If you're hoping China will turn this global slowdown around with a big new stimulus, don't hold your breath. It could yet happen, but probably won't, and almost certainly not soon. China has good reasons to hold off from stimulus, even as large parts of its economy are clearly suffering from collapsing demand.
I was prompted to write this piece by the alarming recent drop in prices for steel, the second-most-important globally traded commodity after oil. Shanghai rebar futures -- the steel market's most-watched contract -- are at their lowest since they started trading in December 2009. Iron ore and coking coal prices are both at their lowest since 2009 and still falling. Chinese buyers are running out of space to store excess inventory, and some are defaulting on long-term purchase contracts.
For me, this is eerily reminiscent of 2008, when I was focused on Ukraine, a major steel exporter. China, which had the Olympics that year, at first seemed heroically impervious to the global slowdown that was then spreading from the United States. Steel prices held up and oil hit new highs.
And then over the summer, China pulled back and prices started sliding. Within six months, China would be back and buying more than ever -- but only after the proverbial blood was on the streets.
History isn't repeating, but it does seem to be rhyming. This year a global slowdown is spreading mainly from Europe, and the worst fears are about the globally crucial European banking system. China and other emerging markets have been struggling with commodity price inflation, and would like some relief. Knowing how the Chinese leadership responded to a similar situation in 2008, I expect they will stand back and wait for better prices.
And when China responds -- I think only next year -- expect it to underwhelm. China and the world have changed a lot in the last four years. Although China remains one of the world's most competitive economies, it has been rapidly building up private debts that make it vulnerable to a home-grown financial crisis.
A big new stimulus would greatly increase that vulnerability. I don't think China's ultra-conservative leaders will want to risk it.
Even China's credit capacity is limited
The chart below is my attempt to compare China's recent credit expansion with two countries known for their credit excesses: the United States and Spain. As in my previous article on Spain, I am looking at the net credit flows to the so-called "real economy" -- households, public bodies and non-financial companies. These flows rise and fall with every business cycle, but sometimes grow out of proportion and then crash in financial crises.
At first glance, China's credit supply numbers look alarming: they peaked at 45% of GDP in 2009, well over the peak that Spain hit in the middle of its credit bubble.
But, at the risk of being scolded by fans of Reinhart and Rogoff, I have to say that China really is different. China is by no means immune to credit bubbles. But China can afford to expand credit much more quickly than other economies because China is more competitive and faster-growing.
The dotted lines in the chart are meant to give a sense of China's extra credit-absorption capacity. They represent growth of nominal GDP ex-investment, or NGDPXI. I use nominal growth -- real growth plus price inflation -- because growth and inflation both make it easier to repay debt. I exclude production for domestic investment because growth in that area doesn't always make it easier to repay debt, such as when homes or commercial property are overbuilt.
My contention is that credit supply shouldn't substantially exceed NGDPXI growth over any long period, or debts will accumulate and eventually cause a financial crisis. The United States and Spain are excellent examples: their credit supplies were multiples of their NGDPXI growth rates for many years.
China's credit supply was in line with its NGDPXI growth until 2009, when credit supply suddenly shot through the roof just as NGDPXI collapsed. As an export-focused economy, China was hit hard by the global contraction. Its non-investment-related production contracted in 2009 in real terms.
But the big Chinese credit stimulus, announced at the end of 2008, turned what would have been a recession into another year of world-beating growth. The government ordered banks to dramatically boost lending to industry and public infrastructure projects.
China's stimulus was partly successful. Growth bounced back, and not only of investment. But inflation also raced, undermining China's competitiveness, especially with other emerging markets where most of China's export growth potential lies. By the second half of last year, China was busy cutting back its credit supply to tame inflation just as Europe began sinking back into recession.
My chart holds two last important points. First, China's ex-investment growth is slowing faster than its overall growth rate. This fact can be gleaned from monthly statistics on Chinese investment spending that show it growing at rates well over the general growth rate. Outside of investment, I estimate China's real growth rate in the first half was less than 3%.
Second, China's credit supply is no longer coming down. Credit supply normally shrinks when the economy slows, so the recent stabilization of credit supply reflects government intervention. China is already stimulating some, but not nearly enough to stop or reverse the slowdown.
Next Stimulus: Late and small
An attempt to cure this slump with a repeat of the 2009 credit stimulus would be half as effective and twice as dangerous. Credit supply is already at such high rates -- a quarter of GDP -- that it would have to move to recklessly high rates just to make a difference.
You've seen the reports about all the questionable real estate and local government debts that China has accumulated over the past four years. Does anyone really think it would be a good idea to double down?
China does have another stimulus option. Western governments, mainly through the IMF, are urging China to adopt a fiscal stimulus instead of a credit stimulus.
Fiscal stimulus has the big advantage that the debt burden is placed on the central government, and not on the myriad of private companies, state companies and other public entities that carry the debts of Chinese credit stimulus. China's central government could handle the burden: it currently owes about 26% of GDP and had a miniscule deficit last year.
The IMF is urging China to direct this would-be fiscal stimulus towards consumption, rather than investment. That would be an easy way to start down the road of "rebalancing" the economy to more production for domestic consumption and less dependence on investment and exports, something almost everybody agrees China ought to do.
Personally, I don't agree that China should "rebalance" in quite that way. China is an extremely competitive exporter, and there is great potential for it to lead the next big boom in global trade among emerging markets. To let that happen, China's leaders will need to back off from central planning and allow entrepreneurial culture to develop. Investment can decline from its current absurdly high levels but not too far. China needs more R&D.
In my vision, the Chinese consumer becomes more cosmopolitan and influential in the world. In the "domestic-consumption-led" vision of Chinese rebalancing, he becomes a parochial nationalist, loyally buying the products of a domestic industry urged by government to cater to guys like him. Bleh. But I digress. I was explaining why China is unlikely to adopt a big fiscal stimulus.
Fiscal stimulus has many of the same drawbacks as credit stimulus: they both boost imports and inflation and put downward pressure on the currency. The previous stimulus used up much of China's capacity to absorb those pressures. Besides reducing China's trade surplus, the stimulus brought practically overnight wealth to some people, some of whom are looking to move with their money out of China. Meanwhile, foreign investment is falling, and Chinese companies are covering dollar short positions because they a feeling less confident in the renminbi.
China ran a large enough trade surplus in the first half of the year to cover the capital flight and dollar short-covering, and still add slightly to its foreign exchange reserves. But a big new stimulus of any kind would put China's leaders in an uncomfortable position. They would have to choose between defending the renminbi against depreciation pressure, which would sap liquidity and undermine the stimulus, or letting the renminbi fall, which would undermine their prestige.
It pays to remember that China is, after all, an authoritarian country. Its leaders are extraordinarily averse to putting themselves into any situation that could threaten their continuity. They have hoarded far more foreign exchange reserves than they could possibly ever need. And they have studiously avoided running up large state debts. I don't see them suddenly changing their minds. Fiscal stimulus might sound good to your ears, but you're not a member of the Chinese politburo.
The best hope for stimulus lies with the new Chinese government that is expected to take office early next year. Unless the global slowdown somehow turns around by then, they will be under pressure to show their mettle and make an impact. It's possible they could be more reckless than I expect and go for a big stimulus.
But I don't think China's new leaders will want to take such a big risk. I would expect them to try to satisfy as many Chinese people as possible for the minimum cost. It's not China's turn to reboot global markets.
Of course, the Chinese must come back to the industrial commodities markets, sooner or later, softly or with a bang. But those six months in 2008 seemed like forever.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.