China has been primarily responsible for driving global growth since the Crisis began in 2008. Auto sales, for example, would have seen negative growth world-wide without China. And auto manufacturing is the world's largest manufacturing industry. The energy and chemical industries have been in a similar position. Whilst China is also now responsible for nearly 50% of global metal demand.
China's growth has thus given a tremendous boost to the emerging economies, whose raw materials have fed its seemingly unlimited appetite for infrastructure investment. In turn, this has boosted corporate earnings everywhere. Currently, for example, around 50% of earnings for the S&P 500 companies come from operations outside the US.
Yet most of us have a very hazy idea about China's economy and its population. It therefore seems timely to present some key facts about its economy and discuss how investors can protect themselves from the likely crisis ahead.
Contrary to popular opinion, the economy is now widely seen within China's leadership as having suffered a "lost decade" between 2002 - 2012 (yellow shading):
- The key is the green line, showing how it has become dangerously dependent on infrastructure investment
- Infrastructure spend is now nearly half of GDP - an unbelievable amount for an emerging economy
- The red line shows the impact on urban household spending, which should be the motor of the economy
- It has instead actually fallen to just 28% over the decade
- The purple line shows rural household spending, which should also be seeing reasonable growth
- It has fallen to just 8% of GDP, although nearly half of China's population still live in rural areas
This is why we are now starting to see radically new economic policies from President Xi and Premier Li. They really have little choice. As state-owned China Daily wrote last week:
"People always say China's economic growth model is export- and investment-driven. But if you look at the data for the past two or three years, it is becoming solely investment-driven. Exports in 2012 made a negative contribution to GDP growth, and if you deduct speculative funds disguised as trade payments, you'll find that exports were a drag on growth again in 2013. As the economy increasingly relies almost solely on investment, any slowdown in investment could curtail growth."
The black line in the chart shows net exports, and confirms the point they are making. China is no longer the "manufacturing capital of the world." Its exports peaked at 9% of GDP in 2007, and have since fallen sharply. And no economy in the modern world has ever based its growth on infrastructure investment, for good reason.
What is the point of this investment, if the population cannot afford to use it? And how can this investment ever be repaid if the population cannot afford to use it?
The "answer" for the past 5 years has been to try and bridge the gap via a massive credit bubble worth $10tn (more than total GDP). This covered up the problems caused by declining household spend by instead creating a 'wealth effect'. The US Federal Reserve did the same in the 2002 - 2007 period, and created the sub-prime bubble instead.
The result of the policy was that China's banks added $14.6tn of lending over the period, equivalent to the entire size of US bank loans. And the US banks' loans were built up over a century, not 5 years. The sheer volume of this lending suggests credit checks must have been virtually non-existent. Equally important is that the effectiveness of the lending in stimulating GDP growth has been falling sharply:
- In 2007, each dollar of credit added 83 cents to GDP
- By 2012, each dollar was only adding 29 cents; last year, a dollar added only 17 cents
- Estimates suggest the figure this year may be as low as 10 cents
- At this level, lending will have almost no impact on the wider economy
The only sensible solution is to cut back sharply on investment, whilst starting to boost consumption and household spending. The former has to happen immediately, due to the risk created by the size of the credit bubble. But the latter can only take place slowly. Total household spend is, after all, only a third of GDP today. As China's Academy of Social Sciences has warned, clearly reflecting the views of the new leadership:
"To have more sustained and quality growth, we've got to let the growth rate go down."
It also explains why Premier Li warned in his first press conference that the changes underway would "feel like cutting one's own wrist." He was referring to a Chinese legend, in which a warrior who had been bitten by a snake cut off his hand to save the rest of his body
New Premiers do not normally start their term of office in this way. We can only recall one other example in modern history - Winston Churchill's first speech to the UK parliament on taking office in July 1940 as the Battle of Britain began: "I have nothing to offer but blood, toil, tears, and sweat."
The seriousness of the situation, and the dire warnings being given by the leadership about the necessity for change, suggest that much of the current debate over China's likely level of future GDP growth is missing the point. Zero growth at some point in the next 2 - 3 years would seem to be a prudent Base Case.
It is thus no exaggeration to suggest that developments in China could become the 3rd wave of the financial crisis that began on Wall Street in 2008, and moved to the Eurozone in 2011. Investors therefore need to review how they are positioned for this event.
Risky assets - and momentum stocks such as Twitter currently on stratospheric price/earnings ratios - will be the first casualties as investors abandon ship. Instead, there will be another 'rush to safety', as they seek markets with deep liquidity and strong governance. US Treasuries could therefore surprise on the upside.
Essentially, China's crisis will therefore see investors once again abandoning the pursuit of 'return on capital in favor of 'return of capital'.