Chinese Math

A cyclical upturn in Chinese data around the turn of the year led the consensus to believe that China’s new leadership would generate another investment boom similar in magnitude to 2008-2009 (see chart below). Wall Street points to increasing evidence of an end to de-stocking in China.

UpturnWe can’t blame them for trying but the fact that Chinese growth is decelerating so soon after another massive injection of liquidity does not bode well for the global economy. Andy Xie reports for Caixin, “The recent surge in money supply was viewed as validation of another investment cycle. The money has been used mostly for retiring old and higher interest rate debts and for holding onto speculative positions in land and mining. The market’s view of one more old fashioned investment boom is just fantasy.” Similarly, Soros sees China shadow-banking risks similar to subprime. “China can keep its current economic growth model for another year or two, but not for another decade, as household savings are no longer sufficient to subsidize the majority of the economy. The transition won’t be easy, because less investment may result in slower growth and increase the chances of a so-called hard landing.” And recently, a senior Chinese auditor has warned that local government debt is out of control, per the FT. A recent paper by GMO details the plumbing of the Chinese financial scheme, clearly illustrating why China’s Credit System Looks Vulnerable.

 GMO

China’s structural rebalancing has only just started. This fading “recovery” is simply a countertrend bounce within an extended decline in economic activity. A recent IMF Working Paper concluded, “There is little doubt that China’s extraordinary economic performance over the past three decades is in large part attributable to investment” and that, “Going forward, the challenge is to engineer a gradual reduction in investment to a path that would maximize social welfare.”

The problem with even a “gradual” reduction is that the magnitude of any reduction is still absolutely massive. For example, China would have to reduce the investment share of GDP by at least 10% and perhaps as much as 20% just to get into line with other emerging economies at equivalent stages of economic development. We reviewed the arithmetic behind such a massive rebalancing in a presentation titled, Easy Money, back in November 2011. Michael Pettis, recently provided investors with another refresher on the difficulty of reducing Chinese investment as a share of GDP. In this example, he assumes China has five years to rebalance – reducing investment 10% below today’s levels:

“If Chinese GDP grows at 7%, in other words, Chinese investment must grow at 2.3%. If China grows at 5%, investment must grow at 0.4%. And if China grows at 3%, which is much closer to my ten-year view, investment growth must actually contract by 1.5%. Only in this way will investment drop by ten percentage points as a share of GDP in the next five years.

“The conclusion should be obvious, but to many analysts, especially on the sell side, it probably needs nonetheless to be spelled out. Any meaningful rebalancing in China’s extraordinary rate of overinvestment is only consistent with a very sharp reduction in the growth rate of investment, and perhaps even a contraction in investment growth.

“In fact I think over the next few years China will indeed undergo a sharp contraction in investment growth, but my point here is simply to suggest that even under the most optimistic of scenarios it will be very hard to keep investment growth high. Either Beijing moves quickly to bring investment growth down sharply, or overinvestment will contribute to further financial fragility leading, ultimately, to the point where credit cannot expand quickly enough and investment will collapse anyway.”

This is just arithmetic, according to Pettis. And based on our math, it is difficult for us to understand how Chinese GDP can grow anywhere near current consensus estimates given such a sharp contraction in investment. It can’t and it won’t. Jim Chanos, famed short-seller and long-time China bear, recently illustrated how China has been generating growth during a presentation at Mish Shedlock’s Wine Country Conference earlier this month.

Chicken

I realize this post is already filled with quite a few links, but I’d encourage anyone still long commodities and related investments to take a close look at this slide deck along with the GMO white paper. The game is over folks. Per Xiao Gang, Chairman Bank of China, “To some extent, this is fundamentally a Ponzi scheme.” That said we do understand that Chinese math operates under different assumptions than those applied to the prudent allocation of capital. This is best illustrated by the photograph below, taken on our way up to the third floor of a hotel in Danyang. Anyone else curious?

Elevator