The Rapid Ascent
China has been a fascinating story for the past few decades. As a country its citizens have reaped the harvest of unprecedented wealth creation, leading to a relative increase in quality of life the world has never seen.
China is now home to the 2nd largest amount of billionaires (213), second only to the United States (536). China also laid claim as the country with the 2nd largest nominal GDP in world, and just recently, and relatively quietly, in 2014, became the country with the largest GDP by PPP standards (arguably a more accurate measure of true production, includes adjustments to account for exchange rate and cost of living differences).
Yet it seems that the castle is about to come crumbling down. Fueled by lax lending rules and excessive government spending, China's debt levels have exploded.
A report from McKinsey published in 2015 can summarize better than me:
China's debt is rising rapidly. Fueled by real estate and shadow banking, China's total debt has quadrupled, rising from $7 trillion in 2007 to $28 trillion by mid-2014. At 282 percent of GDP, China's debt as a share of GDP, while manageable, is larger than that of the United States or Germany.* Several factors are worrisome: half of loans are linked directly or indirectly to China's real estate market, unregulated shadow banking accounts for nearly half of new lending, and the debt of many local governments is likely unsustainable.
*Includes debt of the financial sector.
View the McKinsey report here.
In just the past week global markets have been pummeled by worries concerning lower than expected manufacturing data coming from China's Caixin Purchasing Managers' Index (PMI). Indices around the world took large hits, the Shanghai Composite was down 4.1% on the same day. In the following week the 5% and 7% circuit breakers were tripped twice. As of 1/11/2016, the S&P 500 is down 5.9%, the Nasdaq is down 7.38%, Shanghai Composite Is down 14.72%, the Hang Seng is down 8.61%, all in less than 2 weeks of trading into the new year. At the same time commodities prices have fallen off a cliff, with cooper prices and oil prices at 6 and 10 year lows (although theoretically this should be good for economies that are net consumers of commodities). What a great start to the year!
For China, the theme of the decade has been to move from an investment based economy to a consumption based economy. The idea is that as population growth slows and a middle class emerges, Chinese citizens will develop a taste for luxury goods, fancy cars, and protein as a food source. They will no longer be satisfied working in factory-cities making cents by the hour while their neighbors, peers, and family members enjoy the luxuries, the status, and the prestige of a modern lifestyle. The question to be asked is: Can China's domestic consumption fuel domestic GDP growth, or is the consumption merely a byproduct of the excessive debt? I believe in the Chinese consumer.
There have been various articles published in the past 6 months on Chinese consumption. One article published in the Financial Times argues that consumer spending growth is slowing down. If future growth is already priced into the market, then a slowdown would be worrisome. However I would argue that nowhere else will you see the growth figures that you see in China. Beijing and Shanghai, China's two largest cities, have seen retail sales grow at over 6% and 8% respectively, while smaller, less developed regions have higher growth rates. GDP grew at 6.9% in 2015. While the headline is that this is the slowest in 25 years, as I mentioned earlier, China is the second, if not the largest country by GDP in the world. Nowhere else will you see as much real, tangible growth in non-percentage terms.
Let's take a look at the evolution of the U.S. and Chinese economies and see how stock market performance and consumption have changed relative to time. If you compare the grey and orange lines, it can be seen that U.S. consumption has increased steadily as the S&P 500 (via the SPDR S&P 500 Trust ETF (SPY) has increased as well, respectively. Compare this to the yellow and blue lines, we can see that household consumption has skyrocketed. While the Chinese Stock market (via the iShares China Large-Cap ETF (FXI), which plots the Shanghai Composite in particular) has also increased impressively, it is still behind relative consumption when compared to U.S. data. These are crude data and rough approximations but truly show has fast China has grown in the past two decades.
Source: U.S. Department of Commerce Bureau of Economic Analysis, The World Bank
Ultimately, stabilization needs to happen in China to convince investors that there won't be a hard landing. The savings rate must also decrease for consumption to be affected heavily. And for the savings rate to decrease a significant amount, there needs to be policy reform on a national level. There needs to be a safety net for consumers. Health insurance, home insurance, car insurance, mortgages, loans, consumer financing, credit cards, unemployment, social security, are all forms of security that we take for granted. As these industries an policies develop, we will see the Chinese consumer evolve into a consumer that the likes of this planet has never seen before, surpassed only by maybe one type of consumer, a super-size Big Mac devouring, gas-guzzling V-10 F-350 driving, M-16 toting, red-blooded American. Now that's what I call the Chinese Dream.
Disclosure: I am/we are long BABA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.