Commodities related stocks are getting pole-axed today. Fortescue down 5.5%. Mt Gibson down 6.4%. Whitehaven Coal down 8%. And the big daddy of them all, BHP, down 4% and trading at a three-year low.
First Greece was to blame. Now the China slowdown hypothesis seems to be gathering credibility. Has the China crash begun?
‘Hard to say’, as my partner tells me every time I ask her a question that she can’t answer with 100% certainty. But the data is looking scary.
I’ve been tweeting all of the interesting stuff I find but here’s a selection of my favourites:
In a series of interviews over the last week, bankers and senior executives from provinces all over China, in a range of light and heavy industries, cited a broad deterioration in business conditions. Two of them said that some tax agencies in smaller cities had been telling companies to inflate their sales and profits to make local economic growth look less weak than it really was, while reassuring the companies that their actual tax bills would be left unchanged.
There is plenty of fudging going on with Australia’s economic budgeting but this is taking it to a new level!
We’ve been expecting a dramatic slowdown in China’s rate of fixed asset investment and the latest data is consistent with that hypothesis. I don’t know if the Chinese authorities can or will stop the economy from unraveling, but I know the adjustment is an adjustment that needs to happen, either now or some time soon.
For the past few years, the correlation between the AUD/USD exchange rate and the Dow Jones Industrial Average has been extremely high (0.89 for the stats enthusiasts, which means 89% of the movement in the exchange rate can be explained by movements in the Dow Jones Industrial Average). Every time the US economy shows signs of life, the Dow Jones rises, and so does the Aussie dollar. The theory being that a strong US economy means a strong global economy and high commodity prices. Good news for Australia.
With a large portion of the Value Fund invested in stocks with exposure to the US economy, every piece of good news on US employment or GDP has been offset by bad news on the currency front.
The strength of the correlation has surprised us. For commodity prices, a strong US economy is minor good news. A slowdown in China is major bad news. As we’ve been pointing out for more than a year, internal infrastructure spending is far more important to China’s economy (more specifically, China’s demand for our resources) than exports. So a strong US won’t offset a slowdown in infrastructure spending in China.
I’ve no idea why it’s taken this long, but the nexus seems to have broken. For the past two weeks, the US stock market has gone up while the Aussie dollar has gone down (you can see this clearly for yourself on the far right of the graph). There seems to be more and more fear about the state of the Chinese economy and, no longer constrained by the correlated dollar, stocks like QBE and Computershare, with significant exposure to the US, have been on a tear.
It is, of course, impossible to say with confidence. But I get the feeling we’re at an important inflection point. One we’re very well prepared for.
Two years ago, Professor Michael Pettis of Peking University's Guanghua School of Management was something of a loner in his view that China’s infrastructure-led growth was creating gargantuan problems. Now, with land sales falling off a cliff, house prices reversing course and the central government forcing Chinese banks to roll over local government loans that had no hope of being repaid, the structural problems with China’s economy are widely accepted (at least in the international press … you don’t read much about it in the local papers).
The debate is no longer about whether China is overly dependent on infrastructure spending. It is blatantly obvious the associated buildup in local government debt is unsustainable. The question now is whether an adjustment can be made without a dramatic slowdown in the overall economy.
The proponents of the ‘soft landing’ scenario – GDP growth slowing from its current run rate of 10% per annum to 7-8% per annum – argue that China’s rapidly burgeoning middle class will pick up the slack. Increasing consumption growth rates, they argue, will offset the slowing growth in infrastructure spending.
There are two problems with this argument. Firstly, the Chinese authorities show no signs of reversing the policies that cause consumption to be such a small proportion of the overall economy in the first place.
Those that propagate the consumption argument seem to think consumption is low because of some genetic quirk amongst Chinese households that imbibes them with a sense of thrift and saving, in stark contrast to spendthrift Western consumers. The Chinese, we’re led to believe, are sitting on piles of savings just waiting to be unleashed in a wave of wanton consumerism.
Luxury brand owners would like that – sales of Louis Vuitton and Chanel are already soaring in Asia – but there’s nothing cultural about China’s lack of consumption. It is a result of specific government policies that transfer wealth away from households and towards borrowers, exporters and government.
By holding interest rates artificially low, wealth is being transferred from savers (households) to borrowers (businesses, state owned and otherwise). A controlled, low exchange rate translates to artificially high import prices, another direct wealth transfer from households to exporters.
It should come as no surprise that the consumption component of GDP has been shrinking (see the discussion between Nouriel Roubini and Patrick Chovanec below).
Far from unwinding these impediments, China has loosened monetary policy and stopped letting the exchange rate appreciate at the first sign of trouble. In the short term, the consumption proportion of GDP may well decline further.
Secondly, it’s a mathematical impossibility for growth in consumption to offset any meaningful slowdown in investment.
In 2011, investment represented 5.2% of China’s 9.2% overall GDP growth. Everyone agrees they are spending too much on investment. Yet even if they build the same number of houses, the same number of high speed rail lines, roads, subways systems and airports as they built in 2011, that would mean investment growth of zero.
Assuming net exports hold up in 2012 (an optimistic assumption given Europe’s economic woes), consumption, currently only one third of GDP, would need to grow 20% to generate overall GDP growth of 8%. That isn’t going to happen.
Of course, investment growth can be negative. The collapse in housing construction has deducted 1.2% from US GDP since 2008. In fact, I’d say a contraction in infrastructure spending is likely at some point.
With another government stimulus, the day of reckoning can be delayed. The Chinese Communist Party’s decennial leadership transition will take place at the end of 2012 and the last thing they want is economic turmoil. But everything I’m reading indicates Pettis is on the money. Whether it’s this year or next, China’s inevitable hard landing is coming.
Apologies to those who didn’t grow up in the Eastern states. Matt tells me that he’s never heard the advertising jingle I can feel a XXXX coming on. It works for me though, I get the feeling the Chinese are working on something big.
The Chinese economy is being buffeted by two unrelated winds. The first is Europe’s woes and the second is an inert US economy. Both are proving a serious drag on China’s export growth. Export and import growth have slowed dramatically and net exports are expected to contribute less than 3% of GDP this year, down from 7% in 2008.
The external environment is problematic. Internally however, the problems are bigger. The FT recently reported dangerously low levels of property market transactions in China’s largest cities. China Vanke, the country’s largest property developer, reported November sales 36% lower than the previous year.
So the problem with Japan – and indeed with every other country I can think of that suffered very long periods of post-boom stagnation – was massive over-investment based on a very distorted investment-driven growth model. The period of stagnation was partially caused by the struggle to service excessive levels of debt, partly caused by the continued capital misallocation, albeit at a slower pace, and partly caused by the effective writing down of all that overstated GDP.
These – with the possible exception of the debt – are not the problems from which the US or Europe are suffering. They suffer from a typical debt-fueled overconsumption boom, whereas Japan suffered from a typical debt-fueled over-investment boom, and Japan’s period of over-investment was much, much more extreme (centralized investment booms can last much longer and go much further than decentralized consumption booms). This is why I think the Japanese experience tells us almost nothing about what Europe and the US will go through.
On the other hand, it might tell us a lot about what China will go through. In fact we can make a more general point. Command economies (Japan, the USSR, Brazil and many others during their “miracle” periods) tend to have much more rapid investment-driven growth during the good times and much more difficult and longer-lasting adjustments. Capitalist democracies are more prone to consumption-driven booms, which aren’t as extreme and don’t last as long, and their adjustments tend to be brutal but relatively quick. – Michael Pettis, August 2011
Michael Pettis is a professor at Peking University's Guanghua School of Management, a Senior Associate of the Carnegie Endowment for International Peace and my favourite commentator on the Chinese economy (I have included some interesting links at the bottom of the page).
When the US, Europe and most of the developed world entered a recession in 2008, I expected the impact on China’s ‘export-driven’ economy to be dramatic. So did most of the world’s investors. Commodity prices plunged, the Aussie dollar traded down to US60 cents and … the Chinese economy grew 9.1%, only slightly less than the prior year.
Forget about whether gold and Italian bonds make for good investments. It isn’t going to happen. It isn’t going to happen because it isn’t possible.
China runs a massive trade surplus with the US. That means it accumulates US dollars. Now why, you might ask, can it not just convert those US dollars into gold or other currencies?
Well, that’s pretty straight forward. China artificially depresses the exchange rate of its own currency against the US dollar. At current rates, there is substantially more supply of US dollars wanting to convert into Yuan than there is Yuan sellers wanting to convert into US dollars. To keep the exchange rate where it is, Chinese authorities buy all of the excess US dollar supply.
China can’t sell US dollars because it’s buying them. Hundreds of billions of dollars worth.
For the sake of appearances, China might throw a few million Euro Italy’s way. But, as much as the Italians might wish it different, until it un-pegs its exchange rate and stops running gigantic trade surpluses, China is not diversifying anywhere.
Never ask the barber if you need a haircut, so they say. Chinese premier Wen Jiabao has declared inflation dead in a guest column for the Financial Times. The whole article is worth a read, but he saves his best for inflation:
So is this the beginning of the end for Australia’s 17-year economic miracle?
Crises are unpredictable things. We look back now and see that the sub-prime crisis led to Lehman Brothers’ collapse, AIG’s demise and brought the global financial system to its knees.
But even after the losses began to mount on US sub-prime mortgages and funding markets began to freeze, putting the pieces together was no easy task. John Hempton, now of Bronte Capital but at the time working for Platinum Asset Management, wrote a piece titled A History of US Finance in June 2007. In it, he laid bare the corrupt lending practices, perverse incentives and naïve credit agency assumptions that were the undoing of the sub-prime market. He went on to conclude that:
Admittedly it was many years ago. But when I studied economics at university, the theory was that a government could control interest rates, or it could control the exchange rate, but it couldn’t control both.
