So distribution should undo excess
And each man have enough
(William Shakespeare, King Lear - Act 4, Scene 1)
In a long litany of bumps on the road to Chinese economic preeminence, irrelevant infrastructure projects, manufacturing oversupply in key industries and real estate bankruptcies have been heralding great caution in domestic household consumption, mirroring truly uncertain times
With China’s dominant position in Asia and the country’s pervasive economic influence around the world, facts on the ground – deflationary trends and a weakening economy – focus the attention of friends and allies, competitors and reluctant counterparts alike
Mutually reenforcing trends – economic growth head-lining inevitability of the geopolitical giant’s leadership – were yesterday’s consensus
In a tailspin, things could turn out differently in times of structural crisis
This may well be the case today
What is to be done ?
Our notes focused earlier on China’s structural economic challenges, highlighting the magnitude of the domestic malaise
In a series of articles about China's economic prospects, in the short to medium term, published since early October 2023, the reversal of the country's 'growth model' and the conundrum of Chinese leadership, were spelled out in no uncertain terms
- A Broken Growth Model (Oct. ’23)
- Rearranging the Deck Chairs... (Nov. ’23)
- Debts Coming Due (Nov. ’23)
- When the Music Stops (Dec. ’23)
In a nutshell
The argument goes like this
GDP growth rests on three pillars and on three pillars only
- demand of the domestic consumer market,
- investments (private and public) made in the country
- and exports, netted from imports (net foreign trade supporting the local economy)
When growth of anyone of these three drivers falters, the resulting slack in demand has to be picked up by the remaining two or else...demand in the country will drop, creating deflationary pressures - this is true in any country but China's challenge might be the largest of all
The flip side of China’s growth story is the debt build-up which financed the infrastructure investments and the property boom, twin engines which kept economic growth on track
Infrastructures are reliable investment options in developing economies
- China, over the past 20 years, has been no different, except in the order of magnitude
- Outcompeting one another, eager to win the favors of Beijing, local governments have been the relentless engineers of China’s infrastructure build-out
- Therefore, actual local government debt kept growing, reaching a momentous 80 trillion yuan ($11 trillion) - more than 60% of China's annual GDP - of which 54 trillion yuan ($7.5 trillion) are interest-bearing , mostly owed to Chinese bank, according to Reuters (as of September 2023)
Next to infrastructure investments, property developments have been the fail-safe gift for growth in China’s ‘command’ economy, debt-financed just like the country's infrastructures
- Real Estate – between 25% and 30% of GDP – is the weakest link in China’s growth model and used to represent a large chunk of the country's investment share in total GDP (40% to 45%)
- Burning bright, in a speculative bout feeding the fire of property prices across China, from the favored seaboard to the forlorn North East, private investors felt secure...until they were not (with prices down 10-15% in Shanghai, suffering drops of as much as 50% in remote regions...)
- Ultimately, of the two bankrupt real estate giants, Country Garden recorded more than $180 billion in liabilities as of June 2023 and Evergrande had debts amounting to more than $300 billion - extraordinary numbers which still must be compounded by off-balance sheet debt for unknown amounts....
China’s real estate really was, and remains TBTF – "too big to fail writ large" – how to come to grips with the crisis is uncertain to this day
What to do …
Our conclusion, last November, still stands
Hit by two overlapping crises - a debt crisis and a structural imbalance disrupting the growth model - China is seeking to douse the flames of debt running wild, leaving structural issues for later
But it is a far cry from addressing the issues ailing China’s development model
- Debt is manageable whenever the finance contributes to economic growth by way of productive investments...
- When it is not…suboptimal build-up of infrastructure and real estate may still be supported for a short while, but debt ends up in as many little Ponzi schemes, committed to more debt to pay-off past debt
- Structural issues, requiring novel growth drivers, cannot sidestep the perennial weakness of household consumption, a reliable driver of economic growth around the world…
Economic growth rates have been a marker of China’s past competitive success, compared to more conservative rates recorded in the developed world and 2023 was – at 5% – showcased as proof of China’s resilience - and no less critical in keeping the debt-fueled expansion on track
As noted at the time by Albert Edwards (Société Générale), the GDP deflator, which facilitates comparisons between data cycles, adjusts nominal GDP downwards to remove inflationary pressure or – as was the case in the Q3 - 2023 growth estimate – upwards to account for a deflationary impact by adding a 1.4% deflator and implying a weak nominal 3.5% GDP at the time
If the 5% ‘growth’ record in 2023 turned out to be a creature of political convenience, a 2024 nominal GDP projection in a range from 3.5% (at best) to a low 2.5% will reflect the pitfalls of the Chinese growth model, exposing the inadequacy of a large share of costly debt commitments
As for the intractable structural conundrum, household consumption composed only 38 % of China’s GDP in 2022 – and this rate has actually been declining
To approach the global average in other countries, estimated at 63 %, would be a sea change - improbable by any measure in the current socio-political setting of China
- Domestic consumption has been historically quite weak, and household savings, extremely high at 23 to 25% of GDP, approx. three times the global average (7-8%), seem to reflect a deep sense of insecurity
- Globally, Michael Pettis, professor of finance at Guanghua School of Management at Peking University, highlights the gap between China's share of world GDP (18%) and the country's share in world consumption (13%) - as the country clings to its mercantilist strategy of production exported to global consumers
- Hemmed in by their own growth model, with its focus on institutional and business investment, the government is surely aware of the imbalance, a raw deal for the Chinese households
As of this writing, August 2024, the calls for Chinese 'stimulus' by Western commentators in the financial press do not address the constraints of economic and financial policy, confronting China's government and the Communist Party
- Domestic consumption may grow slowly, at best, as long as capital investment in % of GDP (43% as of 2022) deprives consumers of their share of the national product
- Real estate, inheriting years of over-building, suffers and investment will fall
- With constrained access to additional debt to engage in novel infrastructure projects, local governments will rely on the leeway provided by the central government's bond issues and financial restructuring - limiting their ambitions accordingly
- Manufacturing, a priority benefitting key industrial segments, has already started to pick up some of the investment slack - aiming for global dominance by following the rule book of the solar photovoltaic industry (with a 80 to 85% market share)
As a result, the intractability of China’s structural imbalances just has become even more so
- The manufacturing sector can hardly be expected to compensate the sizable shortfall in real estate investments -
- Overreach in manufacturing - 300 000 jobs in the solar photovoltaic supply chain since 2011 with a current production capacity double China's actual share in global demand - or in electrical vehicles with more than 200 manufacturers grappling with massive oversupply - sets the stage for a predictable shake-out
- Job losses in an already tense labor market will feed directly into household insecurity, dampening consumption
- Further growth of China's global market share in manufacturing will encounter fierce resistance around the world - as seen in the developed countries but also in the global (developing) South
Not a happy anticipation
The slowdown of the Chinese economic juggernaut brings to unforgiving light the terms and the exposure in debt financing, issued by an intricate network of institutional agents - the subject of our next note