China, which was once touted to be the global growth engine, is witnessing a significant economic downturn. The slowdown is not necessarily bad news for China, which grew at an average rate of 9.3% from 1989 until 2012. A sustained period of high growth leads to excesses in the economy and a subsequent slowdown helps in cleaning up the excesses.
However, the focus of this article is not on the current slowdown. This article investigates if the existing growth model for China is sustainable in the long term. Based on my research, I concluded that the current GDP growth strategy is unsustainable. Discussed below are some of the major reasons for this conclusion.
To take the story forward, presented are two charts. The first chart showcases China's new loans, while the second chart gives the GDP and GDP growth.
Click to enlarge
During 2000-08, average GDP growth for China was 10.4%. In terms of GDP by value, the GDP increased by 21.5 trillion Yuan (from 9.9 to 31.4 trillion Yuan). For the same period, 20.3 trillion Yuan of new loans were issued. The impact of debt on GDP growth was significant, with one Yuan of debt leading to an incremental impact of 1.05 Yuan on the GDP.
During 2009-11, average GDP growth was slightly lower at 9.6%. In terms of GDP by value, the GDP increased by 15.8 trillion Yuan (from 31.4 to 47.2 trillion Yuan). For this period, 25.7 trillion of new loans were issued. The impact of one Yuan of debt on incremental GDP growth was just 0.61 Yuan.
New loans are having a diminishing impact on GDP growth is the conclusion one can draw from the above data. This is important to understand, as China is trying to ease monetary policies again to boost growth. Given the kind of impact new loans are having on GDP growth, the policy action is bound to fail.
Instead of being productive, easy monetary policies and excess liquidity can manifest itself in the form of asset bubbles or consumer inflation. The real estate bubble in several cities in China serves as a good example of the point I am trying to make.
Talking about liquidity, China's M2 as a percentage of GDP for 2011 was 181%. The United States (with expansionary monetary policies) had a M2 as percent of GDP at 64% for 2011. Very clearly, the strategy of propping GDP growth through easy money is not sustainable with a skyrocketing M2. GDP growth is likely to collapse when inflation forces policymakers to tighten liquidity.
Further, rapid credit growth (significantly above GDP growth) always leads to a relatively high percentage of non-performing loans. There is a high probability of meaningful write-downs in the banking system in the foreseeable future. Credit growth can collapse as a result of this leading to further economic downturn.
In analyzing the sustainability of the current growth model, it is also important to look at the components contributing to GDP growth after the financial crisis. The chart gives the exports and industry value added as a percent of GDP.
After peaking out in 2006, exports and industry value added are on a gradual downtrend. With expectations of a prolonged phase of sluggish economic growth in the developed economies, exports as a percent of GDP will continue to decline. The same holds true for industry value added.
Therefore, exports contribution to GDP growth will continue to decline and needs to be offset by domestic consumption.
A comparison with other investment driven economies shows that China's gross capital formation as a percent of GDP is in uncharted territories and at unsustainable levels.
China already faces overcapacity in the manufacturing sector and adding further capacity will not benefit growth. Further, infrastructure development also needs to take place in a planned way. Constructing houses and roads can lead to a glut with actual urbanization happening at a relatively slower pace.
Given these factors, maintaining growth of above 8% would be a big challenge for China in the medium term. More importantly, consumption as a percentage of GDP is still below 30% and needs to increase over time.
Having talked about the concerns, I would like to add that China will continue to grow over the long term. The United States, during its rise as an economic power witnessed rough phases and even a depression. Similarly, in my opinion, China is in a period of economic consolidation after nearly 30 years of robust GDP growth.
How good or bad China does from here depends largely on the policymakers. It would be a mistake to intervene in the free economy and try to prop up growth. Instead, policymakers should allow the Chinese economy to slow down and get rid of its excesses.
From an investment perspective, depressed market and economic conditions gives an opportunity to investors to participate in the long-term growth story. Investors can consider exposure to the iShares FTSE/Xinhua China 25 Index (FXI), which gives investors an opportunity to have some large Chinese corporates in their portfolio.
At the same time, investors need to avoid currencies and equities of major commodity producers in the near term. China consumes over 45% of the world's iron, coal and steel. It also consumes nearly 40% of world copper. Over the long term, I remain bullish on industrial commodities.
In conclusion, there is no one formula or strategy to rebalance the Chinese economy. The best way would be to allow the economy to rebalance itself going through some pain in the medium term. It remains to be seen if policymakers in China are keen to prolong the pain.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
