China at the precipice
April 11, 2011
There are many apocryphal stories about the Chinese economy. One involves a 19th century Manchester capitalist declaring to his contemporaries that if he could “just add an inch to every Chinaman's shirt tail” he’d keep his mill running forever.
The shirt tails probably went the other way. Chinese per capita GDP fell – in 1990 US dollar terms – from $600 in 1850 (the same level it was in the year 1500, according to late economist Angus Maddison) to $530 two decades later following a second war with Britain over opium and tea. Chinese GDP bottomed at $448 per capita in 1950, to only recover following Mao Zedong's first five-year plan, a process that also resulted in the murder of between two million and five million people.
Memories are short. Speak to the average Australian bank economist, mining executive or Treasury official and it would seem that China’s GDP per capita was perpetually at least $7518 (IMF, 2010, PPP) and rising. Read the average broker report and you’ll get little indication that China’s program of fixed asset investment is unsustainable, let alone incredibly foolish. Go to the average fund manager presentation and you’ll see the same graphs, pointing to uninterrupted growth, as strong and as long as the Great Wall of China (see below).
Source: Goldman Sachs; BearsEatBulls.com
Yet no matter how hard I try, I cannot reconcile these projections with China’s multitude of domestic problems, its incredibly imbalanced economy and another equally dramatic chart:
Source: UN World Population Prospects; Leith Van Onselen
The figure above shows the estimated point – indicated by the dotted line – when China’s capacity of working-age people begins to decline. China is not the only country with a rapidly ageing population but, unlike Japan, China’s looming demographic crisis is due to top-down government edict, not the natural effects of high productivity, a large middle class and long life expectancy (see Japan’s big chance).
The figure doesn’t even indicate China’s 32 million-strong surplus of boys to girls, but it does beg the question as to how a developing country with no welfare safety net and plenty of social challenges is going to sustain high GDP growth in tandem with high dependency growth. It also begs the question as to when the Chinese Ponzi scheme is going to collapse.
Students of history will know that China’s past is littered with failed dynasties and unrealised potential. Scholars have variously attributed the gap between China and Western Europe over the past 200 years to a mix of poor governance, geographical disadvantage, a culture fearful of innovation, corruption and material decadence. In that respect not much has changed; but over the past 30 years China has witnessed a miracle of economics, lifting hundreds of million out of an ancient poverty.
The real question is, however, will this miracle last without more fundamental change?
The answer is no. China’s growth, to date, has been top-down, not bottom-up, and as such is not sustainable. Beyond a period of true catch-up growth, where Maoist policies were loosened or adapted during the "rich is glorious" premiership of Deng Xiaoping, top-down policy has more recently been about building things via cheap credit, a perverse series of local and provincial government incentives and a foreign exchange account fed through a manipulated currency and cheap manufactured goods.
These goods, in turn, have been produced and exported at the thinnest of margins thanks to a pliant and ample class of rural workers, who in the space of a generation have gone from subsistence farming to a newer type of urban servitude, yet are now running out thanks, in part, to the one-child policy.
For those in the West, and especially in Australia, who see this as some kind of benign, wealth-creating latter-day industrial revolution, it is not. And even if it were, the enthusiasm with which the investment community applauds such Dickensian phenomena is morally reprehensible.
That’s the perspective from those Chinese brave enough to speak out against “socialism with Chinese characteristics” as the present development model is known. Intellectuals, like last year’s Nobel Prize laureate Liu Xiaobo and Olympic stadium designer Ai Weiwei, have been incarcerated, the latter only this week, for criticising Beijing’s politburo. And while many Australians see China only through the lens of iron ore exports and corporate investment, activists like Liu and Ai are conscious of a different view: one that has only briefly flashes across our screens such as with Tiananmen Square in 1989 or Tibet and Xinjiang, China’s westernmost province, in 2008.
In addition to its dubious distinction of executing more people during peacetime than the rest of the world combined, it is also believed that China leads the world in incidents of unrest. Although comprehensive numbers are, unsurprisingly, difficult to come by, it is estimated that one incident involving 50 or more people occurs, statistically speaking, every few minutes, and one major incident every five days; however it is still highly unlikely that China will fall to a popular uprising like in Egypt or Tunisia.
Source: China Strikes CrowdMap
China’s police state is vastly more sophisticated and widespread, while civil society has been atomised by the ruling party, with the destruction of the Falun Gong movement only one example. Communications are tightly controlled, thanks in part to the wholesale re-engineering of US social media technologies like Facebook (Xiaonei), Google (Baidu), and Twitter (Tencent QQ). Business and press decisions are also centrally coordinated, with large companies and media outlets having one or several party representatives, in most cases more powerful than the notional CEO.
The immediate trouble for China, instead, lies not with unrest, nor even Tibet, Taiwan, North Korea or the one-child policy, but within the party. Tao Wang, UBS’s chief China economist, recently told me that one of the country’s biggest risks lay in the relationship between the central government in Beijing, which controls the power, and the provinces, which control the money.
China’s much-discussed fixed asset investment bubble, which Robert Gottliebsen has written about before (see Mixed messages on China), is a symptom, rather than a cause of this fundamentally power-political problem. China’s central government dictates progress and position within the Communist Party and the criteria for this is generally quantitative growth – whether at the factory, village, county or provincial level. The common route to growth is not better fiscal management, however, with 8% plus growth rates usually only achieved through the shuffling of assets or front-loaded construction projects.
The local governments, which own the land, will typically release parcels for development – whether for roads, rail, houses, or entire cities – taking taxes along the way. They will then order state-owned banks to lend cheap funds for construction, regardless of merit, using cash flows from initial sales – and taxes – to make the whole thing appear okay. Government and party bosses are invariably involved; part of an interlinked and mutually dependent cadre of some 500,000-plus dollar millionaires, according to Merrill Lynch.
Source: Business Insider; Nomura; Bloomberg; CEIC data; World Bank (Jan 2011)
Meanwhile, Chinese bank balance sheets look shiny on the surface as mega-listings take place in Hong Kong, London and New York, providing a much-welcomed and little-questioned salve to those cities’ capital markets. But UBS estimates that potentially some ¥3 trillion ($A437 billion) of bank loans are non-performing, a figure similar to that used by respected Northwestern University academic Victor Shih. Other economists, meanwhile, estimate that China has about 20 years of excess fixed asset capacity.
People will talk about the need for this development and infrastructure as if China’s road to first-world living standards were a given, yet this “build it and they’ll come” mentality doesn’t bear much empirical scrutiny. Arguments that the investment bubble is also down to factors like China’s excess of boys – advanced recently by ex-Treasury official Stephen Joske (see Week in View) – looks positively bizarre.
China’s non-performing loans, and the empty skyscrapers, shopping malls and cities (click here) beneath them, look less a sign of growth to come, but more a problem of US subprime proportions. Yet unlike America, a property crash in China, which has more than 125 million people below the UN-defined poverty line, would have far more dramatic consequences.
The battle between the central government – which is aware of this imbalance – and the provincial governments, which are fiscally dependent upon it, will be the defining feature of China’s next few years as the country adapts to Premier Wen Jiabao’s edict of a new consumption-based model. It will not only determine the makeup of China’s ruling elite, increasingly divided between rural-based Maoists and urban capitalists, but will determine for how long the country’s construction and lending binge continues.
Either way, the outlook for Australian mining companies, which feed the construction beast, don’t look good in the long term. Whether the transition away from construction-led growth, however, will take months or years depends on a range of factors: the trajectory of oil and food-price inflation being particularly important. Inflation and mass disaffection will undoubtedly speed the transition, unless the Communist Party actually wishes to relinquish control, but on the other hand, China’s urban and connected elite will be unwilling to kill the goose that’s laid the golden eggs.
Source: TradingEconomics.com; China Economic Information Net
The potential for an inflationary spike, followed by a crash, also exists alongside the more hoped-for smooth transition, where aggregate growth rates are expected to ease to about 6% per annum. This scenario is even more plausible when one considers the enormous volume of money and credit creation that goes on through China’s banking system – a level four times greater than in the United States (see The sting in QE's tail) despite recent rate rises and reserve requirement ratio hikes – plus the paucity of regulatory oversight and the use of off-balance sheet vehicles. Sound familiar?
Such an inflationary spike, however, could also put a rocket, albeit temporary, underneath the prices of everything that Australia digs out of the ground. My suggestion therefore is not to go bearish China or commodities just yet, or join the large list of US fund managers who are currently getting hammered by their prematurely short positions. A more considered approach might instead be to gradually reallocate exposures in your portfolio to China from resource-intensive exposures – whether that is a Chinese index fund, an Australian bank or BHP Billiton (BHP) – to consumer exposures, being the three Fs: food, fuel and fashion.
China’s middle class, after all, is hardly going to reduce its diet of meat, its use of motorised transport, or its taste for something other than the Mao suit just because property prices are crashing. Indeed, if they do then the entire world – not just the Australia – will have a problem.
I’m certainly not that bearish, and while I don’t believe China will surpass America in GDP in my lifetime, I don’t believe the progress of the past 30 years will be completely undone either. I view China in much the same way as I see America in the early 1800s: a growing and increasingly important economy, albeit one that hasn’t passed the tests of dramatic economic and political change.
Some of China’s greatest difficulties, I fear, still lie ahead of it.
I don’t think Australia will continue to ride the dragon’s back forever and just as our economy faced a shock when one great trading partner, Britain, went elsewhere for its goods, Australia will face a shock when China decides it can no longer sustain its present level of resource consumption. I cannot say when that will be, but I have a feeling it will be in the next few years.
The only prudent thing to do in terms of portfolio management in the meantime is not to panic, but to adapt, keeping a small exposure to the resources upside in the event of a future inflationary blow-off (see Movers and shakers), while limiting the downside via a larger exposure to the more sustainable story of Chinese food (see Food for thought), oil (see Oil, stronger for longer) and consumer goods consumption.
Some of the smartest fund managers are already taking this approach, progressively selling down their holdings in mining and mining services companies, while remaining bullish on energy and soft commodities. That’s certainly my view and while in a sense I hope that I’m wrong, the evidence to the contrary is far too scant. And besides, the danger that China is at a precipice is far too great to bet against.
