Why China Is In Trouble
We have expressed doubts about China's economy on several occasions in the past. See: 'Can China's Planners Do It One More Time' and 'Soft Versus Hard Landing', where we have discussed a number of early warning signs in detail. Of course we need not really rely on the specific data describing economic history to be able to forecast within praxeological constraints that China's economy will be in trouble: the knowledge that the country has experienced two enormous credit booms in close succession suffices to allow us to come to this conclusion. The only things that introduce an element of uncertainty are the question of timing and in China's case specifically, the ability of the central economic planners to order the banks around.
To this point we must introduce a qualification: state control over the banking system is very extensive, so that the unwillingness of bankers to take on more risk in the face of faltering boom is certainly not a factor in restricting credit. However, one must be aware that in every bust, what is indeed a factor in restricting credit regardless of the powers of regulators and planners is the state of the pool of real savings.
China: bank credit as a percentage of GDP (source: Morgan Stanley). Since December of 2008, $5.3 trillion in additional loans have been disbursed. Relative to GDP, this is the functional equivalent of the US banking system extending about $11.2 trillion in new loans. If that had actually happened in the US, we'd have witnessed a crack-up boom that would have everybody greatly worried by now - click chart for better resolution.
When considering the ability of banks to grant credit to businessmen, one must always keep in mind what the businessman who is asking for credit actually wants. Ultimately he is not asking for 'money' – he wants to get his hands on capital. This is an important distinction. Money is merely the medium that facilitates exchange – in and of itself it cannot fund economic activity. Hence the importance of the pool of real savings. Money created from thin air cannot replace genuine savings – and genuine savings in turn are the excess of production over consumption. We can therefore see that one cannot put the cart before the horse: rising consumption can never be expected to create a 'self-sustaining economic recovery'. It is not possible to consume oneself to prosperity, that is a Keynesian fallacy. Rather, higher consumption is an effect of wise investment in more productive processes of production.
Here the qualifier 'wise' is of paramount importance. It is not enough to use savings to increase investment willy-nilly. Contrary to the Keynesian view that senseless ditch-digging or pyramid building is 'better than doing nothing', it is actually worse than doing nothing, as it consumes scarce capital.
This unfortunately is precisely what China's planners have done after the financial crisis of 2008. They went on a pyramid-building spree, almost literally. Today there are vast landscapes in China filled with brand-spanking new buildings that stand empty. An overview showing satellite images of the ghost cities and ghost malls dotting China can be seen here.
China: investment as a percentage of GDP compared to real GDP growth. In view of the massive rise in bank credit, we can be reasonably certain that a large part of this investment orgy was actually malinvestment (chart via Morgan Stanley) - click chart for better resolution.
Readers may also want to take a look at this extensive interview with famed short-seller Jim Chanos. At about 6:19 in the video he explains what persuaded him to look at short ideas in China. Specifically, he talks about the construction boom which has been so large as to strain credulity.
China: the contribution of construction activity to GDP (via Opalesque) - click chart for better resolution.
According to Chanos, as of autumn of 2009, 60 billion square feet of new construction were underway in China, half of which was designated for 'office and mixed use'. This means that in the fall of 2009, a 25 square feet office cubicle was under construction for every man, woman and child in China. Granted, these are smallish cubicles, but even under the most optimistic assumptions about future demand for office space this is a truly astonishing number. When Chanos first heard of the numbers, he initially thought that they must be wrong by an order of magnitude. However, he was assured by his analysts that the numbers were indeed correct.
Now, it is easy to conclude that this building boom can not be sustained. Once the 60 billion square feet in construction are finished, leaving rows after rows of empty apartment blocks, empty shopping malls and empty skyscrapers behind, what comes next? Should even more office space be constructed?
Obviously a great many real estate development and construction firms are set to go bust, a process that by all accounts has already begun. From an economic point of view it is also important to keep in mind that the resources that have been expended in this boom have been bid away from other sectors in the economy, where they may have been employed more profitably.
Moreover, a lot of credit has been extended to firms all along the production structure serving this sector.
A lot of credit has apparently been extended by channeling savings into the 'wealth management' vehicles we have recently discussed.
These are essentially fixed income investments promising investors yields that far exceed those they can obtain in savings deposits. Many of the securities are collateralized by the very real estate developments that are now beginning to ominously look like massive malinvestments that will have to be written off. The promised returns crucially depend on rising prices for residential as well as non-residential property.
A chart that shows new issuance versus redemptions of 'Wealth Management Products' in China (via CLSA) - click chart for better resolution.
The construction boom has inter alia also led to a boom in cement production, a boom in steel production and of course a boom in the production of the raw materials supplying these industries. This is why the happy-go-lucky 'this time it's different' boom in Australia is in grave danger of keeling over as well. Both Australia and Canada as major suppliers of commodities should be wary of what is now happening in China. Both countries have experienced massive real estate and credit-financed consumption bubbles on the back of the boom in commodities prices, as an unhappy, though not entirely unexpected by-product.
Recent Chinese Data Releases:
Falling Factory Production and A Big Deterioration in Trade
According to the financial press, China's factory output 'unexpectedly' slowed in June to its weakest level in over three years. As always, one wonders why this was 'unexpected'. How can economists in the aggregate be so astonishingly blind to what should be glaringly obvious? For instance, we talked about the crumbling fortunes of China's steel industry already back in March of this year (see the links to previous articles on China above). We discussed the signs that showed that free liquidity was faltering in November of 2011.
Did economists think these were signals worth ignoring? Did they think it wouldn't matter that the world's biggest steel sector saw its PMI slide to 42? Was the sudden screeching halt in China's foreign exchange accumulation something to be glossed over?
In any case, the warning signals continue to proliferate. Unexpected or not, there is more and more evidence pointing to a slowdown that is far more pronounced than was hitherto widely assumed. A 'hard landing' suddenly looks like a high probability case.
On the decline in factory output, Reuters reports:
“China's factory output growth slowed unexpectedly in July to its weakest in more than three years, underlining stiff global headwinds that may prompt policymakers to take more action to keep growth on track to meet a 7.5 percent annual target.
Retail sales and fixed asset investment also missed market forecasts in official data released in Thursday, increasing expectations that Beijing will act to support an economy that has seen growth sliding for six straight quarters.
Annual consumer inflation, meanwhile, fell to a 30-month low last month, suggesting that the central bank has ample scope to ease policy further after cutting interest rates in June and July.
"We think the weakness will be more stubborn than people had expected," said Li Wei, Chinaeconomist at Standard Chartered Bank in Shanghai. "My view is that political rhetoric is losing its effectiveness in boosting confidence and you need actual actions to boost growth."
Expectations of more stimulus measures in response to the data boosted riskier assets, with Asian shares rising to a three-month high and the commodity-sensitive Australian dollar testing a 4-1/2-month peak.
Apart from lowering interest rates, Beijing has also cut the amount of cash that banks must hold as reserves (RRR) to free up an estimated 1.2 trillion yuan ($191 billion) for lending in a series of moves since November 2011.
President Hu Jintao and Premier Wen Jiabao have promised to step up policy "fine tuning" in the second half of the year to support the economy.
Note how in these press reports the main thing that is emphasized is always how the weakening data will undoubtedly invite 'more stimulus'. It's as though nobody can think of anything else anymore. Stimulus will save us! Wave thy magic wands, central planners!
The market reaction to weaker economic data is similarly baffling: instead of selling risky assets, people actually bought them yesterday, in the hope of, you guessed it, 'more stimulus' to emanate from China. Of course one cannot fool all people all of the time, as the long term chart of the Shanghai Composite Index depicted below shows. In spite of the biggest credit expansion in all of China's history between 2009 and today, the stock market has traced out a typical post-bubble path and keeps grinding lower:
The Shanghai Composite: tracing out a typical post bubble path since the blow-off top in late 2007. Per historical experience with bubble collapses in the past, prices should eventually return to the point where the 'parabolic' bubble advance began - click chart for better resolution.
It is worth noting in this context that profit growth of industrial enterprises in China has plummeted into negative territory for the first time since the 2008 financial crisis. This is from an average of more than 34% annualized growth in the boom years 2003-2007.
Profit growth of China's industrial enterprises has faded back into negative territory after the 2009 'stimulus spike'. As time goes on, the stimulus-induced profits are likely to be revealed to have been nothing but imaginary accounting profits - click chart for better resolution.
Then China released 'far weaker than expected' – here we go again! – trade data this morning. When googling for an article that has the details, the first one we came across this morning sported the following headline: “China Easing May Be in Days, Not Weeks”.
This article was posted by CNBC – they don't even bother anymore to put the salient facts into the headline of their articles. Instead the headline is a speculation on 'when' the stimulus magic wand might be waved. The whole world has apparently become crazy. There is an intense focus on intervention coupled with an abiding faith that it can avert bad things from happening, in spite of an overwhelming abundance of evidence to the contrary. Mind, we would not even need this evidence to show that intervention in the form of monetary pumping and deficit spending won't work. All that is required to conclusively demonstrate this point is sound deductive reasoning and sound economic theory.
However, since so many mainstream economists and the central planners themselves insist on empirical evidence as the be-all and end-all, one wonders why the actual evidence is so studiously ignored?
Here is an excerpt from a Reuters report on the trade data that rattled the markets this morning. It includes a few remarks on other Asian countries that have seen their trade falter as well in light of China's growing problems. In this context, readers may recall the chart of the collapse in Korea's trade surplus with China which we showed on Tuesday.
“China's July exports rose just 1 percent from a year earlier, undershooting forecasts by a big margin and adding to a downbeat set of monthly data that has boosted expectations of fresh government action to shore up the economy.
Fear of faltering demand from China's two biggest foreign customers – the European Union and United States – had seen economists peg back their consensus call for annual export growth to a three-month low of 8.6 percent in a Reuters poll last week.
Instead, the 1 percent rise is the weakest since January, when exports fell, and marked a big pullback from annual growth in June of more than 11 percent. Shipments to the European Union dropped more than 16 percent. July imports rose 4.7 percent from a year earlier, the weakest pace since April and also well short of expectations for an increase of 7.2 percent.
"China will not escape from the global slowdown," said Banny Lam, China economist at CCB International in Hong Kong. He said that the central bank might cut the amount banks must hold as reserves, which frees up cash that they could use for lending, as early as this weekend.
Ahead of the data, China Vice Commerce Minister Gao Hucheng had told reporters it would be a challenge for China to meet its 10 percent trade growth target in the second half of the year. Just last month, the ministry had said it was confident of meeting the target.
Taiwan on Monday posted a fifth straight month of decline in exports in July, dragged down by double-digit drops in shipments to China, Europe and the United States, while South Korea's July exports were the worst in nearly three years.”
Please note the huge difference between the estimates of economists and the actual data. What on earth were these people looking at when they published these estimates? Anyone in the business of forecasting China's trade data simply had to be woken up by the collapse in Korea's trade surplus. At the very least it should have led to a reexamination of previously held assumptions, but apparently that has not happened.
In any case, the data releases emanating from China of late appear to confirm that our suspicion that the slowdown would prove to be far worse than most observers expected was likely the correct hunch.
We agree of course that the authorities will react by implementing addtional stimulus measures, but it should be pointed out that the PBoC has begun a campaign of lowering both interest rates and reserve requirements quite a while ago - to no avail thus far.
It may still be too early to state with apodictic certainty that the slowdown will morph into a 'hard landing', as we cannot judge from afar how much wealth there still is left that might be diverted into renewed bubble activities due to monetary pumping. However, the probability of a hard landing seems to have vastly increased in view of the recently demonstrated inability of the planners to arrest the contraction in growth.
Lastly, we leave you with a chart that shows that China's demographic problems are only just beginning. Similar to many nations in the developed world, China is a rapidly 'graying' society. Soon the central planners may be busy with 'decline management' rather than the management of 'growth'.
The growing old age dependency ratio of India and China – click chart for better resolution.
Charts by: BigCharts, Morgan Stanley, CLSA, Opalesque
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