Does China’s Remarkable Growth Have Feet Of Clay?

By Dan Watson, Contributing Writer, Blairgowrie Associates | October 10, 2012

Despite a slowdown China’s GDP growth is still expected to do well compared to other countries, projected to deliver a relatively impressive seven to eight percent in 2012.

Over the past few years much has been said about the amazing economic and industrial growth achieved by China. Let’s be honest, China’s growth has been absolutely remarkable and is the envy of the world. In 2010 China became the world’s second largest economy, exceeded only in gross domestic product (GDP) by the U.S. Japan was a distant third, eclipsed by China in 2001 with a repeat every year thereafter. By any metric that we could use, China’s success over the last three decades has been extraordinary. China’s agricultural and industrial production both surpassed the dollar value of the U.S. output for 2010. In recent years China has seen the evolution of a genuine middle class, which has fueled an unprecedented real estate boom inside China. Last year there were a number of China pundits speculating that China would overtake the U.S. in GDP before the end of this decade. Given the current anemic U.S. economic recovery one cannot rule out this happening.

As the US continues to amass more debt it is fairly clear that there isn’t a game plan in place to solve the declining economic condition or the massive unemployment situation. Although in recent months the U.S. has seen a slowdown in home foreclosures the overall housing market is anything but healthy. The volume of U.S. home lending dropped 10 percent last year to the lowest level since 1995, highlighting the current administrations uphill battle to prop up the still-struggling housing sector. Unfortunately, the drop in lending may be tied to the U.S. Government banking regulations whose requirements have in affect curbed actual mortgage lending. China doesn’t have this restriction and in fact has cut interest rates multiple times this year to attract more buyers.

In the past few months we have noticed that Federal Regulators are trying some risky approaches to shore up the U.S. housing market. Just four years after toxic U.S. mortgages brought the global financial system to its knees and triggered the deepest recession since the Great Depression, U.S. housing regulators may be making it easier for banks to make bad loans without suffering losses. It’s difficult to tell if this is a short-term focus brought about by the upcoming Presidential election or it’s a genuine effort to jump start the housing market.

The U.S. is not alone in suffering negative housing data. Although not nearly as drastic a situation as can be found in the U.S. market there are troubling signs that the China economic bubble is experiencing significant stress. Back in July of this year, Chinese Prime Minister Wen Jiabao signaled that the Chinese economy is facing “huge downward pressure.” This is the bluntest message to date from Beijing about the Asian powerhouse’s economic problems.

China’s GDP growth is still expected to do well compared to other countries—projected to deliver a relatively impressive seven to eight percent in 2012—but that is considerably slower than the Herculean 10-plus percent rate it has recorded in recent years. With exports falling due mainly to the depressed economic conditions in Europe and the U.S. and the Chinese real estate market crumbling, China has experienced a genuine first time slowdown in its real estate development.

In an effort to address these problems China’s government has taken steps to boost economic growth by cutting interest rates and approving new infrastructure projects through a stimulus effort. However, a number of China pundits worry that China’s “stimulus lite” policies will do little to prevent a “hard fall”, which would have negative consequences for the U.S. and other countries that have come to rely on China to fuel the global economy. Since 2007, China has contributed significantly more to world growth than any other country, and this is projected to remain the case into the foreseeable future. Is China just experiencing a normal economic adjustment or is China on the verge of a genuine economic crash similar to what Europe and the U.S. have experienced?

Before addressing this question it’s important to point out the key differences between what is happening in China’s real estate market as opposed to the U.S. experience. First of all, although there are signs of a definite slow down especially in select cities, what we have not seen is a depression of real estate prices as happened in the U.S. in 2006 onward.

In fact, in most areas in China real estate prices have at worse stabilized or in some instances, slightly increased. This has not happened in the U.S. market where real estate prices have declined as much as 50 to 60 percent in some areas fueled mostly by more than 3.7 million home foreclosures. In fact, in the U.S. home foreclosures are still underway today. 

The Chinese banking system is very different from the U.S. model in that China’s banking system is more or less government-owned. This changes the rules of the game considerably. Standard risk management variables, such as the required capital adequacy ratio, which, by the way, is extremely high amongst Chinese banks, and the non-performing loan ratio, are only of marginal relevance because the integrity of the biggest banks is guaranteed by the government. China’s central government is willing and able to act on that guarantee if required to do so.

The level of public debt outstanding in China is modest and even when contingent liabilities are taken into account, such as debt taken on by local governments, the prospect of China falling victim to a European style public debt crisis borders on impossible. In fact, unlike the experience in the U.S., there is little evidence that any deterioration in the housing market has infected the Chinese banking system. Realizing that nation-wide house prices have not in fact declined, this is perhaps not a surprising situation.

There are other reasons for differences in the two systems as well. One is simply that the Chinese are much more likely to fund their home purchases from savings, often calling upon the assistance of various family members in the process. In part this reflects cultural differences where the Chinese in general are debt aversive, but also it reflects strict down payment requirements imposed on borrowers by Chinese banks.

Although these difference somewhat insulate the Chinese banking system from the melt down experienced in the U.S. it has not thwarted the fact that China is experiencing a genuine slowdown of unprecedented proportions. Economic data released earlier this month by the National Bureau of Statistics showed the extent of the problems. Investment in new buildings and other fixed assets is in the doldrums.
Manufacturers are retreating from ambitious production goals as they struggle with bloated inventories of unsold goods. Even the service sector, still underdeveloped and widely seen by economists as full of potential, is showing significant signs of distress. In fact, most observers believe that China’s economy is weakening more rapidly than official statistics would suggest, which could lead to a much sharper decline than what many economists expect.

The ongoing debt crisis in Europe has stifled a lot of Chinese exports, while flat lining the new middle class consumer demand within China has led to thousands of layoffs, stagnant sales of heavy machinery, and record amounts of coal and iron ore going to waste. Soon it will be obvious to most observers that China is in the midst of a painful slowdown that most likely will be felt around the globe.

However, let’s not forget, China is in the midst of a tremendous transition from being a producer and exporter of cheap goods to a fully industrialized country with strong internal and external demands for high quality technology products. This means that the Chinese leadership want the economy to slow a little bit as the country reduces its dependency on cheap exports. This scenario is a very risky situation especially if the desired changeover is clumsily executed. If China botches the transition effort, it could find itself in real trouble. Facing a decline in exports and a stagnating domestic market might cause the current leadership to make hasty, irrational decisions rather than following the original game plan.

To most observers, China is viewed as a journalist’s dream and a statistician’s nightmare, with more human drama and fewer verifiable facts per square mile than anywhere else in the world, except perhaps in the U.S. during a presidential election campaign. These days, the statistician’s dilemma in China extends not simply to the problem of what is true but also to that of what is important and what truly matters. In the era of a growing China, every agency and investment banker, every short-seller, risk analyst and brand consultant is poised to offer a prediction on China’s economic future. With so many “experts” dominating the information highway how do you separate the static from the real signal?

Back in early July, China stepped up its efforts to reverse the deepest slowdown since the global financial crisis in the world’s second-biggest economy. The central government mandated a cut in interest rates for the second time in a month. Since no one was expecting another interest rate cut before the end of the year, this move strongly suggested that the first cut didn’t accomplish its intended outcome. It was speculated then that the Chinese leaders feared that left unchanged there would be an issuance of a slate of new economic numbers that they felt was likely to give investors serious doubts about China’s financial future.

Some China observers such as Barron’s had already declared that it looks like the “Great China Growth Story” may be falling apart. Although relevant data does not fully indicate this happening one still has to ask, “Is this true”?
As my legal friends often remark to questions of this nature, “It depends.” It depends in part on how deep the U.S. will continue to sink economically and for how long; how quickly Europe starts to improve; how resilient is the new Chinese middle class; and how effective are the pseudo stimulus efforts by the Chinese Government. In short, the future of China is truly tied to the financial health of the rest of the world. China’s domestic market cannot by itself sustain the level of growth experienced by China over the past three decades.

Regarding the U.S. recovery, somewhat similar to the statements about the difficulty in verifying China data the U.S. election has thrown a fog on unbiased, real data access. Each month we noticed that the current U.S. administration has to redo the previous month data regarding unemployment and other key economic metrics. This leads to more speculation than actual facts about the U.S. economic recovery.

In August, there was a release of data that indicated that home resale’s rose to their highest rate in more than two years and groundbreaking on new homes also climbed yielding hopeful signs that a budding housing market recovery is gaining a bit of traction. Of course, the question of sustainability of such efforts has to be addressed.
At the moment we are entering a period of the year in the U.S. in which home sales—resale or new—are not normally robust. Other key economic metrics such as median Income indicate that on average U.S. households have lost about $4,000 compared to what they had at the close of 2008. Unemployment rate remains high and is projected to continue well into next year at current levels. In addition, there isn’t a real game plan in place to reduce the staggering U.S. national debt now standing at over $16 trillion.

The ongoing battle between opposing political parties will most likely continue following the upcoming election regardless of which side is elected to the position of President. This means that little if anything will be done to reduce the debt in the short-term. Meanwhile, the EU is embroiled in internal conflict with member states, in particular, Spain. The bottom line here is that if China’s economic future is truly dependent on a more stable, healthy and robust U.S. and EU economy that may not happen in the short-term.

Most observers feel that China has “bottomed out” in its economic slowdown and is poised to take advantage of growth opportunities around the globe. Their game plan is to overtake the U.S. GDP output before the end of this decade. How they will do that without a strong and vibrant export market remains to be seen. However, it is obvious that China is in a much better financial/economic position as compared to the U.S. or the EU. Still, it is also clear that China’s future is very much tied in with the recovery of both the U.S. and EU economies.

My answer to the question, “Is the Great China Growth Story falling apart?” is a somewhat weak “MAYBE”. Remember, real growth for China has slowed as China is still very much dependent on its traditional export market, which in turn is dependent on the financial health of their international trading partners. Many of those partners have also invested heavily inside China over the past decades and today they too are experiencing a genuine slowdown in sales, both domestic and international, as product inventories build up in their China-based manufacturing facilities. Some have already had to lay off employees with more drastic actions to come.

It’s quite likely that China will continue its recent policy of allowing the Yuan to devalue in order to stabilize or grow its export market. China is also committed to pursuing other options to become less dependent on imports of crude oil and other critical materials. More effort is planned to shore up the fledging middle class and developing a domestic service industry. China leadership maintains that although a slowdown has happened it is simply a short-term reaction to external factors, which they feel will be resolved in a reasonable time period. For certain China is still committed to overtaking the U.S. economically. As always, the question is, “How and when?”

In the meantime, China’s leaders President Hu Jintao and Premier Wen Jiabao are embroiled in a critical two-prong activity—coping with the worst economic slowdown in over three years and preparing for a change in the country’s leadership. Both Hu and Wen are due to be replaced in a communist party conclave meeting to be held sometime in October or perhaps November. It is widely speculated in China that the major reason for being so difficult to set an exact date for such an important meeting is that the high level party members have not yet come to an agreement of the new core members of the party management. 

Most observers believe that it has long been agreed that Xi Jinping will replace Hu and Li Keqiang will replace Wen. However, at this time, the exact schedule for this happening is still unknown. Internally, Hu and Wen are doing their best to stabilize and stimulate the economy—lowering the interest rate is one of the approaches used. Even facing QE3, the Yuan has been artificially kept low in the hopes that exports would not drop too much. It is expected that these efforts would at least continue for a while after the leadership change.

The Hu-Wen period raises the bar for future successors. Under the Hu-Wen leadership, China’s economy grew four times the size it was in 2002, the year in which they came to power, rising from sixth to second place in global rankings, with the greatest amount of foreign reserves, and the largest levels of exports and second largest imports.
However, not everything has been positive under their leadership. China’s remarkable growth has given rise to a number of internal problems, which include: stagnant economic restructuring, pollution; income disparity; greater inequality; the highly unpopular and outdated family planning process and household registration polices; a marked increase tension in the Chinese society between various groups; a looming energy crisis; moral degradation; and the country’s battered international image. In addition, today China reportedly spends more on internal security than on its national defense. 

The new leaders will encounter all of these problems, and more, and will also have to decide how to balance the continuing need for growth against other sociopolitical reforms that will be politically risky, but are the only way to try to create stability and balance in a society, which is becoming wealthier, freer and more unruly. Balancing this situation against the Communist Party’s need to control everything will be a daunting task for the new leadership.
China is now in an era when the tension between the officials and those they are meant to be ruling has reached fever pitch. Recent internal surveys show that central leaders still maintain some level of moral credibility within the Chinese society. However, the same survey indicated that local leaders are regarded with large amounts of loathing. It has been noted that public expressed cynicism about politics in China are on a par with, or even in excess, of those in the west. Welcome to the real world Mr. Xi and Li.