Why China’s Economy Won’t Land Softly
The country has reverted to its old tricks by fueling growth with more credit. Debt is now growing at historic rates.
By Jonathan R. Laing
By all accounts, the economic slowdown in China was the major cause of the nasty U.S. stock market corrections in both August of last year and during the first six weeks of this year. The fear, of course, was that trouble in the Middle Kingdom would drag down global growth and stunt the U.S.’s muddling recovery.
But seemingly overnight in February, investor psychosis over China evaporated, and the Standard & Poor’s 500 index came roaring back 13% before settling back some last week. Nonetheless the S&P 500 and the Dow Jones Industrial Average are still slightly up for the year on a total-return basis, after being given up as roadkill in February.
Traders were seemingly emboldened by some better first-quarter numbers out of China that indicated at least some stabilization in its economy. First-quarter industrial production perked up slightly. Beijing reported year-over-year growth in gross domestic product of 6.7%. In March, China’s foreign-currency reserves grew for the first time in months, as the yuan steadied in value and capital flight seemed to abate.
BUT U.S. INVESTORS SHOULDN’T put too much stock in the China turnaround story. The government is notorious for inflating its GDP and other growth numbers. It’s a nation that appears to be drowning in too much debt.
Perhaps of greatest moment, Beijing in the first quarter seemed to panic, shoving nearly $1 trillion in new credit into the Chinese economy. That’s an epic amount for any economy, especially in a nation with a GDP of $10 trillion. The liquidity boost is the largest quarterly credit surge on record.
So for all the talk of Beijing restructuring away from an industrial and into a consumer-based economy, China seems to be resorting to an old model of debt-fueled growth that has seen its debt-to-GDP ratio surge from around 150% to well over 300% since 2008. This calculation of the ratio—higher than some other estimates—was made by Victor Shih, an associate professor at the University of California, San Diego, and an expert on the Chinese financial system. This ratio exceeds by a wide margin the debt burden of most developing economies.
China is paying the price for the past six years of malinvestment that resulted in mountain ranges of empty apartment buildings, vanity infrastructure projects comprised of unused highways, bridges, and exposition centers, and redundant industrial capacity. These projects yielded temporary GDP boosts during construction, but then lapsed into the netherworld of nonperformance, unable to generate the cash flow necessary to service underlying debt.
As a result, bad credit abounds, largely hidden from sight by loans that are “evergreened” and capital infusions from government-related entities to hide defaults. Perhaps hedge fund legend George Soros posed the issue most baldly in a statement he made a few weeks ago at New York’s Asia Society. He raised the possibility of the Chinese economy enduring a hard landing in the near future. He said the debt problem in the Chinese economy “eerily resembles what happened during the financial crisis in the U.S. in 2007 and 2008, which was similarly fuelled by credit growth…Most of the money that banks are supplying is needed to keep bad debts and loss-making enterprises alive.”
Indeed, the first-quarter credit surge has led to false signals that the long collapse in commodity prices is over because of a revival in all-important Chinese industrial demand. Trading in iron-ore contracts on the Dalian Futures Market has soared more than 400% from a year ago, with daily volume topping Chinese annual imports during many trading sessions (see Asian Trader). Coking-coal futures trading has also gone into hyperdrive. Both steel ingredients soared in price by about 40% this year, until the exchanges intervened early last week to raise margin requirements.
Yet this activity doesn’t reflect any increase in demand in the real Chinese economy. In fact, JCapital, a research outfit that closely tracks the Chinese economy, contends its on-the-ground surveys show steel and copper demand is expected to decline by 4% to 6%.
The heavy trading is more than likely a reflection of speculative bubbles akin to the bubble in Chinese stocks that died over the past year. Chinese punters will play any market if liquidity is available.
Likewise, in the event of any devaluation of the yen, commodity players would see their futures contracts or physical holdings revalued upward.
Some U.S. investors insist that whatever happens in China will stay in China. The rest of the global economy has scant exposure to Chinese debt or equities. After all, Japan’s debt-fueled travails of the past 25 years had little effect on the rest of the world.
We feel this is a naive notion. Just ask Apple, which suffered its first quarterly revenue drop in 13 years in large part from a decline in Chinese sales.