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The growth rate in China is declining but while a 2% growth in Western nations is good news nowadays, a 7.5% growth in China roils the market. Why?
Chinese consumers spend only 36% of GDP compared to 50% in most other Asian countries and 70% in the US. Domestic spending in China is subdued because in a Confucian culture, households feel responsible to provide for their family’s education and medical costs especially when there is no meaningful welfare state in place.
Saving is good. The Chinese are only allowed to save with local banks and in turn these use deposits to finance loans to build factories and infrastructure. Indeed, the largest component of GDP in China is capital expenditure. According to Societe Generale, 50% of the nation’s output is invested in capital expenditure, a rate far higher than other emerging countries. High returns also encourage capital formation. China has an abundant labour supply which keeps the price of labour low and Chinese exports are cheaper because the currency is ‘managed’. These dynamics create an excellent environment for capital formation, which in turn increases productivity and GDP in the future.
Source: Societe General Cross Asset research
China invested even more since 2008. Fuelled by the $585 billion fiscal stimulus programme rolled out in 2009, capital expenditure increased at a rate faster than the other components of GDP (see Chart 1). The purpose of the stimulus package was to minimise the impact of the global financial crisis on China. Its stimulus package was double the 2009 US $787 billion fiscal stimulus package when one takes into account that the size of the US economy is 3 times larger than China.
The programme was successful in terms of growth figures. According to the World Bank, China registered a growth of 9.2% in 2009 and 10.3% in 2010. The downside to this huge stimulus packet is that Beijing pumped money in an already overheated economy.
The programme focused on infrastructure projects and rebuilding areas damaged by the Sichuan earthquake. State-owned banks funded the projects and state authorities chose the interest rate and picked the beneficiaries. Central planners dislike the private sector as they perceive it as a threat to the wellbeing of the state-owned entities. For this reason, the state-owned companies receive easy bank loans while private companies are simply cut out.
The stimulus package set out the allocation for each type of investment and local governments and state companies went on a borrowing spree to fund these projects. State planning invariably misallocates resources and we are sure this happens in China too. Indeed, reporters speak about vast areas of unoccupied housing, rarely used bridges and roads leading to nowhere.
Investment in capital assets has propped up the Chinese economy but is now its Achilles’s heel. A build up in inventory occurs in every boom. The last financial crisis was characterised by the construction of excess commercial and residential property. Excess kilometres of railways were laid during the railway revolution and the same happened with fibre optic in the dot.com bubble. To make matters worse, a large portion of recent growth in China has been undertaken by an inefficient public sector financed by state-owned banks lending injudiciously.
The IMF estimated that in 2011, China had 40% of excess capacity in the manufacturing sector. When excess capacity meets cooler demand after a long price rally, the bubble bursts. Buyers postpone purchases when demand drops and they continue postponing purchases when they realise prices will go down. This is what worries markets when GDP growth starts declining.
The second problem with weak growth in China is that growth rates lower than 6% will not sustain the rate of migrant workers moving from rural to urban areas. Property prices have soared on the expectation that this shift will persist for many years - but if GDP growth rates plunge, less people will migrate to cities and pressure on property prices will mount even further.
The rate at which capital investment in China has grown is not sustainable and must start increasing at a lower rate. Indeed, we are pretty sure this is already happening and the signs are quite evident. Australia, an economy that boomed from the sale of raw materials to China used for its infrastructure projects, is cooling down and the Reserve Bank of Australia is contemplating an interest rate cut at the time of writing. Copper prices and other raw materials are also down.
Irrespective of what China is reporting in its GDP growth figures, capital formation in China must have gone down and in any case, will go down once the stimulus package runs out. If capital investment accounts for half the nation’s output and was the main component driving growth, a decline in capital formation means weaker GDP growth figures.
China has already taken measures to pick up the slack. We expect China to introduce tax rebates, add more stimulus or massage the reported figures if need be. The solution however is to decrease investment and replace it with consumption or exports so that inventory stops piling up and consumption improves capacity utility.
Net exports, as you can see from Chart 1, is not a material GDP component in China and with weak demand in Europe and a shaky recovery in the US it is unlikely that the western world will contribute to Chinese exports. Increasing consumption is not easy either. Premier We Jiabao told the National Peoples’ congress in early 2010 that there is “insufficient internal impetus driving economic growth”. The middle class drives consumption because it has lots of discretionary spending (think of the mobile, TV set and holiday you bought recently). However, it is estimated that only 8% of the Chinese population belongs to the middle class and it will take at least a decade for that rate to rise substantially.
China is stuck between a rock and a hard place. Capital formation needs to cool down but this would decrease output and implode the asset price bubble. A currency devaluation to export more would trigger a currency war and increasing consumption to make up for lower capital investment is difficult to attain because the middle class population is not there yet.
The veneration of rapid growth in China is reminiscent of the admiration and envy for Japan back in the 1980s. Like Japan, China’s stellar growth was partly driven by an asset bubble which is likely to implode. The timing is never easy to determine but in the meantime we will feel safer if our investments are not correlated to China’s growth.
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