Beyond the (Great) wall

Despite a sizable part of the investing community expecting a slowdown in Chinese economic growth, I believe the associated risk is still being underestimated. The consensus estimate for Chinese GDP real growth is 7-7.5% this year. I am afraid that to achieve that result a real miracle will be needed. However, what I am afraid we will witness is not an economic but a statistical miracle.

Although I am no expert in the intricacies of Chinese statistics, numerous signs point to the Asian giant’s real growth already being much lower than the targeted number. According to the most recently published numbers, imports for the first two months of the year rose 10% vs. the same period in 2013. At the same time, exports were 1.6% lower than one year ago. While the former number hints at domestic consumption perhaps taking over the role of main economic driver, the latter is a poor result from an export-driven economy. So despite the improving European and American picture, it is not reflected in the Chinese export figures.

There may be several explanations for this. For one, the weight of China’s foreign trade with emerging countries has grown dramatically, especially among those emerging countries in which economic growth has significantly slowed, from which capital is flowing out, which has resulted in a falling off of lending dynamics, which in turn has put a break on consumption. In recent years, the yuan, both in nominal and real terms, has seen its value rise, in the process eroding the competitiveness of China’s export sector. Moreover, the currencies of those emerging countries that are deemed as competitors of China have dramatically weakened, on top of the 20-25% fall of the Japanese yen over the past eighteen months. It is worth noting as well that in a manner not seen in some time, the yuan has begun depreciating against the dollar, which did not even occur during the 2008-09 recession, when the yuan’s response was simply to stop appreciating.

The Chinese yuan’s performance vs. the US dollar (USDCNY)

Source: Bloomberg

Of course, upon seeing this relatively good import data, the question of whether domestic consumption can take over as the main driver of the Chinese economy must be asked. Recently – specifically, since 2008 – growth in new investment projects have outpaced the growth in domestic consumption. Of course in order to achieve that, extraordinary and substantial budgetary and monetary stimulus packages have been necessary. Both have helped bring about the investment boom, the former relatively quickly, the latter gradually over a period of years.

Excess liquidity pumped into the system could not leave the country due to regulations and capital controls. Because bank interest rates are capped, and the capital markets lack sufficient sophistication, “hot money” had no other choice than to flow in the real estate market.

Money being readily available, companies, as well as local governments, have readily jumped at the opportunity to invest in projects – often doing so without economic rationale.

It is dangerous, however, to use loans to finance investments that do not generate cash flow, for the time comes when taking out new loans is necessary in order to service the outstanding ones. This is the situation in which growing GDP requires taking on ever larger loans, or, in other words, loans of equal size eventually have a smaller and smaller impact on GDP growth. (In American slang: You get “less bang for your buck”.) Of course everything is fine as long as the supply of new loans grows at a faster pace than GDP (or at an ever increasing pace).

But nothing can grow indefinitely – as my friend, Fizikus (Physicist) brought to my attention the other day. This is the inherent problem with exponential functions and models based on them. China is no exception.

What are the signs hinting at this? In the past few months, a lot has been written about the increase in the interest rate on the Chinese interbank lending market – this is undoubtedly a warning sign. Also worrisome is the slow crawl higher of Chinese corporate bond yields (for domestic purchase), which means that for companies in China the price paid for rolling over debts is more and more expensive. The real estate market has also put on the breaks: year-on-year, in the first two months of the year, sales of residential properties have fallen off, and the number of housing construction starts has decreased. Also worth watching is the underperformance of those resources required for the capital-intensive Chinese investment projects (natural resources, which include industrial metals and coal; as well as mining stocks). The price of copper, which usually is a good indicator of what is happening in the global economy, is also countersignaling an uptick. So even though it is difficult to peer over the Great Wall, the signs of a slowdown can already be seen.

Copper prices on the futures market (USD/100 lbs.)

Source: Bloomberg

The Chinese economy – if the numbers of the statistical office can be believed – in the last seven years (2007-2013) in real terms grew at the following annual rates: 11.4%, 9.1%, 8.5%, 10.4%, 9.3%, 7.7% and 7.7%. It can be clearly seen that the rate of economic growth was slowing. From 2007 to 2009, growth dynamics fell off by nearly three percentage points, while – in my judgment – the Chinese economy was in better shape then than it is today.

In the past five years, the debt of the entire Chinese private sector (total debt minus the national debt and the debts of the finance sector) rose by $18 trillion, representing 70% of the GDP. This brought total debt levels over 200% of GDP.

(For the sake of comparison: a proportional GDP-credit expansion in Hungary would require the Hungarian National Bank to expand the  Credit Program for Growth from the current 2.5 trillion HUF to 20 trillion HUF in five years.)

As of today the total balance sheet of the Chinese banking sector has reached 270 percent of GDP. This is an unbelievably huge credit expansion for such a short time span, the likes of which few have been seen in history. A few of these are shown in the diagram below.

GDP-proportional non-financial credit expansion of a number of countries in the years before a credit crunch

Source: GMO

What is common among the countries in the diagram is that a major recession followed the swift expansion of credit. In other words, the credit bubble popped. In the United States, the change in annual GDP went from 1.8% in 2007 to -2.8% in 2009. It is difficult to believe that if the credit bubble popped in China, there would not be a similarly-sized GDP slowdown. Which is to say, the pace of real growth could fall some 3-4%. (It is another question entirely whether the statistics would reflect this…) This will be especially true if Chinese President Xi Jinping remains committed to the economic policy that he promised to the Central Committee of the Chinese Communist Party in November. In simplified terms, it looks as if China may abandon Keynesian economic policy, and instead follow the economic policies of the so-called “Austrian School”, the point of which is that the government should not interfere with the economy’s cleansing process – accepting the short-term pain involved – for the benefit of the long-term health of the economy – meaning that those firms that cannot service their debt go bankrupt, and excess capacity is purged for the system. Confirming these intentions, in recent days Prime Minister Li Keqiang made a statement to the effect that the bankruptcy of a few local government- / state-owned companies was “unavoidable”. It is rare to hear a politician (two in this case) talk like this. What is even rarer is to see the politician allow it to happen. The proof is in the pudding, as they say, and we will have to see how the Chinese leadership reacts if a wave of bankruptcies hits. Based on what we have seen so far this year, we may conclude that resolve perhaps could weaken, and if something very bad happens (major instability in the financial system, for example) the state will offer a helping hand (in the form of monetary and fiscal stimulus) to the troubled debtors. Even if it comes to that, China can still expect a significant economic slowdown. More significant than what the majority of investors would expect.

How are these expectations being priced in? Some assets have already priced in the brunt of the risk of a Chinese slowdown, for example, natural resources, the currencies of certain emerging markets and Chinese stocks. The Shanghai Composite Index is today barely above the 2009 bottom. In my opinion these assets are no longer worth shorting (despite the fact that if things do not work out, they certainly could fall further).

The performance of the Shanghai Composite Index

Source: Bloomberg

There are numerous stocks in developed markets whose profit growth over the past five to ten years has come via the strong economic performance of China and other emerging markets. This rapid international growth has not only been reflected in sales, but in many cases the profit margins have been higher for good and services sold in developed countries. The slowdown (through declining lending activity, weakening currencies, more expensive imports and diminishing household purchasing power) in China and more generally the developing world could be very painful for these companies. However this slowdown risk is not yet reflected in the stock price of numerous stocks trading on stock exchanges in the developed world.

The faith placed in an improving European economy is manifesting itself via continuous capital inflows; for several months now, investors have been buying European and American stocks. In the beginning the buying wave had lifted all boats, even those that have sprung leaks in the meantime. Ever so slowly though, the slowdown in China will begin to have an impact on more and more assets. The German DAX, sensitive indeed to events in China, has plainly underperformed (of course the strong euro has also played a role in that) this year, as have stocks of companies producing luxury items. As mentioned above, there are reasons for this.

Many investors have compared the current situation to the latter half of the 1990’s. At that time, despite successive recessions in the emerging markets (Mexico, Brazil, Asia and Russia) developed markets saw spectacular results. Thus it is that optimism continues to run high on developed markets. The current situation, however, differs from the one fifteen years ago in that emerging countries now play a much larger role (twice what it was then) in the world economy and global commerce. The significance of the emerging world has surged, while the European economy is now more open than ever. All this points to a Chinese (and in general a emerging market) slowdown being more painful for the developed world in general, for numerous European and American companies specifically, and as a consequence, for stock market investors. Therefore, for the latter, it would be worthwhile to decrease exposure.