Ativo Capital

Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

China’s Andy Warhol Moment

Wednesday, July 22, 2015


A brief visit to Beijing last month. The conference organizers had provided a plane ticket to Hong Kong and a stopover in Beijing added $100 to the plane ticket.

Great weather in Beijing. No smog. Few traffic jams. And the boulevards were lined with billions of roses. Visits to Tsinghua and Peking Universities for presentations. The fit and finish of the academic buildings are superb. The quality of the autos in the parking spaces on both campuses was impressive. Faculty offices spacious. The lunch at the restaurant at faculty club at Peking University was superb.

The Chicago center in Beijing had arranged for a student volunteer to help with the logistics, Eric is a senior at Renmim University, which he thinks is the #3 university in the country. Ranking seems like a major parlor game; Harvard is #1 uber alles. Chinese have this obsession with “catching up” with America–more tons of steel produced, a larger amount bet in Macau than Las Vegas, perhaps now a higher GDP and eventually a higher per capita GDP.

For the last two plus years, I have been applying the Andy Warhol theory of economic growth to China. The key idea is that every country has thirty or forty years when its growth rate is especially high. Japan had forty years of rapid growth beginning in 1950, which concluded with a massive asset price bubble between 1986 and 1989. The bubble began to implode in 1990; growth has been much lower, only in part because the population growth rate has been declining for the last several years.

One of the key ideas of the Andy Warhol view is that the growth rates remain high as long as individuals continue to move from the farms to the factories, where they were much more productive. Once the excess labor on the farms has been exhausted, migration slows, and the growth rate plummets.

About three years ago, I first became aware of the contribution of the production of “unoccupied apartments” to China’s ten percent growth rate. Since 2008, China has been building ten million apartments a year; expenditure on these apartments has been about ten percent of GDP. The real rate of return from ownership of an apartment has been twenty percent or more a year from increases in property prices; as a result a large number of these apartments have been acquired as a store of value. Perhaps one million or one and one half million apartments of the ten million of new apartments constructed each year are unoccupied; the owners have had modest incentive to rent because the rental rate of return was so low compared with the return from price appreciation.

As long as twenty million people a year were moving from the countryside to the cities, the prices of apartments increased more rapidly than household incomes, since the demand for urban accommodation was increasing by seven or eight million units a year. The migrants needed accommodation in the cities.

The major constraint on increasing the supply of apartments has been the shortage of land, which had to be taken from farmers. No problem, all the land was owned by the government. But because local governments encountered resistance from the farmers, the supply of apartments increased less rapidly than the demand.

Now the migration has slowed, the demand for apartments has declined, property prices are falling, and construction has slowed dramatically.

I kept asking, “How large is the supply of unoccupied apartments?” One expert in a major investment firm in Beijing said thirty seven million.

China will have to absorb ten to twenty million of unoccupied apartments. Seventy or eighty percent of household wealth is in property, as prices fall, household net worth will decline. Japan experienced a decline of eighty percent in property prices over a decade. Household spending in China will decline sharply. Japan by fifty percent or more.

Just as the automobiles on the campus parking lots are new, most of the infrastructure is recently built. All of this “newness” has a flipside, and that is that replacement demand is likely to be modest for an extended period. China has spent a massive amount on its infrastructure–the roads and high speed railroads, the ports, the water supply and sewage systems, the five star hotels–in the last twenty years.

China’s household saving rate is extraordinarily high, about fifty percent of its GDP. My guess is that household wealth is eight or nine times GDP, a ratio that is more than twice as high as the one in the United States. (The estimate of household net worth is the integral of national saving over the last thirty years,)The major assets include real estate, bank deposits and currency, insurance, and stocks. Household savings finance extensive investment in plant and equipment, both in state owned enterprises and in private firms and the massive infrastructure of roads, toll roads, airports and railroads. And the purchase of U.S. Treasury securities.

China faces some massive adjustments beyond those in the property market. Many of the bank loans to state enterprises must be repriced, because the embedded losses are massive; the banks are brain dead. The government must refinance the banks, and its debt will soar from forty percent of GDP to one hundred twenty percent.

The paradox of thrift will come to center stage, all of these adjustments will lead households to increase their saving at a time when the government wants to secure a surge in consumption. The growth rate will decline sharply even as government expenditure–and the fiscal deficit and government indebtedness–increase sharply.