But Why Cant They…

But why can’t they?

China – our old favourite topic. China has been making a lot of headlines lately…and not for particularly positive reasons. But I don’t want to talk about accusations of trying to implant spies into the Australian government… or their battle to keep Hong Kong under control… or the continued rollout of their “social credit score” system that effectively puts anyone that doesn’t support the government under house arrest…or the systematic rounding up and “reeducation” of Uighur Muslims…

I don’t even want to talk about the increasing number of bank runs occurring among smaller Chinese banks, although that is a very interesting development.

When I talk to people about China, there’s one thing that so often strikes me… how much confidence people have in them. A view along the lines of “…don’t you worry about China… they are a Communist nation and because of this they are in complete control of their country and economy”.

As an example, I listened to a prominent bank economist present a few months ago. A general global economic update. He talked quite a bit about China. For the most part I thought his commentary was pretty good.

He acknowledged the economic challenges facing China – an unbalanced economy…too reliant on building infrastructure and on exports. A need to somehow shift more towards a consumption-based economy.

He acknowledged that their economic growth rate has come down from the dizzying growth we have seen in some parts of the last decade. His message was basically “its all good… the Chinese understand their weaknesses and are working on ironing out imbalances… the lower growth rates should be welcomed as a sign that they are in control and setting their economy on a sustainable path.”

And then he made a comment that really stuck with me:

“…and even at just 5% growth, they will be adding an economy the size of Australia’s every few years!”

What a powerful comment. Adding an economy the size of Australia’s ever few years.

But what does that even mean? Is it even true? I’ve found that really thinking about this presents a useful way to visualise the challenges China faces, economically-speaking.

GDP – a refresher:

Let’s start with a recap of the basics. What exactly is “GDP”? Here’s a definition courtesy of Investopedia:
“Gross Domestic Product (GDP) is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of the country’s economic health.”

So GDP is about measuring the size of an economy by measuring the value of the goods and services it produces.

There are three methods by which GDP can be calculated – the “expenditure method”, the “production method” and the “income method”. If calculated accurately, they will all end up with the same figure.

The expenditure method is the most prominent. It is derived from applying the following formula:

GDP = C + I + G + net exports

Where:
C = personal consumption: spending on goods and services within the private sector
I = private domestic investment: capital spending
G = government spending
Net exports = exports minus imports

Most nations take it upon themselves to calculate their GDP and have a government department that’s responsible for it. In Australia it’s the Australian Bureau of Statistics. In China, it’s the National Bureau of Statistics.

GDP itself is rarely talked about – rarely do we discuss that fact that Australian GDP in 2018 was US$1,432.2 Billion. What we’re all vastly more fixated with is the percentage change from the prior period.

Here’s a look at China’s GDP growth rate since 2000:

Pretty impressive. Just from a visual inspection, I’ll guess the average has been around 8%.

According to the data, China’s GDP in 2018 was US$13,608.15 billion – more than double what it was in 2010. Geez… Australia’s GDP is barely 12% higher than what was recorded in 2010!

So back to our learned colleague’s statement about China adding an Australia every few years…

5% of 2018 GDP is around $680 billion. Australia’s GDP is $1,432 billion. So its true – at a 5% growth rate China would increase its economic output by roughly that of Australia’s economy in barely more than 2 years!

Throughout recent economic history there are observable relationships between a country’s level of “development” and economic growth. Less developed economies tend to grow faster whilst more developed economies tend to grow slower.

Regardless of the stage of development, productivity is at the heart of economic growth. The more goods and services an economy can produce with the same level of inputs – i.e. the more productive it can be – the greater the rate of growth.

As a nation develops, rapid productivity gains are experienced principally via workers exiting the low-productivity agricultural sector to the higher productivity manufacturing sector. Sound familiar? Once surplus labour has been absorbed into the economy (the point economists call the “Lewis Point”), productivity gains get slower and are largely dependant on a country’s ability to absorb technology and move on to production of higher-value goods and services. This requires innovation and the creation of technology.

As I’ve commented repeatedly in recent times, China’s lack of “social capital” such as intellectual property protection laws and a business sector heavily influenced by the government make private sector innovation difficult to say the least.

When it comes to China’s GDP growth, it’s interesting that the result always falls within a quarter of a percent of the government target. This can be explained in two different ways:

The first reason cited as to why GDP always comes in basically as planned is simple – they just make it up! I don’t really need to say much more about that other than there’s credible evidence that the official numbers are fudged.

GDP as government policy:

The second reason relates to what GDP means in China.

For most nations, GDP is simply an output. Sure, the government is generally trying to take actions that stand to improve economic conditions and as a by-product boost economic activity. But at the end of the day, GDP is simply calculated and reported – it is whatever it is.

Not in China. In China, GDP is a specific economic objective. The government decides GDP will grow at XX% and actions are taken to achieve this.

For pretty close to a decade now I’ve been frequently talking about the Chinese economy and very little has really changed. What has changed is a greater understanding and acceptance of the challenges facing China.

Its now widely accepted that China’s economy is imbalanced and the growth path that has got it this far is no longer sustainable. Back to our GDP calculation:

GDP = C + I + G + net exports

As noted above, a large part of China’s growth in the past 20 years has come from putting its vast population to work in factories. Becoming the world’s factory. Net exports have been a large contributor to GDP.

“I” and “G” – Investment and Government – have been the other major contributors. As is well understood, the public and private sector massively overlaps in China – the economy is dominated by state-owned enterprises.

In addition to net exports, we all know well by now that the other “lever” of growth in the Chinese economy is “building stuff” – “I” and “G”. Under their central planning system, the government decides what GDP growth is going to be and then everyone works on achieving that goal.

The easiest way to create economic activity is to build some stuff. Local governments are pressured to create activity in their area and via state owned entities, stuff gets built. Investment in additional manufacturing capacity, new buildings, bridges…whatever.

A recent anecdote – its been reported that China is in the process of planning and constructing new coal-fired power stations that will see it add more generation capacity than all of Europe’s current coal-fired capacity. There’s calls for between 300 and 500 new plants by 2030 – that’s 2 per month for the next 12 years!

Many reporting on this are focused on the environmental side. Indeed, some are wondering whether these plans will invoke the wrath of teenage climate activist Greta Thunberg who delivered a passionate speech at the United Nations earlier in the year scolding global leaders for stealing her dreams and her childhood with their empty words. Yet in all her attacks so far, not once has she mentioned the world’s largest polluter – China.

Putting aside the environmental implications, the economics are more interesting.

Reliable analysis shows that China is now plagued with overcapacity. Too many buildings. Too many factories. And there’s evidence that utilisation rates for existing power generation are quite low.

So why build more?

Because they can and because they need to in order to help ensure economic activity meets their pre-determined level.

Actions like this are often praised as good planning for the future – they will grow into it. Even if that’s true, all they are doing is bringing forward economic activity that should happen in the future to the present. To keep the wheels spinning – to keep that GDP number growing – they will need to find even more projects to invest in next year… and the year after… and the year after.

My main point is that “quality” of economic activity is important. Commentators sometimes like to say that China’s lower GDP growth is still the envy of the developed world. But any nation can create economic activity in the way China has been. To look at what China is doing and then attempt to compare the growth created in the sense of “they just added an Australia!”…well, can we agree it’s a little flawed to say the least.

I’ll take 1% of quality, productivity-driven growth over 6% growth derived from debt-fuelled investment in overcapacity any day!

This brings us to the main reason this sort of growth has become unsustainable.

All these projects need to be “funded” somehow. Money needs to be spent on employees, materials and equipment. That money needs to come from somewhere.

The result of a decade of activity is as follows:

The money funding these projects is largely “new money” – money created by the Chinese banking system in the form of new loans.

Notice that it appears debt levels have been reducing in recent years. However, remember what this chart shows – debt as a percentage of GDP. We noted earlier that GDP is (supposedly) growing at around 6 or 7 percent p.a. in recent years – an extra US$ 600 billion or so per year. Therefore, whilst a positive, the modest decline in debt versus GDP simply means that debt has grown at a modestly lower rate than the economy itself.

Indeed, since the financial crisis, China’s credit growth has risen at a rate of around 20% per year. Whilst the economy has supposedly grown at around 9%. Do you see an issue here?

China’s “credit intensity” has exploded. In the years since the financial crisis it’s taken around 2.5 Yuan in new credit to create 1 Yuan is new GDP.

Circling back to the title of this piece… but why can’t they just keep growing at 7% for years to come? They just can’t.

The easy gains from the manufacturing sector are long gone. Productivity growth has slowed dramatically. Therefore, in order to continue growing at the rates seen in the last 10 or 20 years, they are even more reliant on the “investment” side. But to keep the rate of growth up as GDP becomes even larger, they need to do even more every year than they did the last. Taking on even more debt in the process.

None of this is new – we’ve known about this for years. And my views really haven’t changed in years.

I’ve said for some time that I don’t expect a debt crisis to engulf China although the longer this growth phase carries on the greater the risks of a debt crisis become. My expectation has been that China’s growth settles at a much lower level – probably close to zero for at least a period. This would be “healthy” in the grand scheme of things.

I still think (hope) that they are on this path, although I am watching with interest an increasing number of issues unfolding within the banking system – we know of at least 4 banks that have gone into bankruptcy this year.

I’ve said repeatedly of late that financial markets and economies are in a very fragile state. This is just one more example. A meaningful slowdown in China’s economy explicitly means a dramatic slowdown in materials-intensive investment activity. As a major supplier of those raw materials, such a slowdown has major ramifications for Australia as China is by far our largest trading partner.

It’s frustrating from an investment standpoint. A continued “muddle through” scenario still seems probable and likely presents limited upside. Yet the fragile nature of economies and markets makes the downside scenario a real possibility.

As always, I guess we’ll just have to wait and see…