Michael Pettis has produced a very useful framework for analyzing the Chinese economy. It is based on the (in our view) realistic assumptions:
- China has over invested in infrastructure, leaving a situation in which additional investment is value destroying while increasing the debt burden.
- China's sustainable growth rate is significantly below the current rate so attaining the target rate is only possible through increasing the debt burden.
We add some additional features (not to say problems):
- There is a large overcapacity in many industries (most notably steel).
- The level of outstanding debt is really problematic (at roughly 250% of GDP).
- There is a need to rebalance the economy away from relying on investment and exports, towards relying more on domestic consumption and services.
- China is facing a significant demographic change.
Let's start with the demographic problem:
Here is Bank of America (from Business Insider):
For China to rise to be the world's #2 economy, the country saw its working-age population expand by 380mn people between 1980 and 2015. During this time, millions of people from rural China migrated to cities for urban manufacturing jobs. While this has pushed China to be the world's largest manufacturing economy in 2010, it is expected to peak in 2017. by 2050, the size of China's population will decline by around 60mn, while the working-age population will decline by 212m or around 1/3. This is the size of the current population of Brazil, the world's 5th most population nation.
The people of working age have already started to decline in numbers. Also, as a consequence of the one-child policy (now partly reversed) the number of young people is relatively low.
The implications for growth should be pretty obvious. With a declining working age population, growth has to come entirely from raising productivity.
But productivity is also much more difficult to raise when the pool of cheap labor moving from low productivity (subsistence) agriculture in the countryside to high productivity jobs in industry is basically drying up.
In other aspects is eases the transition somewhat. China needs to restructure the capacity and debt overhang, mostly in state-owned heavy industry. It is difficult to do that because this makes masses of industrial workers unemployed, which could threaten social stability.
It also, as Pettis points out, attacks the power base of many local authorities, which is another problem. But without much inflow from the countryside, this is made considerably easier, although retraining these workers is going to be pretty complex.
It would also allow China to embark on another investment boom, automation and robotization. This is already ongoing, as it happens (from the WSJ):
Suzhou Victory Precision Manufacture Co.'s chairman, Yugen Gao, said the days when the company drew its strength from China's cheap and hardworking employees are gone. "We've been losing that edge in the past three years," said Mr. Gao in his office, overlooking rows of buildings where a battalion of robots was cranking out computer keyboards. "It's one of the effects of the one-child policy." China's appetite for European-made industrial robots is rapidly growing, as rising wages, a shrinking workforce and cultural changes drive more Chinese businesses to automation. The types of robots favored by Chinese manufacturers are also changing, as automation spreads from heavy industries such as auto manufacturing to those that require more precise, flexible robots capable of handling and assembling smaller products, including consumer electronics and apparel.
It's also clear what the problem is:
In addition, the average hourly labor cost-defined as wages plus benefits-of $14.60 in China's coastal manufacturing heartland has more than doubled as a percentage of U.S. manufacturing wages, from roughly 30% in 2000 to 64% in 2015, according to Boston Consulting Group, making the country less competitive as a destination for manufacturers.
These higher wages are good for the transition to an economy depending more on domestic consumption, but they have to be earned first. It is of little help if these wages push people out of work, either because the company is losing competitiveness or replaces labor with robots.
What is the solution to that problem? Any solution involves one of three things, according to Pettis:
- It either involves higher unemployment
- Or higher debt
- Or higher wealth transfers
Doing nothing would likely result in higher unemployment as exporters become less competitive and companies automate production lines in order to survive. How the government has dealt with the situation so far is by letting debt rise.
That is, whenever the economy slowed, some form of fiscal and/or monetary stimulus came online. But debt levels are already at dangerous levels, and increasing debt further gives ever smaller returns (Pettis argues these are already negative, as it happens). Here is Fitch (from The Telegraph):
The credit addiction is becoming increasingly dangerous for two reasons. The efficiency of credit has collapsed. Fitch estimates that each new yuan of credit generates just 0.3 yuan of economic growth, down from 0.8 before the Lehman crisis. At the same time, the growth rate of nominal GDP has halved from around 15pc to nearer 7pc, making it much harder for the country to work off the debt load - the so-called denominator effect. A pattern has become entrenched where credit is rising much faster than the underlying nominal base of the economy, and is achieving ever less in the process.
So what options does the government have left that do not involve rising unemployment or rising debt? Fairly simple, let the currency fall. Pettis is right that this does involve a higher wealth transfer, in this case from wage earners to the tradable goods sector.
He also argues that it involves reversing the transformation of the economy, as demand is switched away from domestic to abroad. But it's the least painful solution. It gives the big industries time to restructure, work away the overcapacities while softening the economic (and social) impact.
And here is another reason why the yuan is likely to decline:
Years of deflation at the wholesale level ("internal devaluation") has come to a halt.
The problem is that further yuan weakness is hard to resist:
- Maintaining competitiveness of Chinese exporters.
- Companies embarking on a string of foreign acquisitions that shows no signs of slowing anytime soon.
- Wealthy individuals stashing capital abroad for lack of domestic investment vehicles and fear of a property bubble.
- Sliding foreign currency reserves in an order to stem the tide isn't a policy option the authorities can practice forever.
- Automatic domestic monetary tightening as a consequence of the forex interventions in support of the yuan is another limit on supporting the yuan
It seems like the route of least resistance, and once that belief takes hold, it might very well become a self-fulfilling prophesy.
And then we have a wildcard in the form of the incoming Trump administration, which could:
- Impose tariffs on Chinese imports
- Designate China as a currency manipulator
We somehow think that rationality will take hold and no trade war with China will ensue, nor will they be branded a currency manipulator for trying to slow yuan devaluation and spending a considerable amount of their forex reserves in the process. But we have to admit, we really don't know.
So far the yuan devaluation has met with very little alarm, which is somewhat surprising considering the mayhem it caused last year. The reason is that rather than a result of a seemingly surprising change in policy, this time around the devaluation is very gradual and expected.
For now, the PoBC, the Chinese central bank has enough forex reserves to keep the process orderly and gradual, but forex reserves are not the only constraint and markets can shift rather violently.
A yuan shock would impose a strong deflationary shock on the world economy, which basically only has the US as an economic motor. We know it frightens the living daylights out of markets as it has done so twice before.
For now, gradualism is still the order of the day though, until it's not.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.