The China Conundrum

Location Date: 
May 24, 2011

It is certainly accepted wisdom that as goes China, so goes the world in terms of global growth and therefore by extension, most of the ancillary themes including commodity prices. Prices there are set by the marginal buyer and what a marginal buyer we have in the power of China.

It is also accepted wisdom that to fund its’ current account deficit, the U.S. sends its’ debt to China, who in turn buys the debt with printed reminbi (RMB), thus preventing the RMB from appreciating or depreciating versus the USD.  The cheap RMB is great for Chinese exports (as the Congress correctly notes) and U.S. gets its’ twin deficits financed (to the chagrin of the Tea party and a growing percentage of U.S. citizens).

The issue that has raised its’ ugly head is that inflation in China (along with India and other parts of Asia) is running very hot, resulting in negative real yields in most of these markets.  The Consumer Price Index (“CPI”) in China is running at 5.3% (just released April figures) and has remained stubbornly high despite four rate hikes since October 2010 and constant rises in the reserve requirements of China’s banks.

Premier Wen Jiabao has blamed the U.S. (along with others) and its’ QE2 policy for causing all of the gushing liquidity to find a home in the commodity markets (oil, cotton, wheat, corn etc.), thereby driving up CPI and food prices around the world.  The Chinese have gone so far as to try to ban inflation by fining companies like Unilever for raising prices (which they settled for $300k!).  That is not going work – Unilever and others will simply do what they have to do to earn a profit.  That being said, critically, food price inflation is running well ahead of CPI in China and if the people cannot afford to be fed, the riots will start (like they have elsewhere).  Overall, inflation is a top priority for the Chinese government.

David Pilling in The Financial Times wrote an excellent piece (click here to read – if you are a subscriber) on the topic last Friday.  He cites the real culprit as the Chinese themselves based on two counts. Firstly, in the latest 5-year plan the Chinese have allowed wages to grow at much higher levels than the economy – often at rates between 20 and 40%!  Secondly, they pumped up their own economy so massively in 2008 and 2009 that monetary growth (M2) is simply off the charts. Chinese banks lent $1.4 trillion in new loans on a $5 trillion economy!  Most of that growth in money found its’ way into massive fixed investment and in particular, residential real estate construction (condos in particular), so much so that “ghost towns” are frequently cited as the offshoot of the madness.  Of course, that massive growth in fixed investment may sow the seeds for future disinflation or even deflation in China.  While China has allowed the RMB to appreciate modestly and they have raised the reserve requirements and deposit rates, this is clearly has not been enough to curb inflationary pressures.

Grant's Interest Rate Observer has stated that M2 in China is pegged at $11.7 trillion, which is 30% higher than the U.S. despite the fact that the U.S. economy is 2.5x bigger than China’s.  The fact that China has capital controls means this money largely stays in circulation in China – not surprising, when real estate (particularly residential) rose at a 33% yoy rate, pricing most first-time buyers out of the market.  China has adopted a policy of greater public housing as a solution but that may backfire, putting pressure on existing housing over supply.  As for the $3 trillion-plus of U.S. dollars on reserve, well who knows? Some of it is going to a mix of other currencies, hard assets (reserves) and investments, and Canada, Brazil and Australia have been big beneficiaries.

Given the massive money growth, it is not surprising Chinese GDP growth is close to 10%.  But what has many analysts worried is that based on the above, Chinese inflation is well above the reported/official number – anywhere from 8.4% to over 10% - making real economic growth nothing more than a “mirage” built upon a massive bubble of bad debt.  Jim Chanos has taken the pole position representing the bears on China’s economic miracle predicting a hard landing (see CNBC interview;  China is a key importer of 40 – 60% of certain core commodities like iron ore, coal and copper – necessary ingredients for construction and building.  Chanos claims that fixed investment is running at 70% of GDP – if growth slows, as it may given that Chinese policy makers are bent on cooling the economy, then a hard landing or very rapid slowdown is likely.  Arthur Budaghyan at BCA notes that capital spending has simply been running too hot for too long.  

Source: BCA Research, May 6, 2011

This has led to a misallocation of resources in the real estate and construction sectors in particular.  The fact that China has moved to ban fourth, third and second mortgages is evidence of a system out of control with speculation.  This, of course, will lead to falling profitability and returns on capital and most certainly a build-up in bad debt for China’s banking system.  The fact that Chinese banks and the Chinese equity market have both been poor performers over the past 12+ months corroborates the idea that these facts are not lost on investors – they will be key leading indicators as to whether the government will need to step in to bail out/recapitalize the banks for what was basically a massive fiscal stimulus disguised as “lending”. The attached chart shows the break in the Chinese stock market may have occurred Monday.

Source: Bloomberg, May 2011

Budaghyan’s view is more cyclical than structural as he still believes China has a lot more investment to grow in time.  However, if Chanos and Budaghyan are correct in the short-run, then deflation will be the name of the game – Chanos recently spoke about “cracks in the façade” already in evidence. 

Source: BCA Research, May 6, 2011

If we couple this with a fall-off in OECD demand given the issues in Europe and the U.S., the problems in China will be exacerbated.  Expect the Chinese with their massive reserves to prop up economic activity again should that occur.  And like the U.S., China will push out their own “debt supercycle” for another kick down the road.  This outcome would be bullish for U.S. treasury bonds.

Of course, the reason that everyone is so focused on China is the fact that its’ growth (or lack thereof) has massive ramifications for the global economy.  In particular, Canada, Australia and Brazil have much to lose (or gain otherwise) if growth falters and a hard landing occurs given the reliance on commodity prices.  However, if one takes a longer term view and balances it with geopolitical risks on oil in North Africa, the Middle East and the rising costs associated with finding and procuring these resources, then the pullback should be relatively shallow – oil goes to $85 and copper to $3 for example.  These are tradable moves for sure and will result in a number of follow-on good risk reward trades before year-end.

Jim McGovern

Footnote: Grant’s Interest Rate Observer, May 6, 2011 (Vol. 20, No. 9) and May 20, 2011 (Vol. 20, No. 10)