What impact will China’s slowdown have on the red-hot contemporary art market?

For emerging-market investors, art has become a critical tool for facilitating capital flight and hiding wealth.

These investors, particularly the Chinese, have become a major factor in the art market’s spectacular price bubble of the last several years.

So, with emerging market economies from Russia to Brazil mired in recession, will the bubble burst?

Just five months ago, Larry Fink, Chairman and CEO of BlackRock, the world’s largest asset manager, told an audience in Singapore that contemporary art has become one of the two most important stores of wealth internationally, along with apartments in New York, London, and Vancouver. Forget gold as an inflation hedge; buy paintings.

What made Fink’s elevation of art to investment-grade status so surprising is that no one of his stature had been brave enough to say it.

And the sums are staggering. In May, Pablo Picasso’s Women of Algiers sold for $179 million at a Christie’s auction in New York, up from $32 million in 1997. Okay, it’s a Picasso. Yet it is not even the highest sale price paid this year. A Swiss collector reportedly paid close to $300 million in a private sale for Paul Gauguin’s 1892 When Will You Marry?

Picasso and Gauguin are deceased, and the supply of their paintings known and limited. But, the recent price frenzy also extends to a number of living artists, like American Jeff Koons and German Gerhard Richter, and continues well down the food chain.

The last unregulated market

So who would pay so much for high-end art.? The answer is elusive, because the art world is extremely opaque. Indeed, art is the last great unregulated investment opportunity.

Much has been written about the painting collections of hedge fund managers and private equity art funds (buying shares in portfolios of art without actually ever taking possession).

In fact, emerging-market investors like the Chinese have become the swing buyers, often making purchases anonymously.

But doesn’t China have a regime of strict capital controls that limits citizens from taking more than $50,000 per year out of the country? Yes, but there are many ways of moving money in and out of China, including the time-honored “under and over invoicing.”

For example, a Chinese seller might report a dollar value far below what was actually paid, with the difference deposited into an overseas bank account. Over all, it is extremely difficult to estimate capital flight; there is simply too little data and it is too hard to distinguish from normal diversification.

Art is easy to hide 

Capital flight from China is estimated at $300 billion annually, with a marked increase in 2015 as the economy continues to weaken. The ever-vigilant Chinese are cracking down on money laundering; but, given the huge incentives, this is like playing whack-a-mole.

The anonymous Chinese buyers at recent Sotheby’s and Christie’s auctions had surely spirited their money out of the country before hand and saw the art as an investment that was particularly easy to hide. It may never even be displayed, but rather rushed off to a climate-controlled storage vault in Switzerland or Luxembourg.

Some art sales result in paintings merely being moved from one section of the vault to another, recalling how the New York Fed registers gold sales between central banks.

The Chinese hardly invented this game. Not so long ago, Latin America was the big driver in the art market, to escape governance-challenged economies like Argentina and Venezuela, as well as drug cartels that used paintings to launder their cash

So how, then, will the emerging-market slowdown radiating from China affect contemporary art prices? In the short run, the answer is ambiguous;  more money is leaking out of the country even as the economy slows.

In the long run, however, the outcome is pretty clear, especially if one throws in the coming Fed interest-rate hikes.

With core buyers pulling back, and the opportunity cost rising, the end of the art bubble will not be a pretty picture.