The China Syndrome - Market Overview

It seems China is facing an economic conundrum these days.  On the one hand, Beijing is trying to transform their country away from a pure “export-driven” economy towards one that is driven by domestic demand.  These efforts have failed for the most part. 

On the other hand, the efforts already put in place to bring about this transformation have also resulted in the lowest GDP growth rate in China since 1990.

So the challenge facing China is simple: How do they achieve this economic transformation within China while maintaining sufficient growth to keep employment growing?  Employment is a key concern in Beijing since rising unemployment often results in public unrest.  

So far the answers to this question have eluded those in power since the growth in domestic consumption, exports, GDP and personal disposable incomes are all falling.

In order to understand their situation better, let’s look at some of the individual pieces of the puzzle to see how it affects us:

Redirection of the Economy

As noted, China has been trying to transform their economy away from exports and toward domestic consumption since 2005. 

One way they have tried to accomplish this task has been through currency intervention by letting their currency appreciate against foreign currencies.  This makes imports cheaper domestically and makes exports more expensive.   

The second method has been through the construction of ghost cities where a new city is built where none existed before.  It is Beijing’s hope that this effort will move people out of the countryside and create the sort of urban domestic consumer the country needs to shift and rebalance the economy.    

The problem with this approach is that peasants from the countryside can’t afford to live there and there are no jobs available even if they could move.  As a result, this effort has been a complete failure, as these massive cities built to house millions of people stand completely empty.

The third method has been the recent reduction of stimulus from the People’s Bank of China (China’s central bank) and a crackdown on illicit foreign capital inflows into the country through shadow banks.

The problem with this approach is that it was enacted at a time when foreign capital was already flowing out of the country and the major banks were short of funds.  This created a liquidity squeeze and near crisis back in June as interbank lending rates soared from less than 3% to a record rate of over 12% overnight.

And finally, the central bank has been imposing new credit and homeownership restrictions in order to fight their real estate, infrastructure and debt bubble.  Again these restrictions have been ineffective as real estate prices and debt - including the explosive debt of local governments - continue to rise at an alarming rate.

Growth and Rhetoric

On July 15 China reported second quarter growth of 7.5% verse 7.7% in the first quarter.  While this number might sound high by our standards, it signifies a reversal in a trend of almost two decades of double-digit growth.

However, the numbers appear skewed and probably paint an inaccurate picture of what is really happening in the Chinese economy.

In the first place, there was a severe drop-off in exports in the second quarter coupled with an acceleration in the outflow of foreign investment, falling manufacturing productivity and reduced financing and investment in the business sector.  These factors point to a slow-down of economic growth that exceed the numbers reported.

Secondly, any official economic number coming out of China has to be taken with a grain of salt. 

Contrary to the rest of the world, China’ GDP numbers are “seasonally adjusted” while everyone else reports this data on an annualized basis.  Of course the Chinese never reveal how their seasonal adjustments are determined or when and under what circumstances they are made.

This factor is borne out in the official China Federation of Logistics and Purchasing’s manufacturing index reported on August 1.  While the official numbers show a slight increase to 50.3 from June’s 50.1 9 (this index is purportedly aligned with world PMI standards whereby above 50 means expansion and below 50 signifies contraction), private assessments say otherwise.

According to the non-governmental assessment of HSBC, this number actually fell again from 48.2 in June to 47.7, indicating continued contraction.

Therefore because of these and other issues, it this author’s opinion that the severity of China’s growth decline is much greater than what was reported resulting in a GDP number that is potentially below 7%.

China’s leaders seem to confirm this conclusion and can’t agree on what their numbers are or will be. 

For example, last month China’s finance minister, Lou Jiwei, stated that their growth rate would be 7% for all of 2013.  This would indicate that the growth rate in the third and fourth quarters would need to be around 6.5% to achieve this number.  He also stated that a 7% growth rate should not be considered the bottom for growth.

In response, Premier Li Keqiang stated that a 7% growth rate would be the bottom line for tolerance of any economic slowdown since they need to achieve a moderately prosperous society by 2020.

With this comment it is anticipated that future “seasonally adjusted” GDP numbers will be at least 7% or greater even though this may not reflect reality.

These comments were followed by Premier Li’s vow on July 25 to increase expenditures on railway construction through a new railway development fund that is targeting 690 billion yuan ($112 billion) of additional investment in the railway industry this year.

This is in addition to the State Council’s approval of tax breaks for small companies, reduced fees on exporters and a pledge to keep the yuan’s exchange rate “basically stable at a reasonable and balanced level.” 

These actions have been implemented to provide stimulus to the economy.

Contradictions

Even though the central government has approved the measures noted, at the same time they have ordered more than 1400 companies in 19 industries to cut excess production capacity this year.  This is in addition to orders and upcoming orders to individual companies to close their doors altogether.   

What is amazing is that the government has identified specific production lines within specific factories that will be shut down.  Naturally, most of these involve industrial commodities such as copper smelting, steel and cement, but no one is immune.

In conjunction with putting people out of work, they are also ordering outrageous increases in the minimum wage even though wages in the coastal cities have already risen 500% over the past decade.  This is part of their transformation plan to put more money in the pockets of workers in order to increase domestic demand.

Isn’t large and centralized government great?

The State Council has also ordered the National Audit Office to carry out an examination of local government debt due to concerns about the rapid growth of borrowing by these entities.  Most of these concerns center upon infrastructure projects that produce high debts with limited returns.

Therefore it is apparent that Beijing doesn’t have a clear picture of their overall debt problem, but realizes there is a substantial risk that many governments may not be able to repay their debts and will default.

These are all acts of desperation.  The bottom is that they do not have a clue on how to address the China Syndrome and achieve the “China Dream.” 

Household Debt, Credit Fueled Investment and Ghost Cities

Contrary to the household de-leveraging that has been taking place around the world since 2008, Chinese households have been on a debt binge. 

As the country has turned to borrowing to finance investment in real estate and infrastructure projects, China’s ratio of total household, corporate and local government debt has exploded from 123% of GDP in 2008 to an estimated 180% in mid-2012.  It is much higher today.

This credit explosion has been fueled by foreign capital inflows, easy credit and rising real estate values resulting in a housing boom and bubble within China.

As noted earlier, Beijing has been trying to fight this surge in credit and in real estate prices for almost three years by tightening capital and lending requirements and by restricting new home ownership to two housing units per household.  Yet even with all their efforts, credit continues to expand and real estate prices continue to go up at a fast pace.

Even the central government’s latest pledge to enforce a new 20% tax on profits from home resales has been ineffective countrywide since cities outside of Beijing have not been collecting this tax. 

Just as with infrastructure projects, the main reason for this discrepancy is because local governments did not want the housing boom to end since they make a lot of money off of the sale of real estate.

Due to the decisions emanating out of Beijing as part of their failed transformation effort, massive ghost cities exist throughout China.  And yet even as these cities that were intended to house millions stand empty, all of the housing units are sold out and continue to appreciate in value.

This is in addition to the speculative real estate boom and price appreciation that has occurred in the coastal cities and the fact that there is an additional 3.7 billion square meters, or about 34 billion square feet of new construction is taking place in China as billions upon billions of square feet stand empty.

The logic behind this seemly illogical development is easy to understand when viewed from the vantage point of the emerging middle class household in China.

The Chinese are savers by nature, with the middle class saving about 38% of their disposable income.  These savings normally come with an objective in mind whether it is to obtain an apartment for personal habitation, investment, or some other objective to meet specific family needs.

So why spend excessively on consumer items or services, as the government wants, when family needs have not been met?

From an investment standpoint, real estate is the best game in town with the appraised value of apartment units within ghost cities doubling or even tripling in price even though they are all empty.  There is no investment alternative that even comes close to this kind of return.

This is why the emerging middle class in China has taken on debt and sunk every spare dime they have buying five or even ten apartment units.  Naturally this was prior to the two-unit restriction imposed about eleven months ago. 

In conclusion, Chinese investors sincerely believe that the value of housing “can only go up” even though there is at least an eight year supply either available or under construction.  Sound kind of familiar?

Banking Restrictions

In a bizarre twist, on July 20 China’s central bank removed the government-imposed restriction on the floor interest rate banks can charge on both commercial and personal loans.  This action was taken to improve the lending competitiveness between banks.  

Even though this will have limited impact in the short-term since banks already lend above the floor, the symbolism is deeply ironic in regard to our own banking system. In other words: As China appears to be trying to move toward a freer financial market system, we seem to be moving away.

The Export Machine verses Domestic Consumption

There are two additional conclusions that can be reached as China tries to shift its economy away from exports and toward domestic consumption:

  1. Even though there will be fluctuations on a month-to-month basis, it is obvious their export machine has slowed-down more than anticipated.  This is occurring during a period of falling domestic demand. 

    Diminished global demand from Europe and elsewhere, the yuan’s past appreciation against global currencies, and exploding worker wages are partially to blame for their current situation. 

    However, their situation has been compounded by an overcapacity in manufacturing, and Beijing’s analysis and determination of which industries have the most overcapacity and which industries deserve government support. 

    As an example, even though they are shutting down factories deemed to have the greatest overcapacity, Beijing has extended easy credit to anyone starting a service-oriented company in the belief that these industries will boost domestic consumer demand.
     
  2. Past attempts to utilize infrastructure stimulus spending in order to spur domestic demand have failed. 

    In addition to ghost cities and the real estate debt binge of Chinese households, local governments as well as the central government have been on a spending spree building infrastructure projects that may or may not be warranted.  

    For example, highways and high-speed rail lines have been built to connect ghost cities and the northwest region with Beijing.  The idea was that companies would be drawn to the area with the lure of cheaper labor and land costs, while still having close proximity to the coast and Beijing. 

    Sounds like a good idea. The only problem is that no one showed up. 

    In a nutshell, while market forces are having a negative impact upon their export machine and domestic demand, central planning out of Beijing is killing them.

So, how do the developments in China affect us and the rest of the world?

Locally, what is happening in China is proving to be a manufacturing bonanza for Mexico.  This directly impacts El Paso through increased trade volumes across the border. 

However, as the 2nd largest economy in the world, whatever happens in China has a ripple effect across the world.

Even though Europe is showing signs of stabilization, their debt and structural problems will place them in a “U-shaped” recovery for an extended period of time, where they merely bounce along the bottom of the “U” without significant growth or decline.  This is important to note since Europe is China’s largest export destination.

Couple this with China’s weak domestic demand, our anemic growth of 2%, and the lackluster growth of the rest of the world and it all comes down to a basic question: Where is China’s growth going to come from? 

The problem this author sees is that the “official” numbers coming out of China going forward may or may not truly reflect the underlying situation in China. 

Based on what we have seen over the past few months, it is anticipated that future “official” Chinese numbers will paint a rosier economic picture of economic stabilization or even growth.

Will these numbers be accurate?  Time will tell.

- David B. Prilliman
 

 

Author’s Note: Harry J. Stone founded Professional Investment Counsel, Inc. in El Paso, Texas in July 1973; exactly forty years ago today.  It is his vision and commitment to a company built upon the cornerstones of integrity, attention to individual client needs and sound investment philosophies that have served as our beacon as we move forward.

Therefore, we would like to sincerely thank our clients and friends who have stood by us, and believed in us, over the past forty years in good times and in bad.

 

Professional Investment Counsel, Inc.  Principals: Gary M. Borsch (garyborsch@sbcglobal.net) and David B. Prilliman (davepic@sbcglobal.net)

© Copyright 2013, David B. Prilliman.  All rights reserved. 
All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice.  Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed.  This report is for information purposes only.