All The Best Cowboys Have Their Eyes on China
The GFC story keeps spreading and spreading and the many headlines it has spawned are like the snake heads on Medusa’s head. This one comes from Pleiades. We all ought to be a bit more discerning about what the economic picture coming out of China looks like. Of course it’s easier said than done and everybody has a fragmented picture of what this could mean.
The reality is that a part of China’s growth has been an illusion. Since 2008, China’s headline growth of 8-10 per cent has been driven by new lending averaging around 30-40 per cent of GDP. Given that (up to) 20-25 per cent of these loans may prove to be non-performing, amounting to losses of 6-10 per cent of GDP. If these losses are deducted, Chinese growth is much lower.
The China economic debate is focused on the alternatives of a soft or hard landing. Both scenarios assume a slowdown in growth and transition to a troubled maturity.
The case for the soft landing assumes that the investment and property bubbles are less serious than thought. Beijing has sufficient financial capacity to boost growth by loosening monetary policy and bank lending, while adjusting specific policies, such as lifting restrictions on housing sales to prop up prices. China is able to boost domestic consumption, replacing investment as the key driver of its economy. Excess capacity is gradually absorbed as the world economy recovers.
Growth comes down gradually, without causing social and political disruptions.
The case for the hard landing assumes the rapid and destructive unwinding of asset price bubbles and problems within the Chinese banking system. A poor external environment and losses on foreign investment exacerbates the problem. Growth collapses triggering massive social unrest and political tensions.
The end of a cycle of debt and investment driven growth is typically disruptive. Japan’s experience, which China has drawn on in shaping its economic model, is salutary. Japan grew by 10 per cent in the 1960s, 5 per cent in the 1970s, 4 per cent in the 1980s, and has remained stagnant since, adjusting to the deflation of its debt fuelled bubble.
A bit reductionist, but you get the picture. China’s taken on a whole heap of debt and shoved it into infrastructure that is not needed immediately in order to stimulate the economy. If and when those debts come home to roost, then China’s going to have a big credit crunch all of its own making. But let’s say for the moment that is abject pessimism. What are we looking at right now?
The latest SMH headline on China has this article saying:
“The point is to make sure there are smooth liquidity conditions that are supportive to growth, but not necessarily a very aggressive easing that would invite future inflation risks,” HSBC China economist, Sun Junwei, told Reuters.
In other words, a decision to ease monetary policy is not necessarily about having snuffed out inflation risks at all. Indeed, those risks start to loom larger barely six months from now, and grow even more intense when inflation is viewed as an expression of economic constraint – too little supply relative to demand – rather than expansion.
China has a shrinking labour force, mandated double digit wage hikes, an export sector losing its competitive cost advantage and an insatiable thirst for raw material imports.
“With China’s working-age population set to decline steadily from 2012 onward due to retirement, the notion that a minimum of 8 percent GDP growth is necessary to sustain full employment and preserve social stability is now outdated,” analysts at Nomura said in a note to clients.
It also means that inflation pressure will build at a much lower rate of growth going forward, a fact unlikely to be lost on China’s leadership, which has seen periods of high inflation often coincide with protests and social unrest.
That actually doesn’t sound as neutral as it is written. Reading it in the context of other articles, a picture emerges where China’s economy could actually stall, if not tank.
Coincidentally Skarp sent in this article which has this tidbit:
But sooner or later there has to be a reckoning. Australian real estate prices have grown out of line with the rest of the world and, more importantly, ahead of even the strong growth in Australian income.
If China has a medium-to-hard landing – and the China boom is not likely to extend past the next few years in its current form – the bloom will come off the Australian economy.
If people start losing their jobs, and are unable to pay their mortgages, it will start creating problems in Australia’s credit markets. That, in turn, could begin the process of finally rectifying the growing imbalance of debt to income in the Australian economy.
Yes, the writing’s on the wall. China probably can’t continue its boom in its current form, which means at some point it’s going to have to have some kind of landing – and knowing they’ve never tried one of these landings before it will likely be a hard one. Should that happen, Australia will be in for all sorts of fun and joy.
Now, it has to be said that whatever is going on right now is not some sustainable ‘new normal’. We’re effectively living in an insulated bubble but one that is destined to pop.
Japan, In The Headlights
Just before the last little bit in that link from Skarp, there’s a discussion on Japan I also want to touch upon briefly.
One other thing that has provided stability in Japan and solace for investors in Japanese bonds has been Japan’s consistent current account surplus. However beginning before, but obviously accelerating after the earthquake, tsunami and accident at Fukushima, Japan has seen its trade balance decline sharply. The reactor meltdowns and subsequent closure of the vast majority of nuclear plants has forced Japan to aggressively shift away from nuclear base load power. But that has meant it has had to pay a lot for LNG, oil and coal for its power generators.
Last year, Japan’s ran a full-year trade deficit for the first time since 1980. The just released data for January show that Japan also ran the largest single month full current account deficit (in unadjusted terms) since the oil shocks of the 1970’s. In addition preliminary data show Japan on track for another trade deficit in February, despite it being traditionally the strongest month for trade performance.
Now, one of the things that the market relies on for Japan is that it is a net saver because it runs a current account surplus – take that support away and the market’s sentiment on Japanese debt sustainability could change very quickly and very aggressively.
We think a Japanese crisis is going to happen – there are some clear warning signs. And we think it will happen sooner rather than later. At present, the market view is that a Japanese crisis as an impossibility because there is so much committed capital that relies on stability that there is a cognitive bias and willful blindness to the risk that it will blow up in their faces.
If that Japanese Crisis mentioned towards the end happens, it will trigger big problems for China, because China holds a lot of Japanese bonds as well. So all the things people are living in fear of about China, will be on the cards. So the question about Japan is when is this going to happen? Some people are saying 18 months but if Noda calls an election, it might be in 6months that the crisis will be in full bloom because basically, Noda doesn’t have a mandate to be raising the consumption tax and he knows it; but the electorate is dying to dispatch the DPJ, so all of this year’s policy agenda in Japan is looking unstable, if not outright impossible.
If they’re forced to the polls and it produces another LDP led government, things could get really bad up north.
A year on from the Tsunami and Fukushima nuclear disaster, we’re looking at a serious maelstrom brewing.