Eight months ago I warned that the China slowdown would be much worse than expected. I suggested the Wall Street parlor game of China economists daintily trimming their GDP growth estimates from 7.5% to 7.3%, etc. was fairly ridiculous because the figures were fictitious. Today on Bloomberg Radio, this view was supported by Leland Miller of China Beige Book, whose firm regularly surveys 2000 China business.
Since our last post, the incremental news on China has been worse than many observers expected. I expect that to continue to be the case. Some Wall Street firms forecast a rebound in GDP next year, but I think that is very unlikely. It is extremely difficult to reposition an economy from being driven by exports and government-sponsored investment to being driven by private consumption and private investment. Japan tried to do it in the 1990s, without success.
What I wrote Eight Months Ago (Which Still Looks Right to Me)
I know almost nothing about China, except what I read in The Financial Times. But what I read is pretty scary; if you apply a little logic it is reasonable to conclude China growth will be much worse than current consensus. Yesterday in an FT column, “wise man” Gavyn Davies made these salient points:
- China will need to spend several years tackling a combination of excess credit and overinvestment.
- China is in the midst of a classic credit bubble. The ratio of total credit to GDP has climbed from 115% in 2008 to 173%, a danger level.
- The debt service ratio in the economy, which the Bank for International Settlements says reliably signals risk of banking crisis, is around 39% (according to SocGen). The danger level is 20-25%.
- Much of the credit financed “low return” capital spending by local governments—i.e., the Chinese equivalent of Alaska’s “bridge to nowhere.”
- The arithmetic to get a soft landing is “formidable.” Private investment growth needs to slow to about 4% in the next decade from 10% in the last decade.
- On the bright side, government has the money to capitalize the banks if necessary.
It gets worse. The latest figures on exports and imports were much weaker than expected, which is not surprising because all of China’s major markets are growing slowly, if at all. The FT quotes a “spokesman for the customs administration” as saying, “Our country is facing serious challenges.”
So, to summarize, the two major drivers of China’s growth, exports and investment, are slowing sharply. A credit bubble is being popped. And much of the credit growth of the past few years funded government projects which, by definition, were made at least partly for political not economic reasons.
Even if the government has the capital needed to prevent a “China Syndrome” meltdown, we can expect Wall Street economists to keep ratcheting down their forecasts—a lot. For the past couple of years the major Wall Street houses have been playing a dainty parlor game of cutting their China GDP growth forecasts 10 or 20 bps at a time—7.5%, 7.4%, 7.2%. My guess is that, before they are done cutting, they will be debating whether growth is above or below 5%. Even competent, well-managed governments of giant, sprawling nations that are simultaneously grappling with a credit bubble, overinvestment by governments, and a sharp slowdown in exports should not be expected to engineer an oh-so-soft landing in GDP growth.
March 2014 Post Script
The recent export figures and PMI data have been very weak, which is not too surprising because most export markets have been soft. The Ukraine crisis won’t help. Real estate prices are rising more slowly. The government has said it will permit some bond defaults, which won’t be great for investor confidence. Obviously it is not easy to shift the economy toward consumptions when consumers are seeing real estate values soften.
I continue to be impressed by the opacity of the China situation. Just how bad are the loans made in the “shadow banking system?” In my experience, when credit bubbles unwind the news is always worse than expected. I am reminded of a Citi executive who said after the last crisis is, “After you get an estimate of the haircut in asset values, the first thing you do is increase it 50%.”
Copyright 2014 Thomas Doerflinger. All Rights Reserved.
