In 1999, Andrew Lawrence conceptualized the skyscraper index, showing a link between the completion period of the world tallest skyscrapers and the beginning of major economic crisis. This relation is due to the fact that during prosperous economic periods, business expansion increases need for office space while economic growth and low interest rates provide easy access to money. This rapid monetary expansion allows financing of expensive projects while technical improvements increase constructions’ potential heigth.
However, building a skyscraper takes several years and upon completion, the monetary frenzy that allowed financing (through borrowing) of increasingly larger real estate projects has usually turned into over-investment and speculation, which ends with a financial crash and an economic crisis.
Andrew Lawrence, took on 4 examples illustrating the skyscraper index: the Panic of 1907, the Great Depression of 1929, the 1970’s stagflation (especially the 1973-74 stock market crash), and the 1997 Asian financial crisis. A more recent example would be the recent Great Financial Crisis (2007-2010), as well as the Dubai stock market crash and the country’s bankruptcy in 2009-10.
While Dubai’s Burj Khalifa tower is today’s world tallest building, the Chicago Spire (which was to become North America’s highest skyscraper, topping at 610 meters), was simply cancelled due to financial constraints. You will find below a list of world tallest buildings together with relevant stock markets’ performance.
As clearly shown on the above examples, the time between the start and completion of the buildings sees a major fall in stock market prices. While this doesn’t prove anything and cannot become an economic law of its own being, it is important to understand how these facts are related.
Numerous economists have worked on the bubble / boom economic mechanisms, including John Maynard Keynes and Hyman Minsky. They explain how an internal dynamic sets in motion with the rise of asset prices, giving companies more incentives to invest into new production capacity but also raising their capacity to borrow money (thanks to lower debt to equity ratios). A virtuous (i.e.: self feeding) circle is started, diminishing economic agents sensibility to risk, especially when this rise is further supported by the creation of new forms of financing methods.
Once debt capacity is clearly exceeded and market agents seek to decrease their risk exposure, a powerful (and again, self feeding) downward trend drains the liquidity out of the market and leaves many companies without much needed cash to cover their operating costs. This is particularly acute in the construction sector, which relies heavily on borrowings throughout the projects as cash can only start to flow upon completion of the building.
When the financial crisis hits, companies who over borrowed will be forced to close doors, along with those not strong enough to weather the drying up of liquidity. As the world tallest structures are usually ambitious projects (both financially and technologically), they tend to be started only after a sustained, strong upward momentum. However, by the time of their completion, the economic optimism is likely to have reversed.
With this framework in mind, let us now turn to the case of China, starting with the following graph (up to early July 2015):
In the present case, China’s stock market surge can be explained by the end of a major economic cycle. The rapid economic slowdown, massive production over-capacities, and real estate excess supply leads financial flows to chase yields in financial markets instead of fixed assets which now offer lower return prospects.
Financial history and macro/micro-economics indicators leads us to believe that a major correction appears to be in China’s future, although the political components of the country create significant uncertainty regarding a definite timeline. If the Skycraper Index is any guide, we should be worried that a number of major skyscrapers in China are currently being completed: the Shanghai Tower (632m) topped up at the end of 2014 and should be inaugurated during summer 2015; in Shenzhen, the Ping An Financial Center (600m) is set to be completed in early 2016, while the Suzhou Zhongnan Center (729m) construction started in early 2014.
Should we follow Mr. Lawrence’s index, we could expect a major correction in the near term (within a couple of years at most). Yet several things should be noted:
- None of Chinese skyscrapers being built are claiming the ‘world tallest building’ record;
- This index is a far proxy, not a definite forecasting tool: it is more anecdotal and draws on side effects of otherwise well known rapid credit growth effects rather than substantial methodology.
Indeed, the best proxy for forecasting financial crisis, credit growth, has been flashing red for quite a long time in China: between 2008 and 2013, China’s credit grew at roughly 20% CAGR, falling short to reach the size of the USA’s in 2013. The following graph also shows the percentage of Non-Performing Loans (NPL) as a share of gross loan. This ratio has decreased dramatically from the previous major economic correction in China, during the late 1990’s Asian Financial Crisis.
In fact, most of the early part of the 2000’s was spent cleaning up the previous mess, until the Great Financial Crisis led the Chinese government to unleash a massive massive stimulus in 2009. Yet what doesn’t show in the official statistics is that it is impossible for a country to have such a low NPL ratio when credit grew so rapidly. The following graph shows the same statistics for the USA, whose credit size ‘only’ grew by 7.6% CAGR between 2002 and 2008.
As the graph shows, NPL declined until the crisis hit in 2007-2008, at which point banks realized that the actual number was much higher. We also urge caution as these numbers may not reflect the true reality of bad loans, which can be rolled over or hidden through creative accounting. Still, these numbers offer us a more or less reliable approximation.
With this in mind, we believe that in China, ever greening (rolling over loans) and the shifting of bad loans to Asset Management Companies hide massive losses that will eventually show up. Now that the economy is slowing down more rapidly than expected, decreasing margins are severely hurting companies’ financials, which may eventually trigger powerful downward debt dynamics. The stock market’s rapid rise, if attributed to the displacement of yield hungry investors and crowd effect rather than underlying fundamentals, would then experience a significant decline (and indeed the current correction as of late June /early July 2015 shows how rapid momentum can reverse).
In any case, we maintain our bearish outlook on China’s macro economic outlook. Selected industries, products and services will continue to benefit from the country’s potential but too many indicators are flashing red for the economy to keep growing at previous rates. The skyscrapers frenzy still has to reach China’s outstanding building of debt and soaring equity prices. Let us hope they do not fall as easily and rapidly as the latter.
Annex I: list of China’s tallest structures
About Nicolas Houilliez
Luxemburg based with strong analytical skills, I worked as market and strategy analyst in large multinational companies. Passionate about China, economics, geopolitics and finance.