Skinny Dipping Anyone?

A: I would like to introduce a guest writer to UrbanDigs.com. His name is Jeff Bernstein is a partner at Guild Partners; a residential investment and development company. I met Jeff the other day and we had some great conversations about what is happening in the macro world today and how we can best take advantage of them with our investments; which is the ultimate goal of this blog with a focus on Manhattan residential real estate investment. So, here is Jeff's first post discussing the rapid growth experienced oversees in China, and whether another financial crisis such as the Asian financial crisis that occurred back in mid 1997-1998 will happen again. A topic worth reviewing.

East Asian Financial Crisis -

The East Asian Financial Crisis was a period of economic unrest that started in July 1997 in Thailand and South Korea with the financial collapse of Kia, and affected currencies, stock markets, and other asset prices in several Asian countries, many considered Four Asian Tigers.

When two ex-Wall Street stock jockeys sit down for a cocktail the conversation inevitably turns to.......China? Well the conversation inevitably turns to investments fads and bubbles that are or may be brewing. By these earmarks China probably ranks as a subject worth discussion. While the economic juggernaut that is mainland China is not new news, recent efforts to slow the pace of growth in China has spurred new speculation about how and when this colossus of an investment trend will end and more importantly, will it end badly? The jury is out on these questions and I will argue that it may be out for some time to come. I'll also argue that it will end badly, no ifs ands or buts. Unfortunately, China has become such a big factor in the world economy that trouble there will reverberate worldwide as it did briefly when the Chinese stock market plunged 8% in one day in February of this year.

Just to re-cap some very well known history. Mainland China's growth has been on a tear driven by industrialization in its coastal regions. This has drawn literally billions of people from the rural hinterlands to the cities seeking their fortunes. Recent commentary also suggests that they are now fleeing under-investment in the countryside particularly as far as social services go. But just to hit a few data highlights - in addition to some "up and to the right" charts shown below:

China Current Account Surplus

Direct Foreign Investment in China

China has been growing its GDP at over 8% per year for 20 years. According to Jim Jubak, of Jubak's Journal "China's government wanted to slow the economy's growth a bit from the 10.7% rate turned in for 2006. A rate near 8% would be ideal, Beijing's planners said at the beginning of 2007, because that is high enough to generate the jobs the country needs to stay even with its population growth and low enough to keep the economy from further overheating. Instead, what they got was 11.1% growth in the first quarter, the National Bureau of Statistics announced April 19. And now the Chinese Academy of Social Sciences is predicting 10.9% growth for all of 2007."

This GDP result for 2007 is actually expected to exceed the forecast on the chart above as growth has seemed to re-accelerate. As a result of the many years of growth, China's current account surplus (roughly how much they sell overseas vs. how much they buy) has exploded as has its foreign currency reserves. Not only has China become "rich", but almost everyone wants to invest there - as show by the Foreign Direct Investment chart. Although I couldn't find a good chart of fixed investment (manufacturing plants and other big stuff being built), suffice it to say that Chinese are equally bullish on their own prospects as foreigners and are "building big stuff" to beat the band. Fixed investment has been growing at rates over 15% per year for years and grew 25% in the first quarter of 2007.

So it's all good, right? Well, not exactly. Each country has its own potential to grow driven by a multitude of factors, which are hard to calculate and estimate. They are basically unknowable with any precision. If a country grows "above its potential" something eventually has to give, usually in the form of higher prices or "inflation" or other imbalances including social problems and pollution. However, if a lot of the investment in stuff is not investment personal consumption (things people buy and consume or put on a shelf), but rather investment in productive equipment (manufacturing plants) like in China, inflation can stay low as the productive equipment churns out tons of new goods, keeping a lid on pricing.

Although inflation in China appears to be under control, the government still seems to be concerned. This may be out of real worry or possibly to assuage foreign governments and investors who believe that growth above potential is dangerous. Regardless of the motivation, China has been raising interest rates ever so slightly and tightening its bank reserve requirements. The half-hearted interest rate increases and refusal to let the currency appreciate much, beg the question of whether the government really wants a slowdown. But most recently the deposit-reserve ratio was boosted by the biggest amount in years, 50 basis points, to 10.5%. Many argue that even this will be of minimal impact as most banks reserves are already well above the 10.5% level.

For now, China's economy looks like a runaway train. Some, including The Economist magazine have pointed out in the past that poor measurement of economic statistics make the fixed investment boom in China look bigger than it really is etc, etc. But one thing that's clear as day to a couple of guys sitting on a barstool is...Nothing grows to the sky and when something appears to be half way there, start to worry, the downsides of unfettered growth, be it at an individual company or a country are usually ugly as the warts that were previously hidden by the growth dynamic come to the surface. As Warren Buffet has been said to have commented "when the tide goes out you find out who is skinny dipping".

Interestingly, over the years when foreign economies have become especially strong companies and individuals in those countries have tended to go on "trophy hunting" expeditions, buying famous brands, companies and real estate in far away lands. These trophy hunting expeditions have often marked the top in their economies and stock markets. Recall when Japanese investors bought Rockefeller Center and Pebble Beach, just before their economy tanked. I recently heard a big New York Real Estate investor talk about the continued potential appreciation in the unique New York market and the huge impetus it would be for prices if the Chinese ever decided to invest 1/10 of a percent of their foreign currency surplus in New York real estate. Be careful what you wish for.

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