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China's rise
over the last two decades
has been perhaps the most
dramatic success story ever. It has led commenters like Goldman Sachs
to use the historical growth
rates to predict when China's GDP, now the second largest ahead of Japan, to cross the US to be number one. But there are
important cracks in the Chinese growth
story that shouldn't be ignored.
The
following recounts some of the structural weaknesses
that have been giving
China watchers like
Gordon Chang, Jim Chanos and Hugh Hendry reasons to warn about the impending problems of China's real estate bubble and debt imbalances.
Money
Drives Economies: China in Perspective
The
most important world monetary
effect is the continuing increase in money created by all central banks.
The following chart shows
the increases of central banks'
total assets over the period
of this crisis, where money printing was stepped up to fight the credit crisis. The amounts are converted to
dollars for comparison.
China
has been the most aggressive
in its use of money creation
to expand its economy and smooth over the crisis.
But
China's economy is not as big as the other economies above, so I calculate
below that China's use of its central bank is even
more extreme by dividing
the central banks' assets
by GDP.
The
Chinese system is different from ours, with much more central control,
so their much bigger central bank's assets may be a structural, permanent difference. It is a little worrying that the growth relative to GDP
is rolling over. The high
Chinese official inflation (5%) in
2011 has been met with some
tightening by the central bank
by increasing reserve requirements. Central bank tightening after extreme loss during the Great Recession can be more difficult
for their economy to absorb. In other words, China faces the same
"rock and hard place" as the Fed and Eurozone,
of balancing the forces of the economy
and inflation.
A
few technical details of developing this chart are needed for completeness: The Chinese economy is very
seasonal, with only 20% of the annual GDP in
the first quarter but 32% in the last. The quarterly data is smoothed by summing up the last
four quarters of nominal GDP. The result looks like the increase in assets is rolling over, but on the
first chart, the expansion of the assets is the biggest of all countries, and their
ratio is actually rolling over because GDP is growing again
(as reported by the government,
which has its own skeptics like me, as they include real estate when it is
built rather than when it
is in use, for example).
How
China Got Here
China
used mercantilist methods to keep the renminbi low and the export economy growing. It set the short-term
rate on deposits to 0.72% starting
in 2002. As inflation rose to 7.9% in 2008, this negative real interest rate of
7% helped induce savers to look for other investments, and real estate became the path for the newly emerging middle class.
The Chinese consumer spends
only 35% of the national GDP for consumption, down from 50% in 1970. It is the lowest of any major economy. That compares to 70% in the US. Housing grew from 2.4% of GDP to 9.1% by 2011. Massive urbanization, including 24
million people per year moving
to the cities, supported
real estate. In 1983, only 10% of Chinese owned their home. That grew to 80% in the 1990s. There was
incentive for investors from the government in the form of no property tax, so the cost
of empty units was shielded for flippers of these units.
Households borrowed
$400+ billion per year to buy
new houses. China has spent
twice as much as the US
on its housing bubble when adjusted
for relative GDP.
The
growth in debt of Chinese households is not captured in official numbers because down payments are supposed to be 40%. A shadow banking system of an estimated
$1.3 trillion has provided loans
that are "off the books." Local government debt expanded considerably and is thought to be about 25% of GDP. Analysts believe that total Chinese government debt is 80% of GDP, not the 20%
to 30% official government numbers
would have us believe.
The
plan seems to be that growth through
exports could support investment
expansion even at high costs, as China took over manufacturing for the world. But there
is a vulnerability to an economy that is dependent on foreign purchases of its goods. In downturns, foreign imports are cut more than domestic production. So China will
likely face a bigger downturn in a coming world recession than will the United States or
Europe, which can manage
to weather a smaller
relative economic contraction by cutting imports while keeping domestic production going.
The
currency peg of the
renminbi to the dollar has made the international imbalances
more dangerous. By keeping
the renminbi low and the dollar high, exports are facilitated. The resulting
holdings of $2 trillion foreign-currency-denominated
reserves make China look wealthy. They have promised to spend to prop up to Europe. But if the renminbi rose, China could become less competitive. The value of
the renminbi is manipulated
by the government to facilitate
job growth through
exports, so traditional fundamentals of exchange rate valuation
may not apply. The
situation now is that China's ability to invest in productive
capacity has outstripped its customers' ability to borrow to buy that output. In essence, we have a bubble.
Countries
that have been depending
on Chinese investment into their country for development of natural-resource
production may find that China's future may not be as bright as expected. That could affect suppliers such as African nations as well as the premier growth country
of Brazil.
Despite the government-induced
borrowing and spending that has propped up China's GDP, the stock market is telling a story of weakness as it has crashed from 6,000 in 2008 to 2,400 today.
One
extremely important flaw is the aging demographic of the Chinese
population. There is no simple macroeconomic
policy to counteract the generational shift. The severe
action of a one-child policy created a bubble of retirees that will be
dependent on a much smaller workforce in the future
for its support. It has been said
that the one child will have to take care of not just two parents but four grandparents. China's birth rate is 30% below the replacement rate. Its
population will peak in 2026. Its over-65 population
will double from 115
million to 240 million in the next two decades.
The
following chart shows the
demographics of today's
distribution in color, and projected
for 2030 in black outline. It will
be a top-heavy society with nonproductive old folks creating a drain on this economic juggernaut.
Politics will provide its own
set of potholes, and in China, where
there is no democratic process, succession means handing over power to like-minded individuals and hoping for an acquiescent populace. It's
hard to know as an outsider how serious the protests and dissatisfaction of
various segments of the society are in comparison to those that are more public in other
parts of the world. China faces a new regime in the
next year that may not be as prepared to manage short-term difficulties. The struggle
for the United States on how to deal with a blind dissident who sought asylum in our embassy just
shows the tip of an iceberg of many underlying complexities of such a huge nation.
Charts Showing
Economic Slowing
Fundamental to China's
economic growth model are
its exports. Not surprisingly,
Europe is the weakest with no growth. The other Asian countries and US
are stronger, but in decline.
Electricity usage growth
has turned down to levels
not seen since the 2009 recession. Fixed-asset investment (FAI) has declined from the breakneck speed experienced in the stimulus-induced
recovery high of 33% to 20% – still a healthy
level, but much slower.
The
longer-term view of FAI
shows the growth rate is
the lowest since 2003. Industrial production is down
to 10 % from a post-recovery
high of closer to 20%. State investment
in railways has fallen
44%. Highway construction has dropped
2.7%.
As
the big stimulus to avoid
the 2008/09 decline filtered
into the Chinese economy, inflation became a worry. The government
increased reserve requirements for banks and limited new lending modestly, resulting in
inflation slowing. Slowing
inflation may not necessarily
indicate economic slowing, but stories of a big softening in real estate
figures (see below) are
consistent with that picture.
Remember, these
are the positive numbers from
the government, so they include some self-serving positive bias.
Real
Estate Numbers Say GDP
Will Slow
Here are some
very weak real estate numbers summarized by Michael Shedlock from a report by Patrick Chovanec,
a professor at Tsinghua University's School of Economics and
Management in Beijing:
- Year-on-year sales in Q1, for all real estate,
were down 14.6%.
- Residential
property sales were
down 17.5%.
- Office
sales were down 10.2%.
- Sales
in January-February were
a disaster, falling
20.9% overall, compared
to the first two months
of 2011, down 24.7% for residential.
- Total
amount of floor space "for sale" was
up 35.5%, compared to the same
date last year.
- Floor
space of residential
units "for sale" grew
47.4%.
- At
the end of 2011, total floor space "under
construction" was roughly
4.6 times the floor space
sold.
- New
starts in April fell
14.6% year-on-year
and 27.0% month-on-month,
for property as a whole.
- Housing
starts fell 14.4% year-on-year and 23.4% month-on-month.
- Office
starts fell 21.0% year-on-year in April and
45.1% compared to March.
- Retail
property starts fell 18.7% year-on-year and 36.8% compared to
March.
- Land
sale revenues in April (RMB 27 billion) were
down 54.7% compared to April last year.
- Foreign
funding for property
development was down
91.4% in March and 80.8% in April, compared to
the same months last
year.
Interpreting these big drops is important because real estate has been
the biggest reason that China was able to appear less affected
by the Great Recession of 2008. Much of the funding of local governments
came from selling off the
land for development. Local authorities
collect 70% of their tax revenue and central government
30% from land sales. Those
revenues have dried up, being
down 80% from a year ago. Chinese statistics include completed development as part
of GDP, even if those units haven't been sold to final users, so as inventories grow, GDP looks
better than what we in the US would calculate by our methods.
An
estimate by Chovanec is that if nominal real estate investment dropped by 10%, GDP would drop from 8% to 5.3%. It would seem from the above numbers that real estate is already down by double that, and if it continues with the export slump, that combination is likely to bring a Chinese recession.
Investment Implications
Chinese stocks are down, and some ETF indexes were identified in my November 2011 article on China in The Casey Report,
titled Danger Ahead from the Excesses of China's Success. Subscribers can find the article here. You can get access in a trial subscription here.
One
way to invest against the Chinese economic growth is to short their suppliers. Japan fits that bill. CDS spreads are blowing out in Japan, as companies there find it
difficult to compete in
the world with a very
high-priced yen. Slowing demand for China's exports in
the coming world slowdown
will affect Japan and Australia as they are big suppliers to China.
While the West has paid
too much to bail out big bankers, Asia has paid too much to a bloated government bureaucracy that does not justify its contribution to the productivity
of the overall economy.
The planned economy is about to learn how the
cycles of real estate can't
be expanded forever.
So
while many have seen the GDP growth of Asia, and China in particular,
as a sweeping endorsement
of future financial dominance, it
is perhaps more likely that the overextended imbalances of too much debt
that are now plaguing Western developed economies will circle around through the same patterns to bring a serious contraction in Asia. These will
affect world commodities, and attempts
to paper over the debt problems will lead to currency crisis. The US looks surprisingly strong by comparison, but it is not invulnerable.
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