Seeking Alpha

China's One-Off Construction Boom

|
Includes: FXI
by: Michael Roat
Summary

In China it's requiring more and more fixed asset investment (see government infrastructure and SOE capacity investment) debt to produce each respective unit of growth.

China's construction and capacity investment boom was largely a one-off for both China and the global economy and accounted for 40% of China GDP growth.

China investment/construction-led credit engine is facing severely diminishing returns and cannot be counted on to further increase Chinese growth in a significant manner.

The common argument is the authorities in China will not allow a disorderly decline. My response is this is something that's going to happen to them, not something that will be allowed to happen.

When it is fully understood the size of China's construction and corporate capacity build-out, it becomes obvious that it will not end well.

China's (FXI) investment-led credit engine is out of steam. There is a difference between investing two yuan to achieve one unit of growth and investing thirteen yuan to achieve the same one unit of growth. That is the significance of this proposition. The diminishing return effect in investment-led economic growth models is real.

The construction and capacity boom in China has led to an oversupply of real estate and excess corporate industrial capacity. Real estate prices are rising purely on excessively optimistic speculation, not true future supply and demand fundamentals. China's government is implementing and has already implemented restrictions on home ownership to cool speculation. This is going to have an effect on home prices as well as on oversupply. I expect Chinese home prices to decline. China is known for ghost cities that are built but not yet populated.

China's corporate debt is excessive at 170% of GDP. There are numerous SOE companies that are reliant on new funding to repay debt. If profits were to turn down, which is highly likely given the secular growth decline and overcapacity, Chinese corporations could struggle to repay debt, which would also increase the banking system's non-performing loan problem.

If one thinks China can maintain 6% growth to infinity, they need to reconsider. China is growing at 6.9% because the economy was juiced with an unsustainable construction and capacity build-out fueled by a lot of debt. There is going to be a semi-disorderly unwind and restructuring of the economy and financial system or an economic reset.

This Chinese reset would involve lower interest rates, a depreciating yuan boosting export competitiveness, lower taxes, higher unemployment, higher non-performing loans, faltering wealth management products, and the need for a banking system recapitalization. I am not predicting the end of China and I don't think it will amount to a 2008 type crisis, but markets can be counted on to exaggerate. In fact, though I think after China recaps its banks, it will signal one of the greatest times to invest in China. Unfortunately, it will get a lot worse in the near term and investors can simply look back to 2015/early 2016.

I believe Chinese corporate bonds are on the cusp of a crisis and the banking system looks vulnerable especially if unemployment rises. Again Chinese corporate debt is at 170% of GDP and a large amount is denominated in U.S. dollars, which I expect to appreciate. As the Chinese government begins to rein in capacity investment-related debt, there are going to be negative filters through effects to employment.

China has avoided the hard process of restructuring the economy until after the political reshuffling this month. Once the current leadership is ensured, the process of unwinding and rebalancing an over-leveraged economy will occur. The authorities will be more willing to tolerate financial instability after the politics this month.

It's quite clear there is a necessity in the Chinese growth model for massive construction and investment demand. I believe while infrastructure and corporate capacity investment can create beneficial economic effects, it has gone too far in China. China is a totalitarian nation and the state-owned enterprises carry out the wishes of the government. The plan was to build as much as possible.

Now everything is built and the economy is facing massive overcapacity, high debt, and over-reliance on heavy industry and construction. Investment efficiency has deteriorated to the point where continued investment cannot further increase growth in a significant manner. This is something the PBOC and Chinese government have to face, whether they like it or not.

It's obvious this is a type of financial event that is going to happen to China, not that it will be allowed or welcomed. The argument I often hear is China's authorities would never allow a hard-landing. It's not their choice. The current investment and construction-led growth model is becoming exponentially less efficient while the stock of debt is at an extremely high level and continues to increase. There is not a good option for the authorities in China.

The best way in my view to short the unsustainable China construction, heavy industry and SOE capacity investment growth model is to buy put options on commodity producers. China is a major demand center for commodities and the commodity sector is the direct beneficiary of China's economic build-out. As these trends reverse, commodity prices will likely decline, potentially sharply. Selling or shorting commodity producers also makes sense based on United States' monetary policy and subsequent U.S. dollar and bond yield appreciation as described here.

Disclosure: I am/we are short ABX, FCX, WPM, GG, LNG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: May also short Continental Resources and Royal Gold in next 72 hours.