It turns out the Chinese are the 'anti-Bundesbank.' Where the latter has such a pathological angst for anything remotely smelling of inflation that the (Bundesbank logic infused) European Central Bank (ECB) refuses to loosen up, despite the euro zone imploding, the real money supply is actually falling in much of the eurozone periphery.
However, the Chinese suffer from their own peculiarities, as an interesting post by John Hempton shows. The Chinese economy seems unstoppable, even if it is slowing down. As long as people move from subsistence farming on the land to industrial or service sector jobs in the city, productivity rises (by 9% per year for the last two decades, according to The Economist) and as long as this process is managed reasonably well, it will continue until they run out of cheap labor from the land.
"Well managed" has various meanings. Keeping the population happy is one. Growth is rather important for that, otherwise all those people coming off the land can't find jobs. We saw briefly what can happen if the growth machine stalled in 2008 as a result of the financial crisis. Tens of thousands of people moved back from the coastal areas to the hinterland where they came from, as China's export markets dried up.
Inflation is another potential problem. Since there is no real pension system in China, the population has to save for old age. In China, this is especially hard as a result of the one child per family policy, which results in a 'four grandparents policy,' that is, one breadwinner potentially has four grandparents to take care off.
Inflation eats savings away because the lower income classes have little in the way of investment opportunities. They have bank accounts, life insurance policies (which work out to be roughly similar to bank accounts) and real estate. The returns on deposits and life insurance policies is fixed at a (usually) negative real rate.
Which is why the Chinese have to save even more, as inflation slowly eats their savings away. The saving rate in China stands at a rather ridiculous 50%-plus of GDP. Households also save for medical contingencies, the education of their kid (a tradition), and for down-payments on houses.
You might wonder why real returns on savings are negative. One way to explain that would simply be excess savings, that is a market outcome not unlike Western economies suffering from balance sheet recessions. But Hampton has a more sinister explanation. Real rates are kept negative simply to allow banks to provide cheap loans for the biggest gravy train on earth, the Chinese state-owned companies
This opens up a rather curious spectrum. For the economy to grow, it is essential that these huge amounts of savings are turned into investments (if this doesn't happen, a shortfall of demand will ensue not unlike the situation in the West). But despite China being a developing economy, it is difficult to imagine there are that many profitable investment opportunities out there.
Hence the low rates, that is, negative real rates. That sets the return on capital bar so low even inefficient state-owned companies can expand, and leave plenty left for corporate and political greed to feed itself on the feast of the savings bounty.
But this expropriation of the lower income classes (yes, it's happening even in nominally Communist China) has its limits. Crank it up too high, and inflation expropriates too much of the savings and the population will start to revolt. Crank it up too low, and the negative real rate on loans to state-owned companies disappears, and the gravy train sets off into the sunset.
Which is why the authorities panicked recently when inflation came down pretty hard, and bank reserve requirements and interest rates have already been lowered. The Economist summed it up:
The state's influence over the allocation of capital is the source of much waste, but it helps keep investment up when private confidence is down. And although China's repressed banking system is inefficient, it is also resilient because most of its vast pool of depositors have nowhere else to go.
And indeed, the infrastructure build-out is on a rather epic scale:
The country will build 70 new airports and rebuild or expand 101 others over the next five years, the director of the Civil Aviation Administration of China (CAAC) said on May 24. [Caixin]
Investments are the biggest contributor to GDP growth, hardly a surprise with 50%+ of GDP savings rates:
Another curious thing is the quality of investment. Yes, the sheer quantity of investments keeps the economy rolling, it has to, as standstill means falling over. But surely when there is so much corporate gravy to spread around and the capital returns for investments being so low, there must be a huge waste in the system. Surely diminishing returns will set in pretty soon, if they haven't already.
Well, waste there is. Leaving apart the lining of pockets and opulent offices, much of the visible waste is in excess industrial capacity and most of all in a dizzying construction boom. Whole recently constructed shopping centers stand empty. Here is The Telegraph:
Land sales make up 30pc of total tax revenue for the central government and 70pc for local government. (For those of us who watched the Irish state balloon on the back of property taxes - when they had a fat budget surplus - this has a familiar ring.)
Construction makes up 10pc of total jobs, and a further 20pc indirectly in cement, steel, metallurgy etc. The government is building 36m homes for the poor, but that will start to run down in two years or so.
Chinese balance sheet recession?
There are even whole freshly build cities empty, like Ordos in Inner Mongolia. This, of course leads to the possibility of a housing bust and all the effects that this brings on, like impaired balance sheets, bank trouble, impotent monetary policy, and plunging economic growth. The fears of the effects of a bursting of the Chinese real estate bubble are widespread:
Western financial experts who fear a bursting of the Chinese real estate bubble point out that the Chinese economy is more dependent on house building than the United States economy was, before the sub-prime lending bubble burst in 2007. [BBC]
However, there are a number of reasons to argue against that:
- Household real estate buying is a way of saving (for lack of alternative options).
- Credit to households for real estate buying is limited. Generally, down-payments of at least 30% are required. China doesn't have anything near sub-prime mortgages.
- The Chinese have only been able to buy houses for a couple of decades, there still is a whole lot of pent-up demand.
- The urbanization itself creates a huge demand for housing as people move from the land to cities (or the cities move to them).
However, against that stand the sky high price-income relation of housing (16-18 times, according to the IMF), especially in the biggest cities like Shanghai and Beijing. Also, while credit supply to households for mortgages is modest, property developers bask in an abundance of credit, for which there is an extensive shadow market:
The financial system has much larger exposure to real estate than appears, and the weak links are the real estate trusts and non-bank lending. The smaller developers are cash-flow constrained and will find it hard to roll over debts. Any defaults will have to be recognised immediately." This may be happening already, since housing sales slumped 25pc in the first quarter. [The Telegraph]
Not everybody is pessimistic. Here is China expert Micheal Pattis:
I have always argued that the rise in Chinese debt, as bad as it is, was not going to lead to a banking collapse or any other sort of financial collapse because of the way local and specific debt problems would be "resolved". Debt would simply be rolled onto the government balance sheet.
And indeed, the public balance sheet has quite a bit of ammo:
Xianfang Ren said China has the means to bail out the banking system and property market in this cycle, and will use them if need be. "Housing is way too important to allow a hard landing." These include deposits (170pc of GDP), government revenues (30pc), the assets of state behemoths (75pc), foreign reserves (50pc) of GDP - I don't agree on this last point since the FX reserves cannot be repatriated without a big currency rise and a shock for exporters. It would amount to monetary tightening. [The Telegraph]
The fundamental problem
So China can kick the can for quite some time. However, if the root cause is not addressed the problem might very well get worse. The central problem is the poor quality of investment and waste in the state-owned enterprises, which have been resurgent as a result. Here is Steven Roach:
there was considerable concern about the recent resurgence of state-owned enterprises, which has tilted the distribution of national income from labor to capital - a major impediment to China's pro-consumption rebalancing [project syndicate]
Much of local property development is driven by a similar kongsi of local party apparatchiks, property developers and banks, rather than market returns. To a significant extent, its political forces driving investment, rather than economic ones. We call China a state capitalist economy for a reason.
There are several ways it can derail:
- The return on capital requirements are so low that the quality of investments worsens, eventually leaving projects bust, or overbuilding, impairing corporate and bank balance sheets.
- Inflation either too high or too low. In the former case the population might revolt, in the latter case the cheap funding to state-owned companies dries up.
How to make the model more rational. Well, we hesitate to lecture here. The simple truth is that China has done pretty well economically the last 25 years. Yet here are a few ideas:
- Ending financial repression will increase the return on saving and increase the bar for investment projects (insofar as returns are an important consideration). The risk here is that investments will decrease, while savings won't. That can be remedied by...
- Building a safety net like healthcare and a pension system. This will reduce the need for the unprecedented high savings rate.
What hasn't been widely noticed is that demographics are already turning worse and the once bulging trade surplus has been greatly reduced. Those arguing that China unfairly manipulates its exchange rate have yet to familiarize themselves with the concept of 'real exchange rate.'
As a footnote, we attend you the fact that the IMF argues that China's 'overinvestment' is greatly overstated. While the level of fixed-capital formation stands at 48% of GDP, unusually high,
But an annual investment-to-GDP ratio does not actually reveal whether there has been too much investment. To determine that you need to look at the size of the total capital stock-the value of all past investment, adjusted for depreciation. Qu Hongbin, chief China economist at HSBC, estimates that China's capital stock per person is less than 8% of America's and 17% of South Korea's.
So that gravy train might be rolling on for quite some time. If the euro area doesn't implode (a risk which we think is all to real), one could even argue that Chinese shares are becoming a bit of a bargain, now that the government seems ready to pull some levers to boost growth.
Here are some ETFs to consider:
- iShares FTSE/Xinhua China 25 Index Fund (FXI)
- iShares MSCI Hong Kong Index Fund (EWH)
- Direxion China Bear 3X - Triple-Leveraged ETF (CZI)
- Direxion China Bull 3X - Triple-Leveraged ETF (CZM)
- EGS INDXX China Infrastructure ETF (CHXX)
- Global X China Consumer ETF (CHIQ)
- Global X China Energy ETF (CHIE)
We think it's a bit too early still (especially considering the euro area vulnerability).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.