Five Reasons China Is Not a Bubble

A year ago, nobody thought China could manage 8 percent GDP growth in 2009. With year-to-date growth coming in at 7.7 percent through the first three quarters and getting stronger, China is poised to break that 8 percent mark rather easily.

The success of the stimulus and the lofty economic numbers China has managed to produce amidst a global crisis has led many to claim China is the next great bubble.

We see five reasons China is not a bubble and believe that its prospects remain strong for at least the next 20 years.

1) Consumption Continues to be Strong

China is transitioning to a consumption-based workforce. Retail sales rose 16.2 percent in nominal terms during October and have been accelerating. The retail sales figure isn’t a perfect proxy, but it is the best available indicator of overall consumption because it does include sales to consumers and not just purchases made by the government.

We also saw strong growth in industrial production (IP) and power generation both were up more than 16 percent on a year-over-year basis in October. Housing starts were up more than 50 percent (yoy) for the second straight month.

2) Structural Changes to Domestic Economy

We’re seeing a transition to a service-related economy. The service industry is the fastest-growing sector (roughly 20 percent faster than construction) and now accounts for one-third of China’s workforce.

In general, the size of the service sector is directly correlated to the amount of goods and services an economy consumes. This is why the government has spent such a large amount of the stimulus on areas that benefit the domestic market—that’s where it thinks the economy is headed.

3) Stimulus Exit Strategy in Place

China’s stimulus exit strategy is simple--create a strong economic base that the private sector can launch from. After private investment surpassed that of state-owned enterprises in September, the two flip-flopped during October.

Given the environment, month-to-month fluctuations like this are to be expected since private investment is dependent on how willing Chinese citizens are to put their own money at risk. Even though Beijing is determined to wean China’s economy off of government stimulus, the government will not hesitate to ramp up activity should the private investors become risk-averse.

4) Government Controls on Flow of Money

After lending more money over the first five months of 2009 than all of 2008, we’ve seen loan numbers come down. There’s a longstanding pattern of new loans slowing down during the second part of the year as banks have historically rushed to meet government-mandated loan quotas.

The magnitude this year’s slowdown—trillions of yuan—is evident of Beijing’s dedication to prevent a bubble from forming. Once the figures grew too large, the government moved quickly to hit the brakes.

While U.S. regulators have many holes to plug in order to keep the economy afloat, the limited number of investment options available to Chinese citizens—basically stocks, bank savings and property—makes it easier for the government to institute controls.

This is what happened in 2007 when the government forced a slowdown in the housing market before it overheated. After its economy grew 12.6 percent in the second quarter of 2007, China took more aggressive actions to cool its economic growth. The government raised lending rates and also raised reserve requirements to shrink the pool of money available for lending.

5) China’s Long-Term Goals Match Up With Short-Term Goals

In the U.S., the Federal Reserve and policymakers are faced with conflicting goals. They need people to spend in order to get the economy rolling again, but their end game is to have the American people spend less and save more.

It’s the opposite for China.

The problem in China is excess savings and not enough spending. The short-term and long-term challenges are the same—to get people to spend more.

Recent signals that China will begin letting the yuan appreciate against the U.S. dollar are not new. For several years, Beijing has stated a gradual appreciation of the yuan will benefit the economy, and CLSA expects Beijing to resume a 5 to 7 percent annualized appreciation process about midway through 2010.

Rapid economic growth may be common in emerging economies, but there’s only one China. Already the world’s third-largest economy on a nominal GDP basis and second-largest based on purchasing power parity, the Chinese aren’t making a break from the back of the pack—they’re leading it.

Domestic consumption, the rise of the service sector and increased private investment won’t make China immune to economic bubbles, but these strengths will provide some protection from external forces.

Romeo Dator, co-manager of the China Region Fund (USCOX), contributed to this analysis.

Comments

[Philip7:]

So China, which is an enormous, nondemocratic country with rampant corruption and basically a 20 year history of quasi-capitalism, has learned how to run an economy better than we have? I'm just asking.

Nov 16 09:35 PM

[China Interest:]

Frank

Where do I begin.

Some of what you have said is correct but much of it is misleading.

Lets go through briefly your points.

1) Consumption Continues to be Strong

Yes consumption is growing (at least temporarily) but could be unsustainable. Refer to what I have written latter using the expenditure equation.

2) Structural Changes to Domestic Economy

The reality is that much of the stimulus funds are going to SOEs not the private sector. Most of it to fund things with negative returns (especially if we had to account for the subsidized interest rates)

3) Stimulus Exit Strategy in Place

Nothing is in place. It is a tug a war battle in central government in China and those winning want to keep the pedal to the metal. Unemployment is the priority not inflation.

4) Government Controls on Flow of Money

Lending numbers remain high and there is plenty of speculation that taps on money won't be turned off (when the priority of the government remains unemployment). There are 6 million university graduates (with lots without jobs) from last year, and there will be even more this next year, and still plenty of migrant workers without meaningful work.

If the service sector is growing why are so many university graduates not finding work?

5) China’s Long-Term Goals Match Up With Short-Term Goals

RMB is pegged but the external pressure is getting very intense.

[Also posted elsewhere]
I will try to use some econ 101 to explain how things are.

Lets begin with the expenditure equation:
Y = C + I + G + NX

Using the equation above lets then explain what has happened in the crisis and China's response.

NX (net exports) are down significantly and the government in response has increased both fiscal spending and monetary expansion to unprecedented levels. The result has been an increase in I and G.

The government (G) spending increased directly - infrastructure spending, etc... while the investment increased via lending to SOEs (as instructed by the government). Sounds all good so far.

But what are the consequences if real GDP is to exceed the potential GDP. In the short-term the economy grows but long-term when real GDP > potential GDP we have inflation. In fact, even though inflation isn't yet showing up in CPI or PPI numbers, it is every bit matching in asset inflation (with M2 growth). Property prices and stock market valuations have dramatically gone up even though nothing else has changed to warrant it. It doesn't stop there. Inflation has a two year lag, so what the government in China has done now in money growth won't be seen for another 1 to 2 years. Furthermore, the increase in I and G in the short-term have temporarily boosted C (multiplier effect) but in the long-run consumption will be crowded out by G and I to correct the equilibrium, bringing real GDP = potential GDP.

It gets worse. Much of the government spending and investment (I) is being wasted on marginal projects, and already it is becoming all to evident that investment is adding capacity to industries with already chronic overcapacity (an increase in NPLs). Without a significant rebound in net exports (NX) - the increased production from new investments must find an outlet. However, consumption (C) is unlikely to grow anywhere near enough to absorb these inventories. Why?

Already I mentioned above that C will be crowded out by G and investment (I) plus we could in the foreseeable future have inflation eroding (taxing) the consumer budget for everyday items.

The property market is now out of reach for many consumers at current prices. People who would have bought a new home are instead having to save for longer, and they are also putting off spending on all the new furnishing. This need for more savings not only dampens spending on a home purchasing but also overall consumption demand on everything. This will become more evident once the purchase subsidy programs (auto, appliances) wind down.

It gets worse. US interest rates are now extremely low and thus there is a huge amount of hot money floating in the world markets (especially the emerging markets). Some of this money has found a temporary home in China.

At the same time, remember that China has increased money supply partly to fund its stimulus program and partly out of the need to keep the RMB pegged to the US dollar without buying even more US T-bills (giving very low returns). M2 growth in China has more than matched money supply growth in USA. But what is good for the US isn't necessarily the right policy choice for China. US so far haven't had an inflation issue because much of the new money in the economy isn't going into the real economy but rather the financial system. China on the other hand is seeing a lot of new money entering the real economy (via I and G).

The US can probably maintain the stimulus program for another 6 months to 1 year without inflation while in China they already need to be exiting. However, China is unwilling to wind down the stimulus because unemployment is a higher priority than inflation.

That means the bubbles get bigger in China without any effective means to keep them in check until the US must increase interest rates. When the US has reduced money growth to control inflation the bubbles in China will have already gone from large (now) to massive, and the hot money will quickly find the means of exiting China. When hot money flows out of China (quickly deflating China's most important sector), and export growth remains stagnant, the scene could get very ugly.

Pivot Capital Management have an excellent report available that illustrates a poignant point about over investment that is lost on many readers. China is no longer a developing nation when it comes to much of its infrastructure. Therefore, the old development model is no longer applicable. Check the report here: pivotcapital.com/r...

Nov 17 01:07 AM

[User 399627:]

Frank, thank you for your hard work but what you get is a lousy job, at best.
retail numbers in China include government consumption. I repeat,GOVERNMENT! Think about the sedans...consumption from residents has been FLAT!!!
I know some IB people are trying to use all kinds of ways to get profit from China, including misleading words from so called "experts", LIKE YOU.

Nov 17 01:50 AM

[prairiedog555:]

I have an associate in China, she says things are really bad and figures are cooked by Government. Many factories shut down. My other Chinese friend runs a factory that produces Nokia phones. He is down to 1 half shift from three shifts 18mos ago.

Nov 17 08:05 AM

[vineet:]

"The problem in China is excess savings and not enough spending. The short-term and long-term challenges are the same—to get people to spend more."

I have been reading many pundits on China and powerful China and all that. I firmly believe The Problem in China is excess of concentrated power and not enough of people engagement. The Short and Long term challenges are the same - to get people to share and engage more in their own destiny.

Are not the views here only Wall St centric just they were before the US meltdown in 2007/2008? A similar situation, ticking time bomb, more visible in China then the US. What then? ? ? ?

Nov 17 10:07 AM

[coreopsis:]

China Interest: You've been posting this canned palaver everywhere. Please go find another sandbox. This one is occupied with serious thinkers.


On Nov 17 01:07 AM China Interest wrote
>
> Where do I begin.
>

Nov 17 10:10 AM

[coreopsis:]

User: you've been used, these are government figures if you look closely. They're produced by CLSA.


On Nov 17 01:50 AM User 399627 wrote:

> Frank, thank you for your hard work but what you get is a lousy job,
> at best.
> retail numbers in China include government consumption. I repeat,GOVERNMENT!
> Think about the sedans...consumption from residents has been FLAT!!!
>
> I know some IB people are trying to use all kinds of ways to get
> profit from China, including misleading words from so called "experts",
> LIKE YOU.

Nov 17 10:11 AM

[Ben Gee:]

China do NOT have a problem. China has money and that is NOT Chinese government figure. China is buying commodities and resourse companies like crazy. That is NOT a Chinese government statement. China has a great trade surplus. That is NOT coming from the government. If these are problems, these problems every government on Earth love to have.
For those predicting China's collapse, that would be the worst nightmare the world can have. Many countries in Africa, Latin America, Central Asia as well as Australia depent on China's economic well being. To China, developing countries rely on China much more than the US, a spoiled rich kid that lost a toy. Many people in developing countries may lose their livelihood if China's economy collapse. Do not get me wrong, China is not helping the developing countries at its own expense. China had found a new way to help other developing countries while helping itself. China is gaining just as much as the recieving countries and both are enjoying the process.

Nov 17 01:44 PM

[Tony Daltorio:]

One more reason China is NOT a bubble:

Look at most of the commenters - very bearish on China - which for a contrarian investor like me says that the China investment story is still in the early innings.

Nov 17 03:48 PM

[Think-About-It:]

I also think that China is not a bubble BUT not for any of the so called reasons that you provided. I don't get your thinking or economics.

Your reason #1 "Consumption Continues to be Strong" tells us nothing about bubble-status. Consumption was very strong in the U.S. right up to the moment our stock and Real Estate bubbles burst.

Your reason #2 "a transition to a service-related economy." What's the point? That services-heavy economies are less likely to reach bubble status? Again, I give you the U.S.

I'll pass on the others as it's past my bed time but would like to add that in my opinion China's high savings rate is not their problem or challenge as many economist/investors believe -- it is one of their strengths. Try growing an economy with low savings and see where that gets you.

You need savings to fund productive investments which raises living standards and enables more savings which fund more productive endevors which raises living standards and enables more savings... it is the virtuous cycle.

You can not consume your way to prosperity.

Nov 18 03:58 AM

[fran:]

"better than we have"? over the past USA decade? who holds our debt? where do you live?


On Nov 16 09:35 PM Philip7 wrote:

> So China, which is an enormous, nondemocratic country with rampant
> corruption and basically a 20 year history of quasi-capitalism, has
> learned how to run an economy better than we have? I'm just asking.

Nov 18 01:41 PM

[Philip7:]

First off, I didn't say we've done a wonderful job of handling our economy the last few years. I'm just saying that all the "China has a done a wonderful managing their economy" is major hyperbole. People were saying the same thing about the US economy in 2007.
They are doing all sorts of things to distort their currency to keep a huge positive balance of payments and to distort their economy to keep a positive growth rate. All of these things, as far as I can tell, to keep the population from rioting over unemployment. Not because they are such economic wizards.
I'm not even going to go into their other problems like pollution or an aging population.
As for their holding our debt, I might remind you of that old saying that goes something like "When you owe the bank a thousand dollars, you have a problem. When you owe the bank a million dollars, the bank has a problem."
BTW, I live in California. Where do you live? There are very few countries that haven't been behaving badly the last several years.

On Nov 18 01:41 PM fran wrote:

>
> "better than we have"? over the past USA decade? who holds our debt?
> where do you live?

Nov 20 02:15 PM