Ambrose Evans-Pritchard has a must-read article on what may be the beginning of the end of the China-as-economic-wunderkind story. The reason for the hesitancy is that the lengthy article that appeared in early May on the front page of the house organ of the Politboro may either be an official declaration or an effort by a powerful minority to press for a meaningful, sustained effort to stop the growth in debt levels. Particularly since the global financial crisis, China has relied heavily on increases in private-sector debt to keep growth levels up. Mind you, borrowing to invest is not necessarily a bad idea if it goes into projects that are sufficiently productive. But as readers know well, China has had investment at an unprecedented proportion of GDP for years, and most of it has gone into assets created for speculation (housing that sits vacant and is seen by investors as an alternative to the stock market) or unproductive increases in industrial capacity. Consider this extract from a March article in the South China Morning Post:
At the peak of its cement production in 2014, China turned out more cement in just two years than the United States had produced in the previous century.
As the first chart shows, the trend finally topped out last year but it still indicates almost 30 times as much cement production in China as in the US, a much larger economy. Is this huge volume of cement really needed? Is this sustainable?
There is certainly an argument for more cement production in China than in the US, which has largely built its cities and its transport infrastructure. China is still in the process of doing so. Its cement requirements are thus proportionately much greater.
True, but 30 times as great with as much cement production in two years as the US recorded in 100 years? That’s pushing things.
And while economic growth in China is faster than in the US, much of it represents just this pouring of cement. Fixed capital formation accounts for 45 per cent of gross domestic product, about twice the average of the rest of Asia, and higher multiples yet than the rest of the world.
This sort of excess crashes if demand turns sour. And it could take a lot more with it than just cement and steel plants
The story is told in many more sectors than just cement. The second chart shows you that China’s steel production is topping out but is still running at five times the rate of all 28 countries in the European Union combined and almost 10 times steel production in the US.
This steel is still being used but there are reasons to doubt the continued demand. Car production last year of 12 million units, for instance, was three times the equivalent of domestic production in the US.
Yes, I know Americans are importing ever more cars as they begin to share the rest of the world’s doubts about their own Chevrolets and Chryslers and, yes, car ownership ratios are still much higher in the US than in China, but three times as much car production in China as in the US still has a feeling of unreality. China is not rich enough yet to afford so large a car market.
AEP recaps the well-known-if-you’ve been-watching signs that China is in the advanced stages of a monster debt binge. The problem with bubbles, as anyone who has lived through them knows so well, is they typically run much further than clinical observers imagine possible. So the nay-sayers look like gloomy Gusses while the momentum traders party until the whole thing goes kaboom. AEP’s danger signals, from his Telegraph account:
China’s debt is approaching $30 trillion. The fresh credit alone created since 2007 is greater than the outstanding liabilities of the US, Japanese, German, and Indian commercial banking systems combined…
To put matters in context, leverage rose by roughly 50 percentage points of GDP in Japan before the Nikkei bubble burst in 1990, or in Korea before the East Asia crisis in 1998, or in the US before the subprime debacle. This gauge is an almost mechanical indicator of a future credit crisis.
As we all know, China is in a class of its own. Debt has risen by 120 to 140 percentage points. The scale of excess industrial capacity – and China’s power and life and death over commodity markets – mean that any serious policy pivot by the Communist Party would set off an international earthquake.
Yet that is what at least an important group of the officialdom is prepared to do. The logic for a crackdown now is that delaying a day of reckoning will only make the inevitable contraction worse:
China watchers are still struggling to identify the author of an electrifying article in the People’s Daily that declares war on debt and the “fantasy” of perpetual stimulus…
The 11,000 character text – citing an “authoritative person” – was given star-billing on the front page. It described leverage as the “original sin” from which all other risks emanate, with debt “growing like a tree in the air”.
It warned of a “systemic financial crisis” and demanded a halt to the “old methods” of reflexive stimulus every time growth falters. “It is neither possible nor necessary to force economic growing by levering up,” it said.
It called for root-and-branch reform of the SOE’s – the redoubts of vested interests and the patronage machines of party bosses – with an assault on “zombie companies”. Local governments were ordered to abandon their illusions and accept the inevitable slide in tax revenues, and the equally inevitable rise in unemployment.
If China does not bite the bullet now, the costs will be “much higher” in the future. “China’s economic performance will not be U-shaped and definitely not V-shaped. It will be L-shaped,” said the text. We have been warned.
The article also describes how China put its foot on the accelerator in recent quarters, so if this article represents a policy change, it would be a real gear shift:
The latest stop-go credit cycle began in mid-2015 and has since accelerated to an epic blow-off, with the M1 money supply now growing at 22.9pc, by the fastest pace since the post-Lehman blitz.
Wei Yao from Societe Generale estimates that total loans rose by $1.15 trillion in the first quarter, equivalent to 46pc of quarterly GDP. “This looks like an old-styled credit-backed investment-driven recovery, which bears an uncanny resemblance to the beginning of the ‘four trillion stimulus’ package in 2009. The consequence of that stimulus was inflation, asset bubbles and excess capacity,” she said.
House sales rose 60pc in April, despite curbs to cool the bubble. New starts were up 26pc. Prices jumped 63pc in Shenzhen, 34pc in Shanghai, 20pc in Beijing, and 18pc in Hefei. Panic buying is spreading to the smaller Tier 3 and 4 cities with the greatest glut.
There is still some fiscal spending in the pipeline, so the robust times will continue at least through the summer. But liquidity is already starting to dry up despite all the money creation as investors are getting more and more evidence that the government will not rescue wealth management products (which are often invested in real estate projects sponsored by local government entities) or the bond issues of state owned enterprises (SOEs). Again from AEP’s report:
Moody’s warned this month that China’s state-owned entities (SOEs) have alone racked up debts of 115pc of GDP, and a fifth may require restructuring. The defaults are already spreading up the ladder from local SOE’s to the bigger state behemoths, once thought – wrongly – to have a sovereign guarantee…
The rot in the country’s $7.7 trillion bond markets is metastasizing. Bo Zhuang from Trusted Sources said more than 100 firms cancelled or delayed bond issues in April due to widening credit spreads…
Ten companies have defaulted this year, with the shipbuilder Evergreen, Nanjing Yurun Foods, and the solar group Yingli Green Energy all in trouble this month. But what has really spooked markets is the suspension of nine bonds issued by the AA+ rated China Railways Materials, the first of the big central SOE’s to signal default. “This has greatly weakened investors’ long-standing expectation of implicit government support,” he said.
Bo Zhuang said investors have poured money into bonds in the latest frenzy. The stock of corporate bonds has jumped by 78pc to $2.3 trillion over the last year. It is the epicentre of leverage through short-term ‘repo’ transactions, and it is now coming unstuck.
Financial crises are always ultimately credit crises. Even when the proximate cause seems to be a stock market crash, the amount of damage done depends on how much leveraged speculation took place and how that affects critical lending and payment systems. Even though Japan’s payment system was never at risk in the implosion of its colossal credit bubble, its banks and economy have been in a zombie state for a full quarter century. Japan’s massive bubble took place through a mere 11 massive “city banks” and another three “long term credit banks”. By contrast, China has a large shadow banking system. Just like our officialdom in 2007 and 2008, it’s very unlikely that they have a good grasp of the extent and the interconnectedness of the risks. They may find out very soon.
I urge you to read Ambrose Evans-Pritchard’s important article in full. Even with my extensive excerpts, there’s a lot more unsettling information to ponder.