China's Problems Impeding Rapid Growth - Part 1: The Cost Of Smog

by: David White


China's GDP has averaged about 8.9% growth per year over the last twenty years.

The smog level in China's ten most polluted cities is about 8 times the level of pollutants in their US counterparts.

An MIT study found that the cost to the Chinese economy of added sickness and extra health care costs due to smog was about $112B in 2005.

This may be nearer $224B per year at the end of 2014. This is a significant negative (-2.5%) for the Chinese economy of about $9.24T.

Many people maintain that China will continue growing at the incredible rate that it has been for the last twenty years. Since the early 1990's China's GDP growth has averaged 8.9% per year. This has led many people to believe China can continue this great growth ad infinitum. It does have a huge, relatively cheap labor force to draw from. More practical people realize that just can't be true. I am attempting to write a series of articles that will cover some of the problems China is encountering and is sure to encounter in the future in its attempt to continue this rapid growth.

One of these problems is the ever increasing amount of smog China is seeing in and around its big cities. The whole world saw how much smog there was at the Olympic Games in Beijing. That was after the Chinese had curbed the smog output of many factories specifically for the Olympic Games. In fact some factories were closed a month prior to the games to give the air a chance to clear. Auto use was curbed too. When you further consider that Beijing is not even on the list of China's most highly polluted cities, you can begin to get an idea of how serious China's pollution problem is.

The following table compares the pollution level of China's most polluted cities to their counterparts in the US.

As readers can see, the 10 worst Chinese cities listed are roughly 8 times more polluted than their US counterparts. The Chinese cities are also much more populated. For instance, Xingtai has about 6.73 million in total population. Bakersfield has about 464,000 in total population. Not only is the pollution much worse; but there are many more people being exposed to it. The World Health Organization's stated acceptable limit is 10 micrograms per cubic meter of PM2.5. All of the above listed cities are above that. The Chinese cities listed are far above that limit.

China is taking action to improve these problems; but many worry the actions won't begin to stem the growing pollution problem. For instance, China expects to take 6 million high emissions vehicles off its roads in 2014. However, China sold about 22 million new passenger autos and commercial vehicles in FY2013. This gives one the impression that the above exchange did not improve the pollution problem. 22 million new vehicles likely provide more pollution than the 6 million old vehicles removed did. Further the other vehicles already on the roads are one year older; and they probably pollute more with age. The traffic congestion problems have probably increased more with the extra vehicles too. With more idling in traffic, there has to be more pollution. China is expected to see 30 million new vehicles sold per year by 2018. This has to further worsen the problem, especially since EV's are not expected to be a large percentage of those new vehicles.

Cities are also expected to grow. About 53.7% of China's population were living in cities at the end of 2013. 60% are expected to be living in cities by 2020. The Chinese expect 90% to be living in cities by the turn of the century. China had a population of about 1.361B at the end of 2013. This is expected to grow.

Many of the cities suffer from surrounding or nearby industrial smokestack output. Hebei province is a particularly egregious offender with respect to pollution. Its steel mills are among the worst offenders. Hebei plans to address its problems in part by relocating large parts of its big polluting industries to poorer countries. It plans to relocate 20 million tons of steel production and 30 million tons of cement production by 2023. These will be going to such places as Africa, Latin America, Eastern Europe, and poorer parts of Asia.

Still one is inclined to think China will find other polluting industries to take the places of the ones being exported. Remember Chinese industry is still growing rapidly, if a bit less rapidly than it had been. Even 7% GDP Growth per year amounts to about +40% GDP Growth over five years. This is easily more than the amount planned to be exported. Further local governments often resist any losses of income. This means that the planned openings elsewhere may only serve to expand total production. They may lessen production (and consequently pollution) in China little, if at all. The Chinese government is more autocratic in dealing with bureaucracies; but it still has a lot of the same problems western countries do. In other words bureaucracies resist change well.

The smog problem hasn't found a solution yet. Instead it will likely continue to contribute to the poor health of the Chinese population that is near the industrial centers. It will also likely contribute to China's growing health care costs. These have risen about 17.0% per year for the last 20 years (from 65.4 Yuan per person in 1990 to 1490.1 Yuan per person in 2010). This is a continually growing number as more Chinese move to urban areas.

An MIT study showed that air pollution cost the Chinese economy only $22B in damages in 1975. By 2005 that number had grown to $112B. The MIT study tries to quantify costs for lost labor (due to sickness) and increased health care costs (above what they would be without the huge amount of pollution). In the years since 2005, I am sure the $112B number has worsened significantly. Doubling the 2005 number to $224B is probably a good ballpark estimate of current costs of smog to the Chinese economy. Further this number does not account for the costs of implementing policies that will cut down on pollution, so the total costs are actually much higher.

China declared war on air pollution on March 5, 2014. China is seeing some results; but China's rapid growth seems overall unlikely to allow a big improvement anytime soon. Don't forget that local governments are resistant to shutting down any industry that is generating jobs and money. China has a long way to go; and smog seems likely to be a continuing (and a worsening) problem for China in near term future years.

This factor along with the many others in this China series I am writing constitute significant headwinds to China's continuing rapid growth. The headwinds will likely have a negative impact on China's stock markets too. Many US investors track these through the use of ETF's like the iShares China Large-Cap ETF (NYSEARCA:FXI). The cumulative severe headwinds from the factors I am writing about are a reason that investments in China seem likely to provide more downside risk than upside risk in the near future.

The ten year chart of the FXI is below.

This chart shows that the Chinese large cap stocks have made overall very little upward headway over the last five years of recovery from the Great Recession. In fact the ETF is still trading for only about 50% of its high before the Great Recession. With many areas around the world experiencing economic problems, the performance of the FXI ETF seems unlikely to see a large upward movement. However, it could show a significant downward movement. For those who disagree, you have an ally in Jim O'Neill, who recently stated it was "ridiculous" to be bearish on China.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.