy, in my opinion, is to see how these twin bubbles develop. While financial markets are sensitive to the cyclical data flow, the real game is how long the global debt bubble could last and what shocks could cause it to collapse.
The Anglo-Saxon Debt Miracle
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Australia, Britain and the United States have substantially outperformed other developed economies in the past five years. The vaunted Anglo-Saxon flexibility has been attributed as the major cause of the better performance of the Anglo-Saxon economies. A better explanation, in my opinion, is debt. Household debt in Anglo-Saxon economies has risen much faster than elsewhere or compared to their history. Australia's household debt to GDP ratio rose by 39 percentage points between 1998-2003, Britain's by 19, and US's by 16.
Source: ECB, RBA, Bank of England, the Fed, CEIC and Morgan Stanley.
Unsurprisingly, Australia's economy has performed twice as well as others between 1998-2003, as its leverage has been rising twice as fast. Euro zone's growth was as good as the US with less leverage rise. The weak Euro was the reason, in my view. This is why, deprived of a weak currency, Euro zone could not grow without creating a debt bubble.
The link between debt and GDP growth is property price. Because of the regulatory constraints in mature economies, rising demand for property on low interest rate translates into rising price rather than production. The wealth effect from a rising property is particularly powerful on consumption, as it spreads among most households.
The massive property bubble among Anglo-Saxon economies is the support for global consumption demand. In theory, it can last if household optimism and low interest rate remain. But, like any bubble, this one will also burst. Australia's property market is teetering on the brink. It could break soon. The resulting confidence shock could prick the Anglo-Saxon bubble.
China's Investment Bubble
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China is experiencing an investment bubble that its scale is unprecedented by its own or international history. The excess this time is twice as big as the previous bubble in 1993. Because China stands alone in attracting foreign capital in this cycle, it has been able to fund a massive investment bubble without devaluing the currency as in the past.
China's foreign exchange reserves more than doubled between 2001-03. Because China sterilizes little of the capital inflow, domestic credit rose by 55% during these two years. This bubble is the same as what Southeast Asia experienced ten years ago: excessive business optimism and massive capital inflow turn into an investment bubble.
Exhibit 2
China's Investment Bubble (% of GDP)
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Gross Fixed Domestic
Investment Credit
1998 31.4
1993 37.6 96.7
1998 35.0 116.8
2003 42.9 est. 160.3
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Source: CEIC and Morgan Stanley.
Excessive optimism about the future is the cause of China's investment bubble. The massive reduction in the US interest rate triggered a large amount of Chinese capital to come back, causing the initial wave of investment boom. The resulting improved economy triggered more optimism and capital inflow. The rapid credit expansion began to depress real interest rate, triggering a huge jump in demand for property, further fueling investment demand in commodity industries and the property sector itself.
What is going in China is a pyramid game on a gigantic scale. Local governments are borrowing massive amounts of money with land as collaterals to build urban infrastructure, hoping that land would appreciate sufficiently to pay off the debts, as Shanghai has done in the past. But, the Shanghai model couldn't apply to everyone. Shanghai has been bailed out by demand for its properties from Hong Kong and Taiwan residents. One Shanghai is already too much for Hong Kong and Taiwan. How could many other cities follow the same path?
A major correction in property price is coming soon. Housing starts are rising much faster than sales. The properties under construction exceed the sales in the past five years. Double-digit vacancy rates are common among major cities. Speculative motives dominate both developers and buyers. The correction could come with either interest rate hike or supply overwhelming speculators' finance.
China Could Prick the Bubble First
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The most obvious candidate for bursting the bubble is the Fed raising interest rate. The better US employment data from last week are pointing at that direction. However, as the current global equilibrium is still against strong employment in the US, I would not count on the Fed raising interest rate soon or aggressive enough when it does.
China pricking its investment bubble is becoming the most obvious risk to the global bubble. A consensus appears to have formed among Chinese politicians that the country is experiencing a major investment bubble and policy actions are needed to prevent further efficiency losses. As local governments continue to go against the central government wishes, new policy actions may be coming.
A large interest rate hike by Chinese government could be coming. Such an action could only take place with further tightening in capital account. Temporary suspension of non-FDI inflow could be introduced along with a major interest rate increase.
