By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010) Part I; Part II.
A significant part of China’s growth has been an illusion. Since 2008, China’s headline growth of 8-10% has been driven by new lending averaging around 30-40% of GDP. Given that (up to) 20-25% of these loans may prove to be non-performing, amounting to losses of 6-10% of GDP. If these losses are deducted, Chinese growth is much lower.
The China economic debate is focused on the alternatives of a soft or hard landing. Both scenarios assume a slowdown in growth and transition to a troubled maturity.
The case for the soft landing assumes that the investment and property bubbles are less serious than thought. Beijing has sufficient financial capacity to boost growth by loosening monetary policy and bank lending, while adjusting specific policies, such as lifting restrictions on housing sales to prop up prices. China is able to boost domestic consumption, replacing investment as the key driver of its economy. Excess capacity is gradually absorbed as the world economy recovers.
Growth comes down gradually, without causing social and political disruptions.
The case for the hard landing assumes the rapid and destructive unwinding of asset price bubbles and problems within the Chinese banking system. A poor external environment and losses on foreign investment exacerbates the problem. Growth collapses triggering massive social unrest and political tensions.
More benign scenarios rely on the self interest of the Party and Chinese leaders, who will risk anything to maintain growth at around 7% or 8% to preserve social stability and control.
But the end of a cycle of debt and investment driven growth is typically disruptive. Japan’s experience, which China has drawn on in shaping its economic model, is salutary. Japan grew by 10% in the 1960s, 5% in the 1970s, 4% in the 1980s, and has remained stagnant since, adjusting to the deflation of its debt fuelled bubble.
China analysts, like Michael Pettis, believe growth will decelerate sharply as the identified problems emerge falling below 5% by the middle to end of the decade. While growth of this level is high by the standards of developed nations, it is below that required in China to meet the needs of its population and their aspirations. A lower growth rate is also problematic for external investors and trading partners, assuming higher rates of growth.
Interestingly, both scenarios assume China continues as part of the international trading system and the global economy. A deteriorating external environment, losses on international investments, foreign pressure on China’s currency and trade policy may drive a more radical outcome. Like its competitor the US, China might be tempted to embrace an isolationist policy as a way of solving its problems.
China would de facto write off its foreign exchange reserves but refuse to purchase new US, European and Japanese government bonds to avoid the risk of future losses. It would further limit access to its own market to foreign investors. China would then redirect its attention to the domestic economy and seek to rebalance its economy.
External economic engagement would be sharply curtailed and would be limited to acquiring needed commodities, technology and skills in the open market on commercial terms. In effect, it would retreat behind a wall as a quasi autarky. Brazil’s import substitution industrial strategy is a possible model.
A variation would be a Chinese zone of economy influence within Asia and the emerging market block. This would entail trading and capital flows within member nations, with transactions denominated in non-G3 currencies. China’s increasing interest in denominating more of its trade in Renminbi and establishment of currency swap lines with interested nations is consistent with this strategy.
China’s large population and huge internal market provide a significant incentive to co-operation. As part of a deal to establish mutual swap lines between the central banks of China and Japan, Japanese investors will gain access to the domestic Chinese bond market.
Isolationism is not a given. But criticism of China’s policies, losses on its foreign investment, domestic needs and perceived weakness of developed economies and their limited tangible future benefit may drive China to re-assess it policy of international re-engagement.
China’s adjustment will affect the global economy.
The global economy increasingly looks to China to drive the world’s growth. These febrile expectations are ill founded. China’s GDP is only around 20% of the combined GDP of the US, Europe and Japan, which make up around 60% of global output. The view that China, because of its large population, can compensate for a decrease in consumption in the developed countries is fanciful. China’s consumption is only a little more than France, a little less than Germany and around 1/8th of the US.
In the aftermath of the crisis, industrial and direct investors have looked at China for earnings growth and returns. High growth rates, fables of urbanization, rising domestic consumption and the need for investment in upgrading infrastructure have attracted investments. Fairy tales about how a billion Chinese would urbanise and consumerise, driving 10 % growth forever and replacing America as the global consumer of last resort captivated audiences at business conferences. In reality, a major source of interest in China and other emerging markets was that it wasn’t America, Europe or Japan.
Investors generally chose to ignore the truth underlying the fairy tales, ignoring how the growth was going to be achieved. China’s debt driven and investment fuelled growth is now vulnerable. There is a significant amount of unproductive investment and mis-allocated capital. Some of this will manifest itself in the form of bad loans.
For businesses seeking to capitalize on the domestic economy, there have also been disappointments.
China’s median household income is around $6,000, less than 20% of that in the US where it is $45,000. There is a growing number of consumers, around 100-150 million, which is expected to double in the next 5 years. But a large portion of China consists of “survivors” (a term coined by research firm Dragonomics) whose income levels only allow purchase of basic food and other necessities, making them less interesting for foreign firms.
China’s growing consumption has been a function of increasing income. But as China slows and the identified problems emerge, growth in consumption is likely to slow, limiting opportunities and returns.
Chinese industrial policy and regulations has also favoured local incumbents. China lack of protection for intellectual property is well known with the practice of shanzhai or clever fakes widespread. The US Trade Representative’s annual report of December 2011 found that 8 of 30 of the world’s most notorious counterfeit markets were in China, including the infamous Silk Street market in Beijing. Around 20-30% of branded mobile phones in Chain are fakes. Estimates suggest that up to 80% of software sold in China is pirated.
Financial investors have also discovered the “muddy waters” of Chinese corporate governance, fraud, lack of transparency and state intervention in business. The Chinese stock markets fell around 23% in 2011, remaining around 60% below its 2007 high.
Chinese Backdrafts …
China’s problems are likely to affect the global economy is a variety of ways. As the Chinese economic slows, it will affect global growth.
There will be significant effects on commodity prices and volumes, affecting resource producers and commodity-exporting nations, like Canada, Australia, Brazil, Russia and South Africa. Chinese demand for iron ore constitutes around 2/3 of the global market. China accounts for 15% and 23% of Brazil and Australia’s exports.
It will also affect demand for industrial goods, especially advanced machinery. China consumes over $500 billion of these products, mainly imported from Europe, US and Japan.
Chinese demand for US dollars, Euros and Yen will diminish. This will force borrowers, primarily governments, to find alternatives buyers for their bonds. This may drive down the value of these currencies and increase the interest cost.
A hard landing will be especially traumatic for the global economy, which has not dealt with its core problems – excessive debt levels, weak non debt fuelled demand and global imbalances. The crisis and its affects have been masked in developed economies by artificial demand from government spending, which is proving increasingly difficult to sustain. In China, it was masked by debt fuelled investment. Now, that feast too is coming to an end.
© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)