Chinese Growth is Bad for Global Economy


In yesterday’s edition of the Diary I talked about how Chinese banks have unleashed another round of easy money, in order to push up economic growth. The Chinese economic growth for 2015 was at 6.9% which is a two-decade low. Many China watchers and economists believe that the real economic growth is significantly lower than this number and is likely to be more in the region of 4-5%.

In order to push up economic growth Chinese banks lent out a whopping 2.5 trillion yuan (around $385 billion) in January 2016, the highest they ever have during the course of a month. This increased borrowing and spending if it continues, as it is likely to, will lead to creation of more capacity in China.
The creation of this excess capacity will provide a short-term fillip to the Chinese economic growth as more infrastructure, homes and factories get built. The trouble is that the Chinese economy is unlikely to absorb the creation of this excess capacity.

As Satyajit Das writes in The Age of Stagnation: “China continues to add capacity to maintain growth. If it is unable to absorb this new capacity domestically, it might seek to increase exports to maintain production and growth. This would exacerbate global supply gluts and increase deflationary pressures in the global economy.” Deflation is the opposite of inflation and essentially means a scenario of falling prices.

Household consumption as a proportion of the Chinese economy has fallen over the years. In 1981, household consumption made up for 51.7% of the gross domestic product(GDP). Starting in 1990, the household consumption as a proportion of the Chinese economy started to fall and by 1999, it was at 45.6% of the GDP.

By 2009, the number had fallen to 35.3% of the GDP. In 2014, the household consumption to GDP ratio stood at 36.6%, not very different from where it was in 2009.

What does this tell us? As Michael Pettis writes in The Great Rebalancing—Trade, Conflict and the Perilous Road Ahead for the World Economy: “In any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and trade surplus to generate growth.” Trade surplus is essentially the situation where the exports of a country are more than its imports.

This is precisely how it has played out in China. In 1981, the Chinese investment to GDP ratio was at 33%. In 2014, the number stood at 46%. What does this tell us? By limiting consumption, the Chinese were able to create savings. These savings were then diverted into investments and the investment created excess capacity in the Chinese economic system. In 1982, the Chinese savings had stood at 35% of the GDP. By 2013, Chinese savings had jumped to 50% of the GDP. The investment to GDP ratio during the same year stood at 48%.

The excess capacity was taken care of by exporting more. And that is how the Chinese economic growth model worked all these years. What this means that with a low consumption rate, the Chinese have always been more dependent on investment and exports to create economic demand. In the 1980s and 1990s, the high rate of investment made immense sense, when China lacked both infrastructure as well as industry. But over the years China has ended up overinvesting and creating excess capacity, and in the process become overly dependent on exports, if it wants to continue to grow at a fast rate.

As Pettis writes: “With consumption so low, it would mean that China was overly reliant for growth on two sources of demand that were unsustainable and hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure rapid economic growth. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.”

In 2014, the household consumption to GDP ratio stood at 36.6%. Hence, the shift towards consumption driving economic growth has clearly not happened. The point being that the country is now addicted to the investment-exports driven growth model. In this scenario, every time there is a slowdown in economic growth, China resorts to the tried and tested investment led economic growth model. And the first step in this model is to get banks to lend more.

As Pettis writes: “The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economists politely call rent-seeking behaviour, while costs are spread through the entire country through the banking system and over the many years during which the debt is repaid.”

This explains why Chinese banks lent 2.5 trillion yuan in January 2016, the most that they ever have. The trouble is that this round of economic expansion will lead to more excess capacity. And this will lead to a push towards higher exports and in the process hurt the global economy.

As Pettis writes: “China is not currently the engine of world growth. With its huge trade surplus, it actually extracts from the world more than its share of what is now the most valuable economic source in the world—demand. A rebalancing will mean a declining current account surplus and reduction of its excess claim on demand. This will be positive for the world.”

What Pettis basically means is that the Chinese household consumption to GDP ratio needs to go up i.e. the Chinese need to consume more of what they produce. But recent evidence clearly suggests that the Chinese government has no such plans and the investment-exports driven led economic growth strategy is likely to continue.

The column originally appeared in Vivek Kaul’s Diary on February 23, 2016

Down 1600 points: Why the Sensex is on a free-fall

As I write this, I am listening to one of my favourite songs, “Free Fallin’”, sung by Tom Petty and the Heartbreakers.

And it is indeed heart-breaking to see the BSE Sensex go on a free-fall today. It fell by 1624.51 points during the course of the day to close at 25,741.56 points.
In absolute terms it is the biggest single day fall ever. But that is not the right way of looking at it (though that is how much of the media will report it).

In percentage terms, the Sensex fell by 5.94% during the course of the day. This is the 29th biggest fall ever. Given this, the Sensex fall today is a big fall, but it is not as big as it will be made out to be.

Much analysis has happened around the fall and various reasons have been offered on why the stock market is on a free-fall.
A major reason that has been offered is that the Chinese stock market has fallen by around 8.5% today. The Shanghai Composite Index is quoting at around 3,210 points, down 298 points from Friday’s close. And given that the Chinese market has fallen, the contagion has spread to other stock markets as global investors try and limit their losses by selling out.

But this is only partly true. The thing is that the Chinese stock market has been going down for a while now. Here is a column I wrote on July 9, 2015, trying to explain why the Chinese stock market has fallen. It has been more than six weeks since then.

Hence, the question to ask is why has it taken so long for the Indian stock market to react to the Chinese fall? Why has the contagion taken so long to spread?
The answer is not as simple as it is being made out to be. Until August 11, 2015, one dollar was worth 6.2 yuan. The People’s Bank of China, the Chinese central bank, over the years, has maintained a stable value of the dollar against the yuan. This has essentially been done to help Chinese exporters. By ensuring the yuan had a fixed value against the dollar, the Chinese central bank took this variable out of the Chinese exporters’ equation totally. This helped Chinese exports and exporters flourish and has been a very important part of the Chinese economic miracle.

Between August 11 and August 14, 2015, the Chinese central bank devalued the value of the yuan against the dollar and pushed down its value to around 6.39 yuan to a dollar. This was the biggest devaluation of the yuan against the dollar in nearly two decades.

A major reason for the same was the fact that Chinese exports for the month of July 2015 had fallen by 8.3% in comparison to June 2014. Even in June 2015, the Chinese exports went up by only 2.8%, in comparison to a year earlier.

But all that happened nearly 10 days back, why is all hell breaking lose now? On August 21, 2015, data pertaining to the Chinese factory sector was released. It showed that the Chinese factory sector had shrunk to its lowest level since January to March 2009.

This data point led to stock markets around the Western world falling. The Dow Jones Industrial Average, one of the premier stock market indices in the United States, fell by around 531 points or 3.12% to close at around 16,460 points. The FTSE 100 Index of the London Stock Exchange fell by 2.8%.

Why were these markets reacting to negative Chinese factory data? The simple answer lies in the fact that a shrinking factory sector is a reflection of weak Chinese exports. And what this means is that the People’s Bank of China is likely to devalue the yuan more in the days to come.

If that were to be the case, it would give Chinese exporters some leeway to cut their prices in order to get their exports growing again. And this will lead to imports prices of Chinese goods coming into the United States, Europe and other parts of the world, falling.

As Albert Edwards of Societe Generale wrote in a recent research note: “This move will transform perceptions about the resilience of the US economy… Up until now Japanese yen devaluation has been the main driver of falling US import prices.” Now the devaluation of the Chinese yuan (i.e. if it continues) will add to falling import prices in the United States.

What this means is that the local goods being produced in the US and Europe will also have to cut prices in order to compete with cheaper Chinese imports. And that can’t be good for the economy.

This is precisely the reason why stock markets through much of the Western world fell on Friday. These stock markets close a few hours after the Indian stock market had closed. The BSE Sensex had gone up marginally on Friday.

So, when it opened today, the BSE Sensex had to adjust to a new level and the possibility of the Chinese authorities devaluing the yuan further. If the yuan is devalued further, it would mean cheaper Chinese goods hitting all parts of the world (not that they are not already). In the process China would end up exporting deflation (lower prices) to large parts of the world.

Lower prices would mean that the economies will not grow at the same pace as they were in the past. And that is a possibility that the stock market needs to adjust to. Further, as markets fall, selling leads to more selling.

To conclude, since I started with a Tom Petty song, I will end with one as well: Coming down is the hardest thing. Hope this helps, dear reader. Happy listening!

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column appeared originally on Firstpost on August 24, 2015