No Soft Landing For China

by: The Independent Investor

Wow, it was just September when most stocks levered to the Chinese market seemed to have no bottom. With evidence of a massive bubble in commercial and residential real estate developing across China, stocks tied to the Chinese construction and housing industry were in free fall. At that time, just a couple months ago, China's export-based revenue was still holding up strong. Despite weakness in many economies worldwide, China's economy seemed to be fairly stable since domestic consumption and export revenues were holding up relatively strongly.

That has changed now, and changed significantly. With recent economic data released showing that the Chinese PMI has dropped below 50 twice for the first time in several years, it is becoming increasingly clear that China is being affected in an increasingly negative fashion by the slowdown in retail spending in Europe. China is now facing a dramatic slowdown in its construction industry and is seeing significantly less revenue from its export sector than was previously expected earlier in the year. This is the primary reason why the central government recently warned of a shrinking annual trade surplus, and Chinese and other central banks have begun easing for the first time in several years.

Now, what is interesting to me about much of the commentary about China's economy coming from the West, is the premise for the belief that Chinese central bankers will somehow engineer what has been termed a "soft landing." This soft landing theory is based on two basic ideas. First, China has a huge cash surplus of over a trillion dollars, and can use this "cushion" to increase economic growth very quickly if need be. And second, since China is not a democracy, the country's central planners will be able to quickly adjust their monetary policy in ways not possible in the West.

The first claim is a myth, and the second is borderline ridiculous. While China does have a large surplus on paper, consider the following. When China wanted to dramatically increase its economic growth rate over the last couple years, the primary way the country was able to do this was by enabling regional governments and banks to borrow at ridiculously low interest rates to fuel growth in the construction and housing industries. Since consumer spending in China today only comprises about a third of the country's total GDP, the construction and housing sectors were the easiest industries to target for growth.

However, now that the boom period is over and the housing units are overpriced and overbuilt, most regional banks and governments are holding huge debts on their balance sheets. Also, and I think this is under-appreciated by many in the western press, with nearly half its population living on a dollar a day, and high unemployment in urban areas as well, China has social concerns that most Western nations do not. Additionally, since China lacks a social safety net in the form of government programs like Social Security, Medicare, or even temporary programs like unemployment insurance, the government may have to significantly increase spending fairly quickly if the growth picture does not improve.

So, with the flexibility of China's surplus in doubt, let's look at the theory that these communist central planners will softly and skillfully land the world’s second largest economy, with their nearly 10 years of extensive experience. Again, I think it is important to start this argument off by looking at the recent past. These are the same central bankers who kept interest rates far too low for too long of a time period, and fueled unnecessary inflation in a number of asset classes and a housing bubble. Also, the Chinese central banks operates in near total secret, and does not have anywhere near the experience of central banks in the West. Finally, with the largest part of China's economy still earns its revenues by export, it is worth asking how much influence these monetary policies can really have on an economy that is now getting hit the hardest by slowing consumption in the West.

To conclude, Chinese equities are down nearly 30%, and appealing long-term investment opportunities certainly do exist in the Asian and Western markets. Still, given that China is now facing a severe debt problem, in addition to seeing slower domestic growth and lower export revenues, investors should be cautious. The Chinese surplus could quickly become a deficit if the Asian economies continue to deteriorate. While the West has its own set of problems, it is worth asking how effective central planners in China will really be if their economy continues to deteriorate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.