- The Chinese economy has enjoyed impressive growth rates since joining the WTO in 2001.
- GDP growth is largely driven by increasing investment, which cannot go on forever.
- Recent economic data are showing signs of weakening, and slowing growth has investment implications for China-related ETFs (such as GXC and MCHI).
On March 8, China's General Administration of Customs (CGAC) reported the mainland biggest trade deficit since March 2012. Exports dropped 18% as the CGAC reported a deficit of 23 billion USD. This is coming on top of increasingly negative news flow out of the mainland recently. This news includes the first onshore bond default by Shanghai Chaori Solar Energy in March, and a drop in manufacturing PMI in late January that triggered the recent emerging market sell-off. Is the Chinese economy -- and China-related exchange-traded funds (GXC, MCHI) -- flaming out? And, more importantly, when the dragon sneezes will the rest of the world get a cold?
The Rise of the Dragon as the World's Largest Trading Nation
Since becoming a member of the World Trade Organization (WTO) in December 2001, China's economy has grown eightfold to overtake Japan as the world's second biggest economy.
Click to enlarge images.
Chart 1 -- The economy has increased eight times from USD 1.32 trillion to USD 8.23 trillion in 2013.
In 2012, China overtook the United States as the world's largest trading nation with its combined imports and exports value exceeding America's trade numbers by $3.87 trillion vs. $3.82 trillion.
Table 1 -- Sum of Chinese exports and imports increased from USD 0.5 trillion in 2001 to USD 3.8 trillion in 2012.
Total (USD 100m)
Exports (USD 100m)
Imports (USD 100m)
Balance (USD 100m)
According to the CIA World FactBook, China is the biggest import partner for Japan, Russia, and the United States, making up 21.3%, 16.6% and 19% of these countries' imports, respectively.
Figure 1 -- China is a major import partner for three of the biggest economies in the world.
Source: CIA World Factbook.
China's impressive trading powers can be explained by the development of its eastern coastal areas into massive port infrastructures, with seven of its main ports (Shanghai, Guangzhou, Hong Kong, etc.) consistently in the top 10 ranking of global busiest ports by tonnage.
Table 2 -- Chinese ports have dominated seven out of the top 10 rankings since 2007.
The increased involvement and integration of China in world trade serves to underline its importance to global economic development as both a major source of supply via exports and a major source of demand via imports. Despite the growth in trade, China's net balance of trade (exports less imports) only contributes USD 0.23 trillion to a USD 7.3 trillion economy in 2012. For the main pillar of growth for the Chinese economy, we have to look at investment expenditure.
Investment Powers the Dragon Forward
China's amazing GDP growth has been powered largely by investment expenditure. From data provided by the National Bureau of Statistics of China (NBS China), investment is the largest contributor to GDP and GDP growth.
Table 3 -- Investment (or fixed capital in units of CNY 100 million) has always been the largest contributor to GDP.
Looking at figures provided by the National Bureau of Statistics China, fixed capital formation made up only 36% of China's GDP in 2001, but in 2014 it composes 45.6%. of the mainland's GDP. In other words, growth in investment has outpaced the other components of GDP like consumption, government expenditure and trade balance. This is in sharp contrast to developed economies like Japan where consumption forms the bulk of GDP.
However, classical economics theory indicates that as investment increases, the marginal rate of return on capital decreases. Once the investment return goes below the cost of capital, businesses start to incur losses and cut back on investment. Investments cannot go on increasing forever.
The Canary in the Coalmine
Early signs of slowing returns on investments are already manifesting in recent economic data. Leading indicators like New Orders and Manufacturing PMI data has already start to weakened to low 50s in early 2014 from 55 in 2010 (values below 50 indicate contraction).
Chart 2 -- New Orders has weakened to the low 50s, bordering on contraction.
Chart 3 -- Manufacturing PMI is also reinforcing the trend in New Orders.
Manufacturing weakness is already showing up in a collapse of exports and worsening of the trade balance in February's trade statistics as reported on March 7.
Chart 4 -- China's trade balance dipped to 23 billion USD in February, the second worst on record.
Chart 5 -- Chinese exports slumped to 1,104.94 hundred million, the worst since 2010 the second-worst on record.
Source: tradingeconomics.com and NBS China.
While one may caution against reading too much into February's trade numbers due to the distorting seasonal effect of the 10-day Lunar New Year festive rest period for factories and workers, it has to be noted that the scale of this so-called "seasonal" slump is much greater than the previous rounds.
China's importance to the world cannot be understated by any means. World trade has integrated China more than ever into the global economy. Any signs of weakness in the mainland economy will definitely be felt throughout the world. More importantly, the signs are starting to show that growth is weakening as evidenced by leading indicators and recent trade data. This lowered level of expectations was also mirrored in the recent National People's Congress where an annual growth target was set at 7.5%, with the Finance minister Lou Jiwei commenting even sub-7.5% growth will still count as meeting expectations. The dragon and China-related exchange-traded funds (GXC, MCHI) may still flame on in 2014, but we may end up with more smoke than fire.
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. I have no business relationship with any company whose stock is mentioned in this article.