Why I'm Bearish on China

I was a little taken aback at Bloomberg’s March 11^th article covering the latest economic news out of China. Exports were reported to have fallen 25.7% but the gist of the article was, “no problem, urban fixed-asset investment was up 26.5%.” It even quoted one analyst saying that net export growth is just a small fraction of economic growth and is easily offset by investment. Let’s be clear: China’s economy is slowing rapidly. Industrial production is in decline, not slowing growth - in decline. I understand that with every asset class in the world seemingly in freefall, we’d all like to believe the Chinese economy is going to keep the world afloat. The downward revisions to global GDP growth keep coming. The World Bank, Goldman Sachs (GS), and the IMF are all calling for negative growth globally, a first in six decades.

Recent revisions, though, are not so much driven by the situation in developed, OECD nations. The latest updates are simply a final capitulation on the “decoupling” theory that said emerging markets had reached sufficient critical mass to drive their own demand regardless of what the U.S. and other OECD countries do. This means that, sooner or later, the numbers for China will be ugly too. The point is not that China is so much worse off than the US or Japan, simply that the gravity applies to China as well as every other country. What goes up…

Chinese exports are falling quickly. This should not be a surprise to people watching the headlines around global trade. Trade globally is declining at a very rapid rate. Japan is getting the most attention with a 35% drop in December exports versus a year prior. Their drop is across the board but is underpinned by high dependence on auto exports to the U.S. Germany is reporting less severe but equally surprising numbers. So why should China be immune? When consuming nations like the U.S. and the U.K. contract, shouldn’t exporting nations feel some pain? You should expect that. It is happening in Japan, South Korea, Germany, AND China. China’s exports to the U.S. have experienced double digit month-on-month declines in November and December of last year. These are not slowing growth, they are declines.

Of course, there are counter arguments that China-bulls offer. The argument is simple and almost plausible: China will simply shift its economy to offset the demand that is dropping off in developed nations. The government will steer a portion of its foreign currency reserves into infrastructure projects and manufacturing output will be redirected exports towards domestic consumption. It is true that the Chinese government has a lot of savings to deploy and can do so more quickly and efficiently than western governments. With consumer confidence declining in China, the latter assertion is more questionable. If domestic demand is substituting for exports, it would be evident in Chinese industrial production data.

Unfortunately, industrial production in China is declining rapidly. The National Bureau of Statics in China tracks industrial production output monthly on 70 different categories from TV production to chemical output to steel production. In any one category, growth can vary greatly due to seasonality and month-to-month fluctuations but in aggregate they paint a good picture of the manufacturing economy. Early last year when global demand was brisk, a half dozen to a dozen might be negative, but the bulk would register year over year growth of 20% or more.

This began to change last August and in the final two months of the year more than 60% of the categories (44 out of 70) had turned negative. Many categories have output still increasing but the across the board reversal has been abrupt. In the month of December 2008, for example, steel production declined 10.5%, motor vehicle production dropped off 18.9%, air conditioner production was cut by 31.4%, and the number of small tractors built were less than half (-52.5%) from December 2007. Is China doomed? Hardly. It is simply mortal and vulnerable in this unprecedented global slowdown. The picture doesn’t show an economy shifting gears seamlessly to generate growth simply by different means as the pro-China investment folks have suggested.

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Let’s do the math. Annual figures for Chinese trade have not been finalized but should be roughly $1.4 trillion for 2008. If exports were to decline in 2009 simply 15% (roughly a return to the 2007 level), this is about $200 billion to offset somehow. Most every economist in the world is still forecasting growth in China, just not at the 9% level experienced last year. Even at half that growth rate (4.5%) off a base of $4.4 trillion economy, the government must come up with another $200 billion in economic activity that was not there in 2008. Thus, to offset the decline in exports and grow at 4.5% (dangerously low level of growth for China), there needs to be an additional $400 billion of economic activity with no further marks to the downside. The government did announce a roughly $600 billion (4 trillion Yuan) stimulus package, over $200 billion which is targeted at infrastructure projects. For that to do the trick you need a few assumptions:

1. Two-thirds of the stimulus is spent in 2009.
2. The spending is 100% efficient, every Yuan spent creates a Yuan’s worth of economic activity
3. No further downside is seen: foreign direct investment holds up, unemployment does not spike, consumers continue spending.

To me, these assumptions are a stretch. With the terms “decoupling” and “contained crisis” solidly replaced in our vocabulary with “global recession” it is clear: we are all in this together. A consumer-led recession starts with net consuming countries, extends to net exporters and will eventually hit the commodity producing nations. We are in the second stage of that process with the full acknowledgement that Japan and Germany are going the way of the United States.

Strangely, though, just as the Chinese decline is finally starting to show in the numbers, there is a pervasive belief that something special about the Chinese economy will allow it to avert the fate of others. The law of gravity does not apply there, it seems. Get ready to shift your mindset: what goes up does come down. By late summer this year, I expect this notion should be wiped away. There might even be pressure on the Yuan to devalue, a further complication to tenuous global trade discussions.

Is China going to emerge from this “great recession” (a term coined by the IMF this week) stronger than before? Quite possibly. Is the Chinese government doing a better job managing its economy? Maybe. Is China going to be spared from this downturn? Definitely not. There may be some GDP growth for China in 2009 but it could just as likely be near zero. The global credit boom elevated the demand for manufactured products to unsustainable levels. The world has far too much capacity to produce, much of it in mainland China. It will take some time to work this off. Stimulus efforts by the government will likely be effective in limiting the damage to the Chinese economy and the much needed improvement in infrastructure, if done right, will benefit the country in the long run. Any notion, though, that the laws of supply and demand don’t apply here are mistaken. Invest cautiously here.

Comments

[Larry House:]

If there is no hope for China, there is no hope for any national economy on earth. You may be exactly right; I don't think so, and I am invested in China, but only time will tell who is right.

Mar 12 12:07 PM

[don2m:]

In the case of China there is a major difference between trading and investing. An investment in China IMO would be 3 to 5 years out. Trading in China is very volatile and is very lucrative if you care to test your timing ability every day and sit at your computer.
One third of the worlds population have begun to see the light of day and they almost can create their own economy just buying and selling to each other. China is a good investment with some restraint.

Mar 12 01:18 PM

[Feng:]

The author doesn't seem to understand that only next export contribute to GDP, not total export.

Mar 12 01:20 PM

[Mad Hedge F...:]

there are far worse places to be. The global economic collapse has finally hit China with full force, knocking down exports by 25.7%, and shrinking imports by 24% in February. The ghastly figures show how rapidly international trade is shrinking. The Middle Kingdom’s trade surplus is in free fall, and it is just a matter of time before the renminbi starts to fall against the dollar. Do you suppose that anyone in the US government understands that this will lead to fewer Chinese purchases of Treasuries, just when they need to sell the most? Better double up on the TBT, the 200% short long bond ETF.

Mar 12 05:56 PM

[Even Walser:]

" It is true that the Chinese government has a lot of savings to deploy and can do so more quickly and efficiently than western governments. "

Yes it is true the Chinese do have considerable saving however I take serious issue with the notion that the capitalist authoritarianism is more efficient at allocating resources than a representative democracy. If history is any measure authoritarianism coupled with capitalism, which used to be called totalitarianism, is a poor allocator of resources.

"off a base of $4.4 trillion economy," more China hype, Chinese GDP is not $4.4 trillion period. 2007 est has Chinese GDP at $3.7 trillion if we are using PPP which is a highly debatable statistic in international trade.

I do not disagree with the general tone of the authors argument in fact I think if anything he has been too soft. Chinese government statistics cannot be trusted, there is very little outside evidence to support the numbers they are putting out. The government has shown time and time again that it will do whatever is necessary to continue to propagate the rising China myth.

It is certain that many of you believed that a $50 billion ponzi scheme at the heart of wall street involving many of the so called best and brightest couldn't happen, but it did. It is important to use a measure of skepticism when viewing China hype. Simply look at the ever growing GDP exaggerations that are pushed on this board, in the media and in financial circles. These numbers matter because companies and individuals invest based upon perception while greedily chasing the "biggest potential market in the world". Need I remind you all of Lenin's maxim " the capitalists will sell us the rope with which we will hang them". China is actively trying to keep up appearances especially in this time of global economic weakness, as a means to showcase their economic might. Putting out false growth, consumption, employment and export statistics would be but a minor thought to the Chinese government.

Mar 13 03:32 AM

[Maxe Paul:]

There is something special about the Chinese economy, they have a huge surplus and an expanding consumer/middle class. They can now cherry pick the worlds assets at bargain prices. They can revert to domestic growth from export weakness and build infrastructure for several years.

If thats not special then i dont know what is?

Mar 13 04:56 AM

[mariocavolo:]

Chinese government statistics cannot be trusted, there is very little outside evidence to support the numbers they are putting out. The government has shown time and time again that it will do whatever is necessary to continue to propagate the rising China myth.

Whoa my friend....its not a myth. I agree with the article pointing out the global/industrial reduction in demand and of course drop in exports...they will hurt BUT what you all need to take more seriously is the enormous amount of cash that exists internally in China, both in the government's hands and in the hands of the private citizens. China, Singapore, Taiwan, will weather this storm better than any other country because there is plenty of cash. I live here in China since 1999. Believe me on this, it is a point foreigners have difficulty comprehending. Good luck to all...

Mar 13 08:15 AM

[Alphameister:]

Seems to me the Chinese ought to commence manufacturing straw men since they seem especially popular these days. When did anyone ever claim that decoupling was absolute? How could any economy heavily involved in world trade not be affected adversely by a once-in-a-lifetime worldwide recession?

The salient points, from my vantage, are the facts that China is expected to grow in 2009 at a rate that would be the envy of any major economy, yet its stock market has crashed more than those of economies that are in much worse shape. There are Chinese stocks priced below book value despite strong growth that is likely to persist.

And didn't the latest report show Chinese auto sales up about 25%? What will that do to the above production charts for autos and steel in the months ahead?

Finally, why is it that we can trust all the negative numbers coming out of China but any positive numbers are highly suspect?

Mar 13 12:25 PM

[Amitabha Mu...:]

For many many years to come it will be extremely difficult for China to decouple its economy from that of America. The economy actually prospered on the basis of creation of a nation of workers who could be exploited to any level such as longer hours and sub standard wages deliberately to keep the cost price very low.
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Mar 13 02:10 PM