Name the Country

Here is a good test of your economic history, which country and what period am I describing?

1. Huge real estate bubble - perhaps one of the largest the world has ever seen, following on from a huge stock market bubble just a few years earlier.
2. Securitized residential mortgages and short term loans, packaged and on-sold to investors with the promise of high returns.
3. Widespread and systemic fraud to enrich business leaders.
4. A huge demographic shift about to take place as the workforce ages and shrinks.
5. Interest rates kept too low for too long, often negative in real terms rewarding speculative behaviour.
6. Rapidly rising debt levels, over 200% of GDP and rising at twice the rate of income growth.

If you said the US in 2005, you would be correct.


If you said China in 2013, you would also be correct.

Here is the problem: while many are watching the US and Europe and expecting them to fall apart at any moment, the real risk lies in the country that most are very complacent about. Developed Western country problems are known issues -  It is not typically the known economic problems that hurt investors, but the ones that consensus says do not exist.

This is hardly surprising given that risk management tends to go out the window in these cases and in periods of low volatility. Known issues often lead to intense scrutiny over exposure and possible outcomes, and this prevents them becoming more dramatic.

The US has done a lot to make it's economy more resilient following the great imbalances of its bubble years; bank recapitalization; de-leveraging; a shrinking trade deficit. Europe's banking system has not been fixed to the same extent, but the adjustment is at least under way despite some lingering structural issues. While these economies may face further hardship and recessions, their restructuring has begun. The opposite case occurred in China after the GFC. Instead of re-balancing it's economy, China doubled down on its investment growth story and fueled a credit and residential construction bubble.

China's credit fueled investment boom is not sustainable, yet there is still a lot of blind faith in a few bureaucrats to pull all these economic levers efficiently to create 7.5% real growth per year for the next decade. This is, despite all the historical precedents for investment growth models not re-balancing easily that Michael Pettis points out, and the precedent of state controlled economies being very poor resource allocators.

China will not fall apart immediately either. However, over the next few years Chinese growth will slow either voluntarily or involuntarily, and this has huge consequences for Australia. A lot of the China story probably won't be apparent until the tide goes out, and we see who is not wearing any shorts. Over the next year I will be aiming to describe Pettis' arguments for re-balancing from the perspective of Australia.