Transcript for Gordon Chang: The Reasons for China’s Imminent Bust

Below is the transcript for the podcast with Gordon Chang:  The Reasons For China’s Imminent Bust

Chris Martenson:  Welcome to another podcast. I am your host, Chris Martenson. And today, a very special guest, Gordon Chang is with us, who I met recently at the Casey Research Summit. And he gave a really inspired talk there. It really caught my attention, and I wanted to make sure we could get him for a podcast. We have him today. He is the author of another Nuclear Showdown: North Korea Takes On the World, released by Random House in January of 2006; focusing on the nuclear proliferation in general, but North Korean crises in particular. His first book is The Coming Collapse of China, Random House. It came out in August of 2001. He is a columnist at, and I am going to be talking about one of those columns that just came out recently. He has lived and worked in China and Hong Kong for almost two decades, recently in Shanghai as counsel to the American law firm of Paul Weiss; earlier also in Hong Kong as partner in the international law firm of Baker & McKenzie. His writings on China and North Korea have appeared in the New York Times, Wall Street Journal, Far East Economic Review, International Herald Tribune and many other places. Welcome, Gordon.

Gordon Chang:  Thank you very much.

Chris Martenson:  It is a real pleasure to have you here. So for our listeners, I gave some of your background, but can you just fill us in briefly about your experience and background in China? How often you actually get to visit there to see for yourself how things are unfolding and any other context that might be helpful there?

Gordon Chang:  I worked in Hong Kong for about ten years in the 1980s, and then I worked in Shanghai from 1996 to 2001. And between those two times, I traveled back and forth to China, and since that time I go back once or twice a year. We just returned a couple of weeks ago from Hong Kong, where there is a lot of news about the Chinese economy, largely because it is starting to turn and people out there are worried about what is going to happen. Not only to what is going to happen in the mainland, but what is going to happen in Hong Kong, because Hong Kong’s economy is very tied to China’s.

Chris Martenson:  China has clearly roared into the world economic stages as a major player over these past ten years, certainly. And a lot of my listeners are really keenly interested in China, because China is now shaping the economic landscape as never before. And so we have questions, big ones, such as for how much longer will China continue to fund US and European indebtedness? And will China’s voracious appetite for world resources lead to friction as we compete in a world of increasing per capita scarcity. In your words, tell us why we should be tracking, over here in the OECD countries, why we should be tracking China closely?

Gordon Chang:  China’s economy clearly is influential. It is the second largest in the world, surpassing Japan in the second quarter of last year. Many people think that it will overtake ours. Time Magazine recently ran a piece suggesting that would take nine years. And the IMF says five years. Now, I do not believe any of that. But nonetheless, that is the global dominant narrative. And right now, China seems to be on a tear but we are starting, to see the signs of the Chinese economy slow, and slow in a way that we have not seen for a decade. And that is why, for instance, people in Hong Kong are concerned. And we are starting to see the signs of deterioration.

Chris Martenson:  It is interesting. In one very important way, China already has overtaken the United States, and that is in energy consumption. I think they did that in 2010 on a total terawatt basis. And so, energy is the driving mode of force for any economy. And so seeing China crawling its energy use by 7% per year, they doubled it in on a decade. That story, you are saying, is slowing down. We saw GDP slow from I guess it was 9.7 and now it is 9.2, and maybe it is going to slip into the eights. That still sounds like really aggressive growth to me. Does that look like a soft landing? Is that is what is going on? Are you saying that there is worry now in Hong Kong that maybe something harder is coming?

Gordon Chang:  I think something harder is coming. In the third quarter of this year, the National Bureau of Statics in Beijing said growth was 9.1%. That is a year on year figure. But if you start to look at month on month numbers, it is of concern. And so you talk about electricity consumption; August to July, electricity consumption slipped 0.1%. September to August it increased by 3.1%. That looks like an economy which is growing at a pretty low rate, if it is growing at all. And there other indicators showing that the economy is actually slipping. So, for instance, oil demand, export orders, car sales. In October, last month, car sales declined 4.2% year on year. And so we are starting to see the signs of the economy flatline. And I think that is the big story. Month on month, this economy is flatlining.

Chris Martenson:  Yeah, sometimes there is a little noise in that monthly data, but you are saying we have seen a couple of sustained months here. Certainly, if we look across the rest of the global landscape, we are seeing a lot of signs of slowing down, from manufacturing orders, trade, and all kinds of things. China is sitting at the center of a lot of trade. And so if their economy does flatline, what is the risk you see?

Gordon Chang:  The risk is certainly, for the political system in China, there are a number of countries where we do have authoritarianism. You have large growth numbers, year after year after year. And all of a sudden, the economy contracts and the political system falls apart. The most recent was of course – well not the most recent, but perhaps the most important example for China – was Indonesia under Suharto. And, economic reasons were part of the triggers for the Arab Spring; youth unemployment, high inflation, those things that we see in China as well. And so clearly, Chinese leaders are concerned about what is going on in the Middle East and North Africa, largely because they have some of the same economic problems that they saw over there.

Chris Martenson:  An article in the Financial Times, November 4th, really caught my eye and I was hoping to get your take on it. It is entitled “China’s Elite Have New International Outlook.” And they note for most of the article that there has been an exodus of wealth and the wealthy to safer shores, but we found these closing paragraphs, which I would like to read out and get your take on them, because these really made my eyebrows jump.

“In private conversations,” the article says, “many of the people who supposedly make up the ruling elite of China express serious misgivings about the direction and future stability of the country, while admitting that they feel largely powerless to effect meaningful change. There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers, says one Chinese banker with close ties to a number of power political families.” He continues, “Almost all of the elements are in place for an uprising like we saw in 1989. Corruption is worse today than it was then. People feel they can’t get ahead without political connections. The wealth gap is much bigger and growling. And there’s been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

What is your take? Those are pretty strong words, I thought, and expressing a serious sentiment. Is this hyperbole or how do you interpret those words?

Gordon Chang:  There is a growing sense, a growing concern in China about all of those things that you just read about, largely because the political system has gotten to a point where first of all it is in a transition. And starting at the end of next year, the Communist party is going to change the officers of their Politburo Standing Committee, the apex of political power in China. We are going to have a new General Party Secretary. And then in the early part of 2013, the government officers change. And sometime after that, the all-important Central Military Commission has a revamp of membership. And so at this time of political transition, the important economic decisions are not being made. But it is even worse than that, because corruption indeed is engulfing the political system. It is causing so much friction in society. The Communist Party is not able to mediate conflict and its only answer is to increase coercion.

And that is why you have survey after survey of the rich and the super-rich, they talk about leaving China. It is not the poor who are going, which we have seen in many waves throughout the last couple hundred years; now the rich are thinking of getting out. They are getting passports, they are putting their families offshore, and this is of concern because this is a leading indicator. If you go about 25 miles south of where I live, and go to Princeton, New Jersey, you will see a lot of beautiful homes. I mean, they are all paid for, they have got a wife there, they have kids, and they have one or two Mercedes in the driveway. It is the perfect American family, except one thing is missing, and that is Dad. Dad is a senior official in Beijing and he is stealing as much money as he can. And at maybe not the first sign of trouble, but perhaps the second sign of trouble, he is on the United flight to New York, because he is not going to stay to defend a regime that is shaking. And that is one of the reasons why I think we have to be concerned about the way the Chinese economy is going, because Chinese rich are starting to see the signs and are beginning to bail out.

Chris Martenson:  Well, isn’t that always true in any country where you have the wealthy try and find a way to spread their wealth. And part of that could be diversification. But you are saying this really against a backdrop of understanding that China does go through periodic convulsions, as it were, and that this maybe the most well connected people with the best insights, those are the ones who are choosing to exercise their options, as it were?

Gordon Chang:  Yes, and it is also the people with the most to lose by leaving. And so we are not talking about some laborer in some inland province who gets a chance to go to Europe or the United States. We are talking about the people who have benefited the most from this system. And they can see the problems at the top of society. We have now a weak General Party Secretary, Hu Jintao, and he is going to be followed by probably by someone who is just as weak, especially in his beginning years, Xi Jinping. This is a political system that will not be able to make the decisions and to implement them that everyone knows have to be made. And that is why, for instance, we have not seen much in the way of reform over the last five years. In fact, we have seen a reversal of reform. And most of the conditions that have given rise to China’s extraordinary growth either no longer exist or are disappearing fast. And so this is an economy in trouble.

Chris Martenson:  Gordon, I had written a while ago that I thought – when I put on one lens and I look at the world and I say wow, I see increasing scarcity of critical resources, land for growing food, water, oil and things like that. It appeared to me like China was pursuing what I thought was a very credible strategy of mercantilist policy, go out, magic checkbook and buying stuff everywhere. Land in Madagascar, and oil from wherever it could get it, etc. And those felt to me like an advantage, as it were, of the Chinese system where they could develop a state policy around getting resources at a critical moment of history and they could go and execute that. Which seemed to me to have potentially some advantages over waiting for our “free market system” to arrive at the same conclusion and to secure things through normal competitive practices. Would you agree that China has been on a fairly strategic platform of securing resources? And if so, are you saying that that strategy is now at risk because of this transitionary phase?

Gordon Chang:  Yeah, absolutely. Chinese leaders have been very determined in their strategic goals of securing commodities. But, and this is a big but, overpaying for oil, and gas, and cooper, and all the rest of it does not really make sense in the long run. These guys in Beijing do not believe in spot markets and because of that they will sometimes just commit too much in the way of resources. And now that they have an economy that needs less oil, needs less copper, needs less iron ore, they are in trouble. And so they have stockpiled this stuff. It looks nice, but I do not think that the world has gotten to a point where the spot markets are going to disappear, which means that China has probably made some pretty bad investments. Yes it is strategic, but it might have been the wrong strategic decision to make.

Chris Martenson:  And so they have overpaid, and we have come into a period of weakness and they have fairly long-term contracts where they are locked in. I see, they have a gas contract with Iran that is, I don’t know, 25 years or something, copper contract same thing, and so oil too. And so you are saying they have overpaid and that this will be a weakness as we go into this period of lower growth?

Gordon Chang:  Yeah, I think that it will be a burden, and if we are talking about a world where scarcity is really the dominant issue, then yes it is great to have even overpaid for this stuff. But if we are talking about a world which maybe needs less of these commodities and where they are plentiful and where prices are declining. Then yeah, I do not think that that was so smart.

Chris Martenson:  The one area that seems tight to me is food, simply – you know, we crossed seven billion, apparently, and land is one thing that we pretty much have all of it under cultivation. And so food is one area where I know, everything that I have read says that China has some real serious issues. They depleted a couple of key aquifers, drawing them down really far. They have had some desertification issues with some of the key land for agriculture. Do you see the food issues in China as being a pressure point for them here?

Gordon Chang:  Eventually it will be, largely because they have polluted a lot of their land, and also because they do not price water correctly. There is a great incentive to use it inefficiently.

You started out by talking about China becoming the world’s largest consumer of energy and yes, that is right. But the point is that they put in five times the amount of energy per unit of gross domestic product in Japan. These are staggering numbers because they just misprice it. Whenever you misprice things yes, you can do a lot in terms of creating economic growth. And the Chinese leaders have been pretty good at that up to now. But inefficiency eventually catches up with every economy. They have a semi-closed system so that they are not necessarily subject to the principals of economics in the same way that we are, but they can only delay the inevitable. They cannot prevent it entirely, and that is really going to be their problem. Because they have done a lot which just does not make economic sense. I mean it might make sense in terms of rapid buildup of an economy, but they have to pay a price. And they have not paid their price yet.

The one thing that people say, oh these Chinese leaders are so great at economic management because they got through 2008, 2009 and they had enormous double-digit growth while the rest of us were suffering. Well yes, they did that but they did that at great cost. And so for instance in 2009, the first full year of their stimulus plan, they dumped something like 1.1 trillion dollars into a then 4.3 trillion dollar economy. And so did they create growth? Yes, they did, but they also created a stock market bubble, a property market bubble, and inflation. And they have yet to deal with the property market and the inflation problems. Those are dislocations that they do not have the answers to. I would rather have our economic problems than theirs any day of the week.

Chris Martenson:  Interesting, I see that the Shanghai Composite Index is down 20% on the year, putting it in bear market territory for the year. And if we stretch back five years, we note that it is down 58% from its 2007 peak. And so even with that 25% boost to GDP with the stimulus packet you just mentioned, it does not really seem to have recovered the stock market all that much. Why is that?

Gordon Chang:   I think it is because in 2009, the Shanghai Composite increased I think 80.0% because of the stimulus. The government had put much too much money into the economy, more money that it could absorb, and so it went into non-productive uses, which was the stock market rise and the property market bubble. And what has happened in 2010 was the inevitable, that the stock market collapsed. And even after a bad 2010, 2011 does not look too good, either. And so essentially what they did was they engineered growth at great cost. And so yes, the Chinese stock market does not really say very much about the way of economic management in Beijing.

Chris Martenson:  Right, well you know every bubble is always looking for a pin. And we noted before that this unnamed high-level banker had said that the only missing ingredient now is a domestic economic crisis. I want to turn now to one likely place, which would be the property market. It is something I have followed pretty closely for a while and I would love to get your take on this. And luckily, you have this recent Forbes article entitled “Property Prices Collapse in China. Is This a Crash?” And you note that what started as a softening of prices in September has turned into a rout in October, with at least one builder you noted cutting its asking prices to the cost of development. And so as with any property bubble, first you get over supply, then softening sales volumes, then stagnant prices, then ever sort of increasingly declining prices. You seem to be implying here we are at that final stage of that progression. Help us understand this a little better, could you?

Gordon Chang:  Yeah, well what happened with the stock market happened with the property market. There was just too much money in the economy and so people then poured money into apartments. And China has gone on a tear building ghost cities and all the rest of it. And the progression that you talked about, which was skyrocketing prices and then stable prices, selling volume, and then property price declines is what we are seeing in China. In October, last month, prices in places like Shanghai declined 30%, as we saw developers start to offer these enormous discounts.

And by the way, these discounts were so big that people who bought at earlier stages in these same developments, where these discounts were being offered have now taken to the streets complaining if you are giving 30% discounts to these other guys, then give it to me as well. And so we have not got a little bit of social unrest because of falling property prices. In Wenzhou, which is in prosperous Zhejiang Province, which was perhaps the most prosperous province up to about a year ago, developers are, one developer is now offering BMWs to the first 150 buyers of apartments.

And this is just a sign that property prices have not only softened, but they are starting to fall quickly. Every market has to go to equilibrium. There are too many apartments in China and not enough buyers and occupiers. And it was going to go to equilibrium in some fashion. What is really surprising observers is that the rapidity at which we see this move to equilibrium. Last year there were, in about I guess it was April or May, the state grid in China reported there were 64.5 million apartments that showed no electricity usage for six consecutive months. That is enough housing for 200 million people, but yet Beijing was decreeing the building of 30 to 50 million more apartment units. This creates GDP, technically GDP.

Chris Martenson:  Yep.

Gordon Chang:  But at the end of the day, there has got to be a correction. And what goes up fast comes down fast. And what we are seeing is the down phase. The only issue is whether Beijing can stop the down phase by administrative measures. But so far the Chinese leaders, Premier Wen Jiabao, last Sunday said nope, we are going to stay with these tightening measures. And that has really created great pessimism in the Chinese property market.

Chris Martenson:  One of the things that I tracked carefully in our own housing bubble here in the US was it really everything, I think, can be tracked price to income. As you mentioned, all markets have to go to equilibrium. A normal market here in the US is a price-to-income of around three to four. By the time you get over five or even six, prices are now six times income in a region. Ah, you have a bubble on your hands. And there were some shocking numbers that came out as high as nine in Orange County, as high as 12 in some places around Las Vegas. And so these were really shocking numbers, and so I cast my attention over to China and I had read reports that had suggested that in certain key metropolitan areas the price to income had gone over 20. Is that true?

Gordon Chang:  I think that that is true. From the last time that we went to Shenzhen, which is just across the border from Hong Kong, we talked to a number of people who were saying that they could not afford apartments. And although they wanted to stay living, stay in Shenzhen, they just could not really afford it and so what they were thinking was moving back to their home villages in the inland part of China, where price levels were much more affordable. And that really is a political issue. And that is why Beijing is not backing off of its property tightening measures, because it wants to make housing affordable for China’s growing middle class, and even perhaps for the poor. And so really what we have is a government now that is really trying to bring the property market down. And of course it wants to do so gradually, orderly. But as you say, it is a bubble, there is a pin, and the problem is that Chinese leaders cannot manage the process of bringing the property market down to equilibrium.

Chris Martenson:  And so how does the property market work in China? I am a private Chinese citizen, a laborer somewhere, and I want to buy an apartment. How does that work?

Gordon Chang:  It works pretty much the same as anywhere else. The only differences are going to be that there are administrative measures that increase the down payments, prevent you from buying maybe a second home, all sorts of things that will make it more difficult on your second purchase. But on your purchase, it is pretty much the same as anywhere else. What’s happened is that the wealthy in China have seen apartments as a store of value, because a bank deposit paying negative interest, because the stock market is a disaster. People have seen apartments as really the store of value. Instead of currency, it is apartments in Beijing. And that is why you had so many apartments not showing electricity consumption, because these were not really places for people to live in. These were just basically here is my cash. I want to keep it in property. And the problem right now is that you are seeing this unwind. And so people who thought that they were wealthy a month and a half ago, now realize that they are at risk because they cannot sell these things. They are competing against developers who are slashing 30% off the price last month. When China’s elite analysts start talking about prices being 50% of where they are this year that means that they are probably privately thinking that no, prices will not halve. They might go down even further than that. And that is really a problem because that mentality, once it gets embedded in people’s minds in China really means that Chinese leaders then have very few tools in which to prop up the property market.

Chris Martenson:  Well, I just want to make sure I am really clear on this. And so when somebody goes and gets a mortgage, is that from a private bank for a state bank?

Gordon Chang:  Most likely it is going to be a state bank, because the state banks dominate the banking system. And so you have the four large state banks. And then you have a lot of other large state banks below that. There are a few banks that are in private hands, they are pretty few and far between. These state banks do have some private ownership because they have issued stock in these massive IPOs, but the state still controls them. And that is why people call them the state banks, even though they have issued shares in offerings.

Chris Martenson:  Okay, so my back-of-the-envelope calculations, when I look at a price-to-income ratio that is over 20. You can easily arrive at a 70 to 80% fall in house prices. With overshoot, you could make an argument for more. That is just to get back to a market-clearing price. It does not matter to me what the development cost was because the developer probably overpaid for labor, land, materials, everything. The market-clearing price is what people can afford to buy. And once the psychology of bubble bursting takes hold, it takes time and even if the prices ran up really fast it still takes time for these things to clear out, sometimes years. And so we might be looking at sort of a multi-year protracted sort of a slump in the hotter markets. And so what happens then, state bank is sitting there sitting on a pile of bad mortgages. What happens in the Chinese system when somebody cannot pay a mortgage? Is it a normal default process or is there recourse attached to that loan in some way. And if these state banks start going bad, how do they get bailed out?

Gordon Chang:  State banks, because of China’s terrible court system, the banks do not really have that much recourse against defaulting borrowers. And so essentially the government in Beijing is just not going to want to see banks foreclosing on a lot of this stuff, and so I do not see that really happening. What it means essentially, though, is that Beijing has got to bail out the state banks. They have done that before. They did that at the end of the 1990s, and they did that to a lesser extent about five years ago. The state banks are actually critical to the economy, so they are the last institutions to fail.

The problem for China, though, is that the bailout ten years ago, they still have not cleared out those bad loans out of the basic system. Because what they did was the Finance Ministry indirectly bought those bad loans from the banks. But those bad loans now are on the books of the Finance Ministry, hidden from view, and they have not sold those of yet, because China’s leaders really were loathed to take losses. If we want to see what their mentality is, the best thing to do is look at the way the Japanese handled their bubble. Instead of recognizing their losses and getting on with it like we did with the Resolution Trust Company and the savings and loans, they decided to try to manage their way out of this softly.

And so Japan had recession-like stagnation. China, best scenario is that they look like Japan, an ailing economy. Probably in China, though, it is going to be worse because the Japanese people were living in a democracy. The Chinese people are not, and we have seen the reactions of Chinese people whenever there have been problems in the markets. And so this does not look good for the Communist Party. That is why they are very nervous in Beijing. That is why they are spending more on domestic security than they are on the People’s Liberation Army. They know that they have a real problem and they do not know how to get themselves out of it.

Chris Martenson:  That is an interesting observation, that when the leadership thinks there is social unrest coming, that you can track their nervousness by their domestic security expenditures. That is a trend that I think is, I could point to a couple of other countries and make a similar sort of an observation. But back to your point, then, I am wondering in your view to what lengths then does Chinese leadership go to keep the GDP growth story going? I mean, will they go to just what we might look in and say these are absurd lengths? Or at some point does reality just overwhelm those efforts and despite their best efforts, you have your market-clearing event? How do you see this?

Gordon Chang:  I see the Chinese leaders are going to have to relent. They have said in the last couple of months that they are not going to let go of their monetary tightening and their other administration measures to cool the economy, but they have to. The problem for them is that they do not have the same flexibility today that they had in 2008, 2009, when they went on the world’s biggest spend-a-thon. Right now, they still have inflation, which is a problem for them. And they have the buildup of questionable loans in the banking system. And that limits their flexibility as to how much stimulus that they can dump into this economy this time. I mean, they have already built their ghost cities. I mean, what are they going to do? Are they going to build more of them? Well, yeah, they might but that is going to be a real problem, because they are now facing some real hard constraints. The Chinese leaders say that inflation has come down in October. They are talking 5.5% CPI growth in October, year on year. It is probably double that. The real issue, though, is food inflation.

They are talking about 11 or so percent food inflation, year on year. But it is probably again double that. The food inflation in the United States, not a big deal, Americans spend what, 9% of their disposable income on the food. The poor in China spend somewhere between 45 to 48 maybe 50% of their disposable income on food. And so when you are talking food inflation, even of 11%, which is the official number, that is a problem. But when you are talking about 25%, which is what it may actually be, that is a disaster for China’s leaders. And that is why they cannot really just do what they do now, what they did before. Because they know that they are going to reignite inflation. And that is a problem for them that really poses a hard constraint. Yes, they will try to spend their way out of it. That has been their default position. But right now, they have some real hard constraints on that tactic.

Chris Martenson:  What if they allow their currency to really rise in value? That would certainly quell the food inflation. It would mean that their oil import costs would go down on a yuan basis. Does that solve anything or does that just put such a bullet in their export markets that it creates a larger set of problems on that side?

Gordon Chang:  Well, it does both of what you say. It certainly will have real devastating effects on the export market, which is already in trouble, largely because of a falloff in European demand. But when they do som