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WHITE PAPER

March 2010

China’s Red Flags

Edward Chancellor

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n the aftermath of the credit crunch, the outlook for most developed economies appears pretty bleak. Households need to deleverage. Western governments will have to tighten their purse strings. Faced with such grim prospects at home, many investors are turning their attention toward China. It’s easy to see why they are excited. China combines size – 1.3 billion inhabitants – with tremendous growth prospects. Current income per capita is roughly one-tenth of U.S. levels. The People’s Republic also has a great track record. Over the past thirty years, China’s Gross Domestic Product has increased sixteen-fold. So what’s the catch? The trouble is that China today exhibits many of the characteristics of great speculative manias. The aim of this paper is to describe the common features of some of the great historical bubbles and outline China’s current vulnerability. Section One: Identifying Speculative Manias and Financial Crises Can we confidently identify a speculative mania before the bubble bursts? Is it possible to spot an incipient financial crisis before it explodes in our faces? Based on the performance over the last decade of most leading economists, central bankers, and Wall Street pundits, the answer to these questions is surely a resounding NO!

Past manias and financial crises have shared many common characteristics. Below is an attempt to list ten aspects of great bubbles over the past three centuries. 1. Great investment debacles generally start out with a compelling growth story. This may be attached to some revolutionary new technology, such as railways in the nineteenth century, radio in the 1920s, or more recently the Internet. Even when the new technology is for real, prospective rates of growth may be exaggerated.1 Early growth spurts are commonly extrapolated into the distant future. Alternately, the growth story may be spun around the exciting prospects of a particular...