No sooner than global financial markets participants “catch their breath” from the ongoing turmoil in European and US markets, investors and speculators will soon turn to worrying about how the economic slowdown in Europe and the US will affect China’s economy. The results of such musings are not likely to prove edifying for commodity markets.
China's Export Dependency
Exports comprise roughly 30% of China’s GDP – an extremely high share by any measure. However, some economists have vigorously contended that this figure overstates China’s dependency on exports since value added is not properly accounted for in the trade accounts. According to this view, net exports represent merely 10%-12% of Chinese GDP.
I believe that this debate regarding the accounting of value added is largely sterile. It misses the point. The importance of the export economy to China’s growth model over the course of the past two decades has more to do with the knock-on effects of the export economy than the direct value added of exports themselves.
For example, China’s export economy has driven massive investment in infrastructure. From an infrastructure point of view, it does not matter what percentage of the goods being processed are foreign or domestic. It still requires the same amount of port facilities, highways, roads, warehouses, railroads, trucks, and etc. The construction of this infrastructure does not enter into the GDP accounts as exports. However, the economic activity surrounding this build-out of outward looking infrastructure has been a key driver of Chinese GDP.
Similarly, foreign trade has indirectly been the primary impulse driving urbanization, which in turn, has been the main driver of putatively “domestic” GDP growth. Peasants from the countryside have flowed massively into the cities in search of factory jobs – or for jobs in formal or informal industries that supply and service factories and their workers.
The local suppliers of the goods and services that keep the factories humming, the retail trade that services the workers, the construction industry that builds the housing for the workers and the commercial centers where they shop – all of this drives economic activity that in GDP is accounted for as domestic GDP. However, all of this GDP was ultimately driven by the export economy.
Accounted for correctly, foreign trade was probably responsible, directly and indirectly, for 50% or more of Chinese GDP growth in the two decades leading up to 2008. Without the export boom, the Chinese economic miracle as it occurred would simply not have been possible.
The Unhealthy Transition to Domestic Driven Growth
In the last two years since the financial crisis of 2008, the slowdown in the growth of exports has meant that in order to maintain overall GDP growth rates at around 10%, the Chinese government has had to promote the stimulation of economic activity that previously was driven by the export sector.
The Chinese government has done this in two ways.
First, the Chinese government has promoted massive growth of direct government spending at both the national and local levels.
Second, by far the most important way in which the Chinese government stimulated growth between 2008 and 2010 has been through the enactment of policies that have encouraged a dangerous and almost indiscriminate growth of credit in the private and quasi-private economy. The inefficiencies and imbalances that have accumulated as a result of this policy of massive debt-led domestic demand growth are quite spectacular.
The inefficiencies that have been wrought by Chinese policies can be partly illustrated by the fact that between 2008 and 2010, through a variety of conduits, Chinese government policies stimulated the pumping of roughly 3 Yuan of new credit into the economy, which ultimately redounded in 1 Yuan of GDP growth generated. In other words, it took 3 Yuan of credit growth to create 1 Yuan of GDP growth.
Gargantuan inefficiencies, easily detectable through analysis of statistics such as credit growth and GDP at the macro level, can be readily observed at the micro level.
For example, it has been well publicized that many municipalities as well as private and quasi-private enterprises that took on massive new debts (and were pushed by the central government to spend) are already having trouble paying back those loans. Indeed, many commercial real estate ventures are essentially insolvent as massive inventories have accumulated and the rate of sales has generated insufficient cash flows to allow debt servicing. Thus, many real estate developers are currently relying on new soft loans in order to avoid going into default on the old loans.
The fact that 3 Yuan of debt had to be created and spent in order to generate 1 Yuan of positive GDP very clearly suggests that if those 3 Yuan of debt stimulus had not been expended, the Chinese economy would have suffered a massive contraction between 2008 and 2010. This fact, plain for anybody to see, gives the lie to the claim that the Chinese economy was not export dependent prior to 2008.
In fact, the Chinese growth model has been so dependent on exports that only spectacular and reckless debt-led domestic demand growth prevented an all out collapse of the economy.
Experts may differ on whether such counter cyclical expenditures, and in such magnitudes, were ultimately wise. What cannot be debated is that there will be a price to pay for the debts and the inefficiencies created by this hasty transition.
Today China has Limited Stimulus Options
From 2008, through 2010, in order to head off an economic collapse, China substituted debt-led domestic demand growth in lieu of the economic activity that had previously been driven directly and indirectly by foreign trade. This drastic transitional policy has created unsustainable imbalances in the medium term.
As the global economy slows, and China’s export sector once again comes under pressure to contract as it did in 2008, Chinese policy makers will find it much more difficult to compensate for the loss in foreign trade-related output.
For 2011, and 2012, China has two avenues to compensate for the loss in output due to the cooling off of the foreign trade sector and its massive subsidiary domestic economy:
- Credit growth to private sector. In terms of stimulating the economy through the expansion of credit to the private sector, this will be increasingly difficult. Total credit to the Chinese private sector as a percent of GDP, adjusted for per capita GDP, is virtually the highest of any nation in the world. The private sector in China has limited capacity to take on more debt. To illustrate only one instance of this general principle, one may ask: How many more empty shopping malls and office buildings can be built without legitimate sources of domestic demand?
- Deficit spending by the public sector. Certainly, China has the wherewithal to engage in a second round of fiscal stimulus. If the private sector cannot build any more empty office buildings for example, then the Chinese government certainly can – either directly or through various sorts of subsidies. The debt of the central government as a percent of GDP is quite low. And in any event, most of China’s debt is held in local currency. Since the Chinese central bank can largely control the money supply, there is virtually no financing restriction upon the discretionary fiscal stimulus capacity of the Chinese central government.
In sum, as can be appreciated, it is not that the Chinese government has no ability to respond to the global slowdown. It can, and it will.
However, due to the massive growth of private sector debt and the inefficiencies precipitated by the last round of fiscal and monetary stimulus between 2008, and 2010, the marginal effectiveness of potential fiscal and/or monetary stimulus has been significantly reduced.
In 2011, and 2012, it will be much more difficult for the Chinese government to compensate for external shocks to its foreign trade sector (including the massive amounts of domestic economic activity that is essentially subsidiary to the foreign trade sector). The massive increases of private indebtedness, and the concomitant imbalances created in the domestic economy, have severely limited the marginal effectiveness of potential Chinese counter cyclical monetary and fiscal policy.
A slowdown of economic growth in Europe and the US will to some degree be countered by counter cyclical policies instituted by the Chinese government. However, this time around, it is unlikely that the Chinese government will be able to prevent a substantial slowdown of the domestic Chinese economy.
Chinese officials may be able to prevent outright contraction; but not a substantial slowdown.
As participants in global financial markets contemplate this prospect, commodities will get hit very severely. Under such a scenario, it would be very surprising if oil did not fall below $70 and copper did not fall below $3.00. Indeed, the entire commodity complex will probably get smashed. This includes the precious metals.
Commodity oriented stocks and ETFs such as Freeport-McMoran Copper & Gold Inc. (NYSE:FCX)
, Rio Tinto plc (NYSE:RIO)
, Energy Select Sector SPDR ETF (NYSEARCA:XLE)
, iShares Dow Jones US Oil Equipment Index ETF
), SPDR Gold Trust ETF (NYSEARCA:GLD)
, iShares Silver Trust ETF (NYSEARCA:SLV)
and Market Vectors Gold Miners ETF (NYSEARCA:GDX)
should be avoided on the long side, and shorts can be considered.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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