The Chinese economy experienced a reversal in momentum over the past couple years as the Chinese government unleashed a combination of ultra-loose monetary policy and huge fiscal stimulus. These initiatives changed the narrative of China in economic decline that was hard to escape in 2015 and early 2016. These initiatives also gave Xi Jinping the political capital to seize an unprecedented amount of authority by modern Chinese standards as Chinese citizens and the global investing community began to believe the illusion that China is on a sound path for prolonged growth.
In reality, all of the initiatives pursued to boost the Chinese economy in late 2015 and beyond were inherently unsustainable. The results of these initiatives, while undeniably positive by short-term growth metrics, were disappointing relative to the scale of the stimulus unleashed over that period and have had limited lasting effects beyond the mountain of debt left behind. Now, with this stimulus waning off, the world will have to come to terms with what the Chinese economy looks like when the government isn't doing everything in its power to artificially boost the economy.
While many sectors of China's economy (technology, healthcare etc.) are primed for long-term growth without any need for stimulus, there are sectors (primarily property) and regions (primarily the northeast) where recession is inevitable in the absence of large-scale stimulus. This is the result of years of politically-driven, unrelenting investment in sectors and regions where the growth engines of the past are no longer relevant. While it may have once made sense to build ghost cities and subways to nowhere in the hopes that an urbanizing and growing Chinese population would eventually fully utilize them, under the current backdrop of slowing rates of urbanization and a working-age population in decline, the rate at which cities and infrastructure were developed in the past is no longer appropriate.
In a managed economy, these market forces and feedback loops don't always impact change right away. There are political considerations such as what to do about the citizens currently working in a dying industry or how to deal with the tensions in a region in decline. These considerations enable politicians to allocate capital to regions and industries in decline, and while these efforts may mask the effects of the decline in the short term, they are entirely ineffective in shifting the underlying supply/demand dynamic that is leading to the decline in the first place. The fact of the matter is that China doesn't need as much real estate construction or as much infrastructure spending as it did in the past. What makes this difficult for China is that it has so much at stake, both in terms of workers with expertise and outstanding loans that need to be paid back in these sectors. The inevitable contraction that will occur when these market forces take hold will displace workers and lead to significant write offs in debt issued to these sectors.
That being said, Chinese leadership understands that these market forces are not going away. After pumping its economy with stimulus during the politically sensitive time period of 2016-2017, Chinese leadership is once again comfortable letting market forces run relatively free (The 19th Party Congress in which Xi Jinping renewed his term and expanded his authority occurred in October of 2017). This has led to a clampdown on lending which has had a particularly rough impact on property developers that have been reeling for financing options ever since. Property players that were building and selling like there was no tomorrow in the boom of 2016-2017 now find themselves tightening purse strings to make ends meet. This is having a significant impact on new investments in the industry:
After a boom driven by loose financing rather than fundamentals that occurred during 2016 & 2017, investment in real estate construction is contracting for the first time since the measure began to be published publicly beginning in 2005. This contraction is the response to years of overbuilding relative to demand and is being catalyzed by a decline in credit growth. This is also no drop in the pond for the Chinese economy as the property sector directly comprises about 10% of total GDP and significantly more when considering all of the ancillary functions that support the sector.
There has also been the realization that many of the infrastructure projects built out in earlier fiscal stimulus packages are not financially viable as there is not the population to support them. As an example, check out the Chongqing metro stop, a line that cost billions to create, millions to operate annually and is chronically unprofitable due to insufficient demand. This project is emblematic of current infrastructure spending in China. While projects like these previously made sense in China with a rapidly growing and urbanizing population, they are no longer viable under current demographic trends. The central government is responding to this by only green-lighting projects that are financially viable, of which, there are very few. This is having a significant impact on growth created through fiscal stimulus:
Investment completed by state-owned & controlled enterprises serve as a proxy for trends in infrastructure spending and fiscal stimulus more broadly. As Beijing comes to grips with the fact that the spending through fiscal stimulus programs has not been effective in creating lasting economic growth, it has tightened its strings on local governments which are having a dramatic effect on spending growth by state-owned & controlled enterprises. After the politically driven boom in 2016 and into 2017, investment growth by government-controlled entities is slowing to a rate not previously seen in modern China. This trend will also have a dramatic effect on the Chinese economy as a whole as investment completed by state-owned & controlled enterprises amounted to ~27% of GDP in 2017.
Both of these trends are extremely bearish for commodities as China consumes the majority of many of the world's commodities and the vast majority of China's commodity usage is for residential construction and the development of infrastructure. There's also reason to believe that these sectors of China's economy will continue to slow in the near future.
The fact of the matter is that there is massive overcapacity in property and infrastructure, so as long as market forces are at play, we will see contraction in these sectors. The only way to stop it is through yet another massive stimulus program, which does not appear to be on the horizon.
First off, Chinese leadership is uncomfortable with the rate at which debt is rising as well as many of the unscrupulous ways in which this debt is being issued and marketed (See Wealth Management Products, Peer to Peer Lending etc.). The Chinese government has clamped down on many of these unstable lending schemes and this is having a dramatic effect on lending in China:
Total Social Financing is falling:
Total Social Financing refers to the volume of funds provided by China's domestic financial system to the private sector. After a government-sponsored boom beginning in late 2015, we are starting to see TSF decline on a YoY basis. While declining trends here are a necessity for the financial de-risking of China, they bode poorly for Chinese growth going forward as the growth in sectors such as property & infrastructure are entirely dependent on credit growth.
China is also limited in what it can do to stimulate lending at this point in the global economic cycle. The U.S. is tightening quite a bit:
Which makes it difficult to loosen monetary policy in a significant manner and risk having capital leave the country to higher rates abroad, especially at a time when the yuan is under so much pressure:
To summarize, China's demand for commodities will continue to decline as its property and infrastructure sectors contract in response to the massive overcapacity that was the result of previous stimulus programs. The only way out of this contraction is another stimulus program which is unfeasible for both political and economic reasons at this time. Xi can't appear to be weak and go back on his efforts to de-risk the economy, and China can't afford to loosen monetary policy significantly and have the yuan continue to depreciate as money leaves the country. The best response to this for investors is to short commodity producers as they are the most exposed to the inevitable contraction in these sectors.
Disclosure: I am/we are short XME, VALE, MCHI, EWH, BTU.
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.