The Cracks In The Great Economic Wall Of China

Includes: FXI, GXC, PGJ
by: Micah Dickson

China has just gone through their once in a decade power transition. While the transition of power has appeared to have gone smoothly, it does not mean that the challenges facing China have diminished at all. Xi Jinping and his regime face a host of challenges. These challenges vary from economic to societal in nature. The current course China is on is utterly unsustainable. The question is, can the new Chinese leadership make the necessary reforms to keep the country from a political and economic collapse? Investors must consider the size and scope of the challenges facing China as they make decisions on where to allocate their assets for the coming year.

Economic Challenges

Any true economic growth is based upon investors and consumers acting on information. The accuracy of that information can decide if that economic growth is sustainable or not. Many of the basic economic numbers coming from China have largely been called into question. Li Kepiang, possible future premier of China, said in 2012 that the GDP figures were "man-made". There has also been documented cases of the growth in many Chinese industries being quite different from the overall GDP numbers that are reported.

Unfortunately, China's state owned enterprises are becoming a prime example of the failure of accurate information from China itself. State owned enterprises are filled with Communist Party leaders who use them to bolster the Party's power. Included in the list of state owned enterprises are banks that provide loans to businesses. These businesses include other non-financial state owned enterprises. These loans are given at lower interest rates and in unlimited amounts. This incestuous relationship gives state owned enterprises an advantage over other smaller enterprises inside the country. Besides being incredibly corrupt, this system has led to what has been referred to as "zombie companies". These are companies that should be going bankrupt because they are unable to repay their debt. The Chinese government is not allowing these companies to go bankrupt. Instead the state owned banks are being forced to continue to lend money to the enterprises despite their inability to repay the debt. Matthew Boesler from the Business Insider commented on the effects of these practices in this way, "This is causing a deterioration in asset quality on banks' balance sheets, and increases the chances that the government will have to bail them out down the road". Some estimate that the debt to equity ratio of many state owned enterprises exceed 230%. This is a staggering figure. Even with all of these negative developments, the "official" amount of non-performing loans in the Chinese banking sector is only 0.9%. This obvious contradiction is why so many of the numbers out of China are deceptions.

The banking sector numbers are not the only numbers that are troubling. The state owned enterprises have been showing weakness for a while. These enterprises make up 40% to 50% of GDP. From 2001 to 2009, these state owned enterprises made 5.8 trillion Renminbi (RMB). This would equal $931.1 billion in the United States. Normally, this would be a tale of their success. But if you remove the government subsidies for that same time period, the real average return on equity for the state owned enterprises would be a negative 6.29%.

These problems are compounded by a growing real estate bubble. Part of China's growth has come from the government's investment in the building of infrastructure. Robin Banerji and Patrick Jackson of the BBC describe the expansion like this, "The country is said to have built the equivalent of Rome every two months in the past decade". The problem with this rapid expansion is that supply is beginning to overtake demand. Satellite images are showing entire Chinese cities empty many years after their construction. The World Bank's Holly Krambeck gave a frightening example of this in the city of Chenggong. She says, "In Chenggong, there are more than 100,000 new apartments with no occupants". This is becoming the story all over China as new buildings, office spaces, and other projects are lying empty due to the lack of occupants able to fill these empty structures.

These factors should cause investors to be cautious about their positions in China. A red flag to any investor should be the inability for Chinese companies to be audited by firms outside of China. If these large economic challenges are not addressed, China may see anemic economic growth as Japan did in the 1990s or worse, an economic catastrophe that could rock the world markets as investors begin to move their capital to other parts of the world. This could be hastened by the growing perception of many in the United States, China's largest customer, that companies that do business there are hurting American workers.

Political Turmoil

China is currently finishing their once in a decade transition of political leadership. This however has not come without serious hiccups in the road. There is serious tension inside the Chinese hierarchy which is beginning to reveal itself. As Dean Cheng reported about the 2012 National People's Congress session, "As this year's session came to a close, outgoing Premier Wen Jiabao warned of the potential for chaos and cited the Cultural Revolution of 1966-1976". This statement immediately preceded the ousting of Chongqing Party Secretary Bo Xilai from the Communist Party. Bo, his wife, and many extended family members were also charged with a variety of crimes including corruption, murder, and adultery. His populist tone and rising star in the Communist Party made him an attractive candidate for higher office and many reports say he was campaigning for a position on the CCP Politburo Standing Committee. This committee is the most important and power part of the Chinese leadership. Bo's rising star quickly extinguished after his former police chief tried to defect to the United States. Because of how common corruption is inside the Party, many find it strange that Bo Xilai was ousted and charged so quickly and publicly. Dean Cheng makes this comment regarding the scandal: "Such major developments-occurring in the midst of one of China's most public political events-suggest that Chinese politics are in major turmoil."

While the event with Bo Xilai is scandalous, it is an extension of the ongoing concern of many inside the Party of the increasing corruption and the deterioration of the perceived legitimacy of the Party. Premier Wen, who is exited his position during this most recent transition has even publicly called for the power of the Communist Party to be reduced. In the 2011 World Economic Forum in Davos, Switzerland, Premier Wen was quoted as saying:

A ruling Party's most important duty is to follow the constitution and the law, and restrict its activities within the constitution and the law…. This requires changes in the use of the Party as a substitute for the government and in the phenomenon of over-concentration of power. For this, we need to reform the leadership system of the Party and the country.

But these reforms will be close to impossible to carry out as the 70 wealthiest members of the National People's Congress are ten times wealthier than the top 660 government officials here in the United States. This is due to the fact that state owned enterprises are run by members of the National People's Congress or by a close relative of those members. Any reforms would mean these members would have to give up their sources of wealth and power.

As we've seen in many cases, economic troubles can strain political relations even further. If China does not make changes, the corruption and decadence in the ruling Communist Party could become the scapegoat for any "hard landing" China experiences. If China experiences a hard landing, it would lead to the second largest economy in the world falling into political chaos. This would create uncertainty that would trump the uncertainty experienced from the problems in the European Union.

Societal Challenges

The political problems in China are compounded by the fact that there is growing unrest among the average citizen in China. The largest problem is that of forced evictions by the Chinese government. After the Financial Crisis of 2008, the Chinese government began implementing an extremely large stimulus package. The main thrust of the stimulus package is to build up infrastructure across the country. In order to do this, many Chinese cities are forcibly and violently evicting citizens who live on land that is going to be used for new government building projects. The stories of these forced evictions have caused outrage throughout the Chinese population.

An example of how outraged many citizens are is the Chinese fishing village of Wukan. The citizens of the village became fed up with land grabs from the government. In response, they rushed the offices of the local government during a protest. After the protest, one of the protest leaders died while in custody. This led to the village ousting the Communist Party leadership in the village and democratically electing local leaders. While this rebellion is an extreme example, what caused the outrage is still there and is becoming prevalent among the Chinese people.

Land grabs are not the only problems, income disparity, working conditions, and many more social ills are beginning to bubble over. In 2010, China experienced 180,000 protests, riots, and mass demonstration. This is staggering. Unfortunately, many of the complaints are too narrow to begin a nationwide movement that will cause sweeping reforms inside China. That will not last for long. More and more of the protest leaders admit that the underlying problem with the country is the one party system that has dominated the government for so long. This growing public anger combined with the political turmoil inside the country could combine to create a deadly chemical reaction.


The Chinese model is quickly becoming a potential Chinese nightmare. While it has created incredible wealth inside China, it has created a monster that does not seem to be able to make the necessary changes. China has to go back to the path of reforms that Deng began in 1970s in which their economy becomes freer. Unfortunately, the incredible corruption that has sprang up from China's economic growth is beginning to insulate itself. Communist Party leaders have shown hostility toward any change.

Investors must consider these factors when looking toward China for the growth that is missing in the United States. While that growth may be advantageous in the short to medium term, it could be an incredibly risky bet in the long term. If China does not address its economic, political, and societal challenges, the Great Wall that is the rising Chinese economy may have a mighty fall.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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