There can be no doubt now that China is undergoing a "hard landing." But that hard landing will soon turn into a crash. Although this is not the consensus view of analysts, the experts have called the slowdown badly wrong so far and are still wrong. No amount of fiscal and monetary stimulus to the domestic economy can dodge the pending crash. That is because the crash will be driven by chronic overcapacity (driven by capital misallocation) in the production of commodity goods for export; structural weakness in the domestic banking system and the existence of vast speculative bubbles, which must at some stage burst. Hence, stimulating domestic consumption will change nothing.
Many of us have invested in China based or exposed assets because we have been told "you must have some China exposure, long-term growth, etc, etc." There may be long-term growth but not for a while and ahead of a violent crash the sensible China asset allocation is 0%.
I have already offered up five small-cap China shorts on SeekingAlpha here, here, here and here) but in a second article later this week I shall outline a specific list of larger investment calls based on the inevitability of China suffering a great economic crash during the next 12 months.
The debate during the summer was whether China would suffer a soft landing or a hard one. In the soft landing camp were most of the sell-side economists and the Government of the PRC. Thus when second quarter GDP growth was announced at 7.6% in early July, Xianfang Ren, an economist at IHS Global Insight in Beijing told AP that "overall, this is a soft landing, but we can see that the Chinese economy is undergoing serious pain."
Ren confuses a soft landing (official numbers) with serious pain (the real economy). That is a common error. The consensus among analysts was (and still is) that, as in 2008, the Chinese Government could revive economic growth by a combination of cutting base rates and starting huge infrastructure programs. This analysis is wrong on two counts: it fails to address the nature of the problems and, consequently, the policies are not working.
There have always been grave doubts as to the reliability of Chinese GDP statistics anyway - they appear to be created in an overly optimistic manner. Thus, while second-quarter GDP was reported to have grown by 7.6% (down from 8.1% in Q1), Platts reported that demand for oil grew by just 0.5% year on year in May. That is hardly what one expects of an economy meant to be growing at 8% per annum. Meanwhile the China Coal Industry Asociation admits that coal stockpiles have been at record highs (and growing) since May - there simply is not the demand. That is not exactly what one expects in an economy meant to be growing at 8% a year. Electricity demand growth has now fallen to c5% per annum and is still falling. It is not just Western critics who seem to think that official GDP data and what is happening in the real economy do not add up. Li Keqiang, a Senior Chinese politician admitted in 2010 that the numbers are "man made." And so when I refer to a hard landing, I do not refer to Chinese GDP data but to what is happening in the real economy. Although, I do expect even the man-made GDP growth numbers to shrink rapidly.
In the real economy, the issue China faces is that it has enjoyed a vast misallocation of capital. This is partly a result of Central Government diktats, the 5-year plans that identify growth industries. The truth is that Chinese politicians are as useless at picking winners as we are in the West. And it is partly due to the nature of the Chinese banking system, which is driven by state "encouragement" as to where it lends and which appears to have much looser lending criteria than banks in the West. Thus it takes $7 invested by debt in China to add $1 to GDP while in the U.S. that number is $4-5. China may have many attractions for investors but when it comes to allocating capital, it is highly inefficient. And this is particularly pertinent because what has driven Chinese economic growth in the past decade has been a combination of huge investment spending and exports - this is not an economy driven by domestic consumption. The practical result of the misallocation of capital is (if we ignore the trifling matter of large-scale theft and fraud) that there has been excessive real economy investment either in commodity markets where China has created global overcapacity or in industries where there really is no economic case at all. And as such, quite a lot of those banking assets will at some stage have to head off to money heaven.
And so what is the state of the real economy? Over the past few months I have run a series of articles detailing the scale of the slowdown in everything from underpants and sock production to steel production to ship building. The story is the same across the board: record inventories, collapsing sales, factory shutdowns, order levels which were predicted just six months ago to rise by 10% this year actually falling by 10%. On a daily basis data comes out that shows that industry after industry in China is seeing a collapse in demand, although that is perhaps not yet reflected in actual GDP data. Shall we start with Steel? Courtesy of Proactive Investors:
Raw steel production in China recorded a 2% increase in early August this year taking the country's steel production to a record 400% increase over a period of 10 years. In 2012 China's steel production is expected to touch 715 million tons. Despite production cuts, slackening demand and rising stockpiles China's output for 2012 is expected to be 5.2% up from 2011.
The paradox here is that though the demand for steel is down and reaching lower levels daily, Chinese steel mills are still producing to achieve record steel output figures. According to China Iron and Steel Association (CISA), the country's steel stockpile is up by 26% from last year. The CISA also reports that the country's steelmakers saw profits fall by 96% on the back of slowing demand, triggering speculations about a possible revival of tax breaks for Chinese steel producers. However, the country's steel production shows no signs of letting up barring a few production cuts.
Many analysts believe that perhaps the numbers don't reveal the full story as China's steel production figures are largely based on the output of state owned manufacturers whose primary objective is to meet the government's production targets, irrespective of market conditions.
So just how is that sustainable? It is pretty much the same across all sectors. What has caused the slowdown? It is not that China is uncompetitive. Labor costs have risen a little (but are still pretty low) but it is that all key export markets have seized up. China's biggest export market is the EU. I do not need to elaborate on what is going on there. Then there is the U.S. where economic growth is anemic and there is growing anti-China rhetoric. A poor third is Hong Kong whose fate is pretty closely tied to that of China. In commodity markets, a slump in demand can only cause prices to slump and that can only be corrected by a loss of productive capacity. But that poses a secondary problem for China. Its banks.
Charlene Chu from Fitch Ratings issued a note last week warning that China's banking sector assets are now almost $21 trillion, up from $9 trillion in late 2008. This is an extraordinary rate of banking growth. Even a modest shock could "wipe out the sector's entire earnings," she warned. In an earlier note from last December ( I give Chu gold stars for foresight) she warned:
"Recent stress in informal lending and among property developers, SMEs, and local governments has not reached systemic levels. Nonetheless, Fitch Ratings believes these are not isolated cases of distress, but rather emblematic of excesses from the credit boom and a policy orientation that overly relies on credit controls and low fixed-interest rates; prioritises the state sector above private companies and savers; and favours forbearance and support over restructuring. In this light, recent problems could be only the beginning."
And where could that shock come from? Well how about the collapse of tens of thousands of loss making producers of commodity products for export. A report out on September 9, about the crisis facing "Sock City," a new town that became the centre of China's sock industry demonstrates the problem. Sock producer Xu Liele claims "73 clothing firms have gone under this year, with some leaving behind debts of billions of yuan. Things have not been so bad since 2003, when foreign buyers stayed away because of the Sars crisis." Sock City is small but 73 sets of bad debts in socks in one small town can be multiplied many thousands of times across China as a whole as this crisis continues. At some stage the real economy crisis may well turn into a banking crisis as well.
But there is a secondary aspect of the capital misallocation. I am ignoring the elements of political fraud and corruption raised by the Bo Xilai case. He salted away $1.3 billion and it is believed that some other senior party officials have trousered more (Mr 4%, the former Railway Minister, is believed to have relieved the PRC of $2.8 billion). This will provide much newspaper fodder but the real crisis is in the various bubbles China has created.
The policy of loose money designed to recover from the 2002-3 and 2008 crises prompted some to invest in hard assets but others to back entirely speculative schemes. The Chinese banks have been only too willing to assist. The property market is an obvious disaster waiting to happen. All the major cities now contain office blocks that have never been occupied and never will be occupied but have been traded as speculative counters. Taking this lunacy one stage further China has allowed the construction of near ghost new Cities. In 2010 there were an estimated 64 million empty homes in China. And yet 20 new Cities were being built each year and property prices in established Cities moved ahead fast. In Shanghai between 2005 and 2012 second hand house prices increased in value by 73%.
But the real lunacy is in the ghost towns - vast new creations of homes which lie empty. One million people were meant to live in Ordos in inner Mongolia. All the flats and houses have been sold to investors. But it lies empty. At what stage to the investors earning a negative yield (after maintenance costs) on an asset that will never generate a cent in cash realize that it is worthless? This is a bubble.
But housing and office space is only one bubble of many. Perhaps the most ludicrous is the great walnut bubble. Prices of this nut (supplies of which are virtually unlimited) have gone up by 1000% in a decade as it has come to be regarded as a hot alternative asset class. This is the lunacy of the Dutch tulip bulb bubble of 1637 transplanted out East. The full gory details of this insanity can be found here.
With all bubbles it is not if, but when they burst. When the various China bubbles do burst the knock on effects on both the real economy and the banking sector are not going to be good. For the latter it will be yet more bad debts to write off against balance sheets that look increasingly stretched. For the former it means ever weaker domestic demand.
The China bulls argue that mammoth fiscal and monetary stimulus will turn things around. Neither policy will cure the problem of capital misallocation. If anything they will make it worse as cheap money is pumped into Walnut accumulation, etc. The bubbles may be sustained and allowed to grow a bit more (making their final implosion even more dramatic) but the real economy needs a revival of exports not domestic stimulus. Indeed given easy money but an economy that is facing a dramatic implosion there is no evidence that this cash will be invested or consumed.
China bulls also argue that much of this is discounted in a domestic stock market valued on just 11 times historic earnings. I would disagree. In 2011 the economy was still growing rapidly. In 2012 and 2013 corporate earnings across most sectors will collapse. In many industries few firms are profitable at all. Earnings visibility for the Chinese market right now is minimal and thus it cannot be viewed as a value investment. I would add that, by weighting, 40% of the Shanghai composite Index is in financial stocks where there have to be real concerns about viability for many companies, let alone earnings visibility.
As an investor I have never felt the need to have China exposure. I simply do not trust economies where capital is largely allocated by the state. And the one-child policy means that its long-term demographic profile is not that attractive either. But even if I believed in the long-term story, right now I'd be selling all my China-related assets and looking to return in early 2014 or perhaps a bit earlier, after the crash that lies ahead. In Part two of this piece I shall make some specific investment calls for those who share the view that a hard landing in China in 2012 will rapidly turn into a crash.