China: The New Japan

china and japan flags

Most people regard China as an economic miracle. An unstoppable juggernaut guided by astute leadership.

In 1979, under the leadership of Deng Xiaoping, China implemented free-market reforms and opened its doors to foreign trade and investment. And so began the road to economic transformation.

In the space of 38 short years, China’s economic prowess has become unrecognisable. It’s on show for all to see.

China has churned out consistently high growth rates — 6%, 7% and 8% — while the rest of the world struggles to move the GDP needle.

Much has been written about China’s gravity-defying property values…which in turn encourage more debt-financed property speculation. Creating a virtuous cycle of asset price appreciation.

China’s exporting capability has provided it with the resources to accumulate substantial foreign reserves.

China is now the world’s second largest economy on a GDP basis.

Around the same time that China was starting its economic revolution, Japan was making its assault on the title of ‘world’s second largest economy’.

After its defeat in the Second World War, Japan reinvented itself into a manufacturing powerhouse — in the process becoming a global economic force to be reckoned with.

Japanese corporate success became a case study for Western business management.

Japan — flush with foreign reserves and access to (seemingly) unlimited debt markets — went on a global buying spree.

Hotels, golf courses, development land, you name it.

In the space of 40 short years, Japan was the pin-up model for the global economy.

The following chart shows that, prior to its long-and-hard fall from grace, Japan also enjoyed consistently high GDP growth rates.

Japan Growth Rate 20-11-2017


Source: grips.ac.jp
[Click to enlarge]

There is nothing like sustained economic success — and banks run by buffoons — to generate a property boom.

Japanese land values, especially in the major cities, increased exponentially.

Japan Land Price Index 20-11-2017


Source: grips.ac.jp
[Click to open in new window]

China’s property market is experiencing a similar ‘south of the mountain’ ascent…the descent is yet to come.

China and Japan (let’s throw in Australia, Ireland, Spain, Iceland, et al) have followed the same economic expansion model…debt, debt and more debt.

The injection of debt — good, bad or otherwise — into an economy creates the illusion of prosperity and, if it continues long enough, invincibility.

Those who are too blind to see the obvious say China is not Japan.

China is a ‘command economy’ — a planned economy directed by the guiding hand of government.

A system where the guiding hand makes a fist and demands state-owned enterprises (SOEs) and listed companies buy shares to prop up a falling share market…or else.

Seriously, who in their right mind believes that a handful of government officials can outthink and outsmart a marketplace made up of millions of consumers?

Whenever a government gets involved in markets, it ends up as a colossal stuff-up.

The initial intention might be pure of heart and purpose. But, along the way greed, graft and corruption inevitably come to the surface. Human nature is so predictable. 

The other line of reasoning for China being ‘different this time’ is the notion that financial stability is tied to political stability.

I completely understand the theory here.

But, as the old saying goes, ‘In theory, theory and practice are the same, but in practice they are not’.

For example, regime change and military coups are not new concepts…especially if the mob becomes restless. The Arab Spring comes to mind.

The Ruling Party may want/desire/covet financial stability to retain power, but it doesn’t mean that’ll be the outcome. Millions of households under financial stress are very unpredictable.

In recent months, the warnings, from those with an in-depth knowledge of China, have increased.

In October 2017, China Beige Book International published its latest report titled: ‘China isn’t fixing its flaws: Optimism about the economy is based on misconceptions’.

For some background on the China Beige Book:

‘… [the firm] quiz over 3,300 firms across China about the performance of their companies as well as the broader economy. Their responses reveal that much of the exuberance about China today is based on dangerous misconceptions.

The three misconception the firm identified are:

The first and most obvious myth is that China is actually deleveraging, as officials claim.

The second myth is that the Chinese economy has finally begun to rebalance away from manufacturing and investment to services and consumption.

Finally, and again contrary to government claims, China hasn’t slashed overcapacity in commodities sectors.

Contrary to official spin, China’s high debt levels are increasing; much of that debt is adding to the excess capacity in the system.

Nothing has changed. It’s business as usual.

China is increasing its productive capacity at a time when the Western world is reducing its demand (thanks to wage stagnation, high personal debt levels and retiring boomers).

When over-indebted manufacturers cannot generate the cash flow to meet their obligations, China has a serious debt problem.

China — like the rest of the major players — has an economy addicted to debt.

Without debt, the whole magic show is revealed for what it is…a giant con.

We’ve seen this illusion before, yet we’re told ‘this time is different’.

Another China expert who’s not buying the story is Michael Pettis.

Pettis is a professor at Peking University’s Guanghua School of Management, specialising in Chinese financial markets.

In a September 2017 post titled ‘Is China’s Economy Growing as Fast as China’s GDP?’, Pettis made these observations:

GDP does not directly distinguish between activity that increases a country’s wealth and activity that doesn’t.

I would argue that “the end of China’s stellar growth story” has already occurred, and occurred quite a long time ago. Growth in the Chinese economy has collapsed, but growth in economic activity has not collapsed. The growth in economic activity has instead been propped up by the acceleration in credit growth and by the failure to write down investments that have created economic activity without having created economic value.

This means debt will have grown faster than it otherwise would have. Higher-than-expected GDP growth should therefore suggest that we revise downward our longer-term growth expectations. It simply means that a higher level of unrecorded losses must be written down in the future and, because it implies more debt than otherwise, financial distress costs in the future will also be higher.

This is precisely what I’ve been saying for years…GDP is simply a measurement of money — savings and borrowing — going around in the system. The more debt you take on, the greater the positive impact on GDP.

China is not a miracle — it’s a mirage.

China is the new Japan…but with a twist.

When Japan’s bubble burst in the 1990s, our economy was saved by China’s economic transformation.

Throughout the first decade of the new millennium, Australia was a major beneficiary of China’s grand plan.

The mining boom was a direct result of China’s rapid debt expansion (with debt levels going from US$7 trillion to US$28 trillion) after the GFC.

When China’s bubble bursts — and it almost certainly will — there’s no other Asian saviour to prop up our debt-laden economy waiting in the wings.

Worse still, in a case of ‘every man or woman for themselves’, China will pump out as much ‘stuff’ as it can to generate revenues.

China is going to export deflation around the world.

Regards,

Vern Gowdie,
Editor, The Gowdie Letter

Vern Gowdie

Vern Gowdie

Editor at Markets & Money

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

He is a feature editor to Markets and Money and is Founder and Chairman of the Gowdie Family Wealth and the Gowdie Letter advisory services.

Vern Gowdie

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Denis Ross
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Hi Vern, Your analysis is based on some questionable presumptions and overlooks important matters like the differences in debt in China, and say the USA. In the USA a graph of the S&P 500 index use to measure stock market performance of US companies correlates, parallels, the increase in paper assets bought by the US Federal Reserve Bank. From the low point of mid-March 2009 the value of paper assets bought rose from $800 Billion to $4.5 Trillion. The increase is accounted for by creation of new money (credit) that did not go into prodction of wealth but into the… Read more »
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