Vivek Kaul
The Chinese economic growth for 2014 was at 7.4%, a tad lower than the official target of 7.5%. This is the slowest rate that the country has grown at in 24 years.
In the aftermath of the financial crisis that started in September 2009, the Chinese government pushed the banks to ramp up lending. In a recent piece for the Wall Street Journal, Ruchir Sharma of Morgan Stanley estimates that “since 2008 the money supply has nearly tripled to $20 trillion” in China. Sharma further writes that China ordered up “new spending” which totalled to “12% of GDP, by far the biggest stimulus of this period.”
This helped the Chinese economy to keep growing at a fast rate in the aftermath of the financial crisis, even though growth in most of the other parts of the world collapsed. The trouble was that a lot of this money went towards creating infrastructure which was not required in the first place. It also led to a huge property bubble.
As Sharma puts it: “This decay is symbolized by the bridges, apartment complexes and half-empty shopping malls rising across China—many of them wasteful projects that were hurriedly seeded in 2009 and will sap growth in the future. The message: When the state spends in haste, it will repent at leisure.”
At the same time the productivity of Chinese capital has been coming down. It now takes more capital and more loans to get the same amount of economic growth going than it did in the past. In a recent study carried out by two economists working with the Chinese National Development and Reform Commission (NDRC), a top economic planning and regulatory agency in China, came up with some interesting results.
The study found that China’s incremental capital output ratio has risen dramatically over the years. It averaged at 2.6 for the period between 1979 and 1996. It has since jumped to 4 between 1997 and 2013. What this means is that before 1997 it took an average investment of $2.6 to get $1 of GDP growth going. Since 1997, it has taken an average investment of $4 to get $1 of GDP growth going.
The economists also found that the delivery rate of completed capital projects has come down dramatically over the years. The number stood at 74-79% in the late 1990s and has since fallen to around 60%, implying that 40% of the Chinese investment projects have either not been completed or did not finish on time.
The negative effects of the spending binge are now starting to be felt. As Wei Yao of Societe Generale wrote in a recent research note titled China: deceleration as usual, easing as routine and dated January 20, 2015: “More strikingly, property investment growth collapsed to -1.9% year on year from +7.6% year on year, the first contraction in 18 years! Construction data further confirmed that developers are struggling. New starts remained in deep contraction, falling 26.1% year on year; growth of floor space under construction fell below 10% year on year for the first time since mid-2000; and completion growth plummeted to 1.2% year on year from 11.4% year on year in the previous month.”
The non performing loans of banks are also rising at a rapid rate. As Yao wrote in another note dated November 20, 2014, and titled China: easing by not easing: “The non performing loan stock has been growing at a 35% clip this year. Smaller banks have seen faster deterioration, with non performing loans rising 50% year on year. The worse is still to come and banks know it.”
All this does not augur well for the Chinese economy and the government is trying to initiate what economists call a “soft landing”. This may also include ensuring that the Chinese economy does not grow as fast as it was in the past.
As Li Baodong, a Vice Foreign Minister, told reporters after the latest economic growth numbers came out: “China has entered a new normal of economic growth…That is to say we are going through structural adjustment and the structural adjustment is progressing steadily.”
This is a clear hint of the fact that the Chinese government is neither looking at spending more nor pushing banks to lend more, in order to push up the falling economic growth. “The chance of aggressive policy easing remains small,” writes Yao.
The trouble is that the Chinese investment forms a major part of the investment happening all over the world. As Sanjiv Sanyal of Deutsche Bank Market Research writes in a recent research note titled The Capital of China is Moving: “China’s domestic investment currently accounts for a disproportionate 26 per cent of world investment, up from a mere 4 per cent in 1995. In contrast, the United States saw its share peak at 35 per cent in 1985 but now accounts for less than a fifth.”
Why is Chinese investment such a dominant part of total global investment? “China’s dominance is driven by the fact that it saves and invests nearly half of its $10.5trillion economy,” writes Sanyal.
But it is becoming more and more difficult to fruitfully deploy $5 trillion (around half of $10.5 trillion). This is primarily because the “country…already has brand new infrastructure, suffers excess manufacturing capacity in many segments and is trying to shift to services, a sector that requires less heavy investment.”
This means that Chinese investment will go down in the coming years. Hence, if the Chinese savings rate continues to remain the same or does not fall at the same rate, it will lead to surpluses.
Chances are that the Chinese savings rate will not decline primarily because China is ageing at a very rapid rate. “The experience of other ageing societies such as Germany and Japan is that investment rates fall faster than savings rates,” writes Sanyal.
In another research note Bretton Woods III and the Global Savings Glut published in October 2013, Sanyal explains this theory in detail. Sanyal basically says that when people are young, their spending needs are greater. Hence, they need to borrow money in order to consume and/or build assets (like homes). But, as they age, their savings rise and they build up a stock of wealth, which they spend in their old age. Countries work along similar lines. Basically, what this means is that as a country ages (with the average age of its population rising), it tends to save more.
By 2030, China would go from being significantly younger to the United States to becoming significantly older to it, with a median age above 40. The excess savings that will be generated need to be absorbed somewhere.
A lot of this money is likely to find its way into the United States, feels Sanyal. And this might help the US government to continue borrowing from foreign countries. It would also keep interest rates low and help Americans keep their excess consumption going by borrowing. “The next round of global economic expansion may require the United States to revert to its role as the ultimate sink of global demand,” wrote Sanyal in the October 2013 note.
In his latest note Sanyal also states that the United States “has the necessary scale to absorb China’s surplus and the poor state of its infrastructure provides many avenues for fruitful deployment of capital.” Nevertheless, he goes on to write that “history suggests that some of this cheap money would inevitably find its way into trophy assets and bubbles.”
As far as theories go, this one sounds pretty logical. Let’s see how it goes. That only time will tell.
(The column appeared on www.equitymaster.com as a part of The Daily Reckoning as on Jan 23, 2015)