China Is In Trouble

For a weekend reflection consider this excellent piece published in Caixin, Andy Xie describes the two edged sword that will soon swing back on China's economy.

Dealing with a Double Whammy

In the past decade China gained Western jobs and exports markets, but the loss of both means that serious systemic flaws are being laid bare

By most measures China's economy has slowed quickly since the last quarter of 2011. Electricity production, the National Bureau of Statistics reports, grew 1.7 percent in April and May from last year. Over the past decade the annual growth rate was 12 percent. Also in April and May, the railroad ton-kilometer figure grew by 1.3 percent compared to the same months last year, down from the 6 percent growth seen from 2005 to 2011.

 

Due to the resulting decline in commodity prices, the inflation situation has improved, which lessens pressure on the household sector. At the same time, the slowdown has not caused widespread reduction in employment. There may be some impact on construction jobs already, but, as the labor market was very tight before the slowdown, the employment picture remains healthy.

 

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

 

State-owned enterprises reported 11 percent growth in sales but 10 percent decline in profits in the first five months. Private enterprises may have fared worse. It appears that the slowdown has impacted government revenue and business profits rather than labor income.

 

Asset markets have fared badly this year. The stock market is depressed. Despite some pickup in the last two months, the property market is depressed and may remain so for several years. As the slowdown disproportionately hits business profits, asset prices will likely remain depressed.

 

Declining Efficiency

Government spending plus SOE investment already exceed half of GDP, while household consumption is about one-third of GDP. The world has never seen such lopsided distribution between the state and household sector. Modern economic history demonstrates that government economic activities have low efficiency. Hence, government involvement in the economy should be limited to where the market doesn't work well. When SOE sales are 78 percent of GDP, the government obviously dominates the economy. Rising inefficiency is inevitable.

 

Many argue that China has been growing rapidly, hence the system must be pretty good. This view is misguided. Rising inefficiencies in the state sector were offset by rising export proceeds. The latter kept the economy's cash positive. The Chinese people paid the price by accepting wage increases below productivity growth. The difference was used to pay for the state sector's rising inefficiencies.

 

High inflation in the past three years, as reflected by near double-digit GDP deflator – the broadest gauge of inflation – reflects that lower wage growth is no longer sufficient to offset the increase in the state sector's inefficiency. China's inflation is always a tax on the household sector. There has been no exception. The tax inevitably pays for government expansion and/or SOE inefficiency.

 

The reason for the above is that Western economies are falling. In the past, they lost jobs to China and borrowed to support consumption. China benefited from both, gaining jobs and exports. The double benefits covered up lots of domestic problems. As the bond market no longer supports such unsustainable spending in Western economies, their demand has fallen and China's exports have fallen with it. At the same time, China's market share of global trade is so high that increasing it is difficult because the West doesn't have many jobs left to shift to China. The double benefits China enjoyed have become a double whammy.

 

Without another export boom, China's domestic problems are exposed. If the government tries to stimulate the economy by increasing money supply, more inflation and declining efficiency will result because the stimulus money mostly ends up in the state sector and export revenue won't rise sufficiently to pay for rising inefficiency.

 It is my view that commodity prices are quite vulnerable due to rapidly decreasing demand from China's manufacturing sector. 


Copper looks particularly fragile.


Unless I am missing something, deflation looms large.