Minimal Volatility In Chinese Economic Data

by: Michael Roat

China's data reports are incredibly consistent, smooth and have recently nearly exactly matched expectations.

The Chinese government has an important interest in managing expectations and maintaining market confidence in their economy.

In China, it is requiring increasingly more debt to power economic growth because of diminishing returns in investment driven growth models and overcapacity.

The Chinese credit engine is running on low fuel as shown by the increasing incremental capital output ratio. There is a debt bubble and economic growth to service it is slowing whether the Chinese government wants it to or not.

There are numerous reports of local Chinese governments falsifying economic data.

The Chinese since the GFC have engineered a massive infrastructure and investment driven, construction-driven economic growth model. It worked wonders in the beginning and provided a huge influx of new credit and demand to the economy. The problems began when each new unit of investment demand in the economy began producing diminishing returns to GDP growth. Currently it is requiring over three times more fixed asset investment to produce each respective unit of growth. The model has run out of steam, but Chinese authorities have continued to push it further building a major debt bubble with slowing growth to service it. This is why the authorities in China have a rebalancing and deleveraging plan.

The plan, albeit quite optimistic, goes as follows. The Chinese consumer picks up the slack from declining and inefficient investment demand. Credit expansion and growth increase from consumption as the indebted sectors of the economy such as corporates and SOE's which have taken on massive debt during the infrastructure build out, deleverage. This would result in a beautiful rebalancing for China.

The other scenario is the hard landing where slowing GDP (income) growth, higher unemployment, and decreasing household net worth creates a barrier for the proposed consumer rebalancing. Slowing GDP growth and potential financial instability may very well bring down consumption with it. In this case, increasingly inefficient investment demand with slowing consumption demand would be a negative for China.

If this consumer rebalancing does not come through for China in the near term, growth could drastically slow with financial stability concerns arising. Again, the reason is inefficiency in investment demand at the current stage of the investment-led growth model. This is producing more and more debt with less economic growth. Remember, China is a totalitarian nation and a command economy. The plan was to stimulate credit expansion and economic growth through increased fixed asset investment in the economy. This was in the form of infrastructure, real estate and corporate capacity. It worked, but is largely more of a one-off effect, not a sustainable growth model.

It is highly questionable, whether China has truly stabilized at 6.8% or the authorities are trying to maintain a semblance of stability. If the incremental capital output ratio is on an uptrend, which means it is requiring more investment debt for each unit of GDP growth, then growth will slow as the authorities either 1) try to rein in debt by slowing inefficient investment or 2) push it to even more diminishing returns.

I've presented multiple bearish articles on China and maintain confidence in the thesis. I believe a non-performing loan and banking crisis will be at the center of the event. Corporate Chinese debt is at 170% of GDP and servicing capacity could decline as the economy slows. China could pull off a near miracle perfectly-timed consumer rebalancing and I believe over the long run the rebalancing will succeed, but first I think there will be a hard-landing. When China recaps its banks I will be more optimistic, but it will get worse in my view in the near term. The slowdown in investment-led economic growth will likely pull down consumption with it, through weak income growth and employment.

According to the New York Times,

But measuring the size and health of the world's second-largest economy can be difficult at best. Its official figures have become implausibly smooth and steady, even as other countries post results with plenty of peaks and valleys. Officials in far-flung regions are admitting their numbers are wrong. And outside experts crunching the data have come up with different - and usually weaker - results.

Reuters reports multiple local Chinese governments overstating revenue and other data. I believe the market is very sensitive to China-related events and investors can look back to 2015 and early 2016 when these concerns were at the forefront of the market. Non-performing loans are also understated by a significant amount according to Credit Lyonnais and Fitch credit rating agency.

Disclosure: I am/we are short GG, FCX, ABX, CLR, RGLD, WPM. 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.