China’s Economic Growth: A Financial Wonder of the Modern World?

One of the true wonders of the modern world, which goes largely unrecognised, is that China manages to collate and report its quarterly economic growth to the world in less than two weeks.

That’s right – just two weeks to report on the collective activities and output of over 1.3 billion people. In contrast, Australia takes over three months.

We know China is a centrally planned economy (and that Australia suffers from poor productivity performance) but this is ridiculous. Even more ridiculous is the West’s desire to believe and hang onto every bit of data that flows out of China, no matter how dubious.

Well, as dubious as it may be, Chinese economic growth came in at an annualised 8.1 per cent for the three months to March. While this is the slowest pace of growth in nearly three years, it should not come as a major surprise.

Just recently, outgoing Premier Wen Jiabao said China’s aim was for economic growth of 7.5 per cent this year. So the consensus view will no doubt be along the lines of ‘this is all a part of the slowdown and rebalancing plans’.

But don’t believe the hype. China’s economic growth problems are both huge and complex. Its 12th Five Year Plan (2011-15) calls for a rebalancing away from investment and exports and a focus on consumption-led growth.

But two years into the plan, that’s not happening. China tried to engineer a slowdown in investment in 2011. Tighter monetary policy saw loan growth and money supply decelerate sharply (see chart below). This caused China’s massive investment boom (basically a property and infrastructure boom) to start deflating.

But there were little signs of the consumer coming to the rescue. So the central planners got nervous and loosened monetary policy again.

It turns out China is back to its old ways…relying on credit growth and investment to hit its economic growth targets.

We saw evidence of this on Thursday. The Peoples Bank of China released monetary data for March. M2 money supply grew 13.4 per cent year on year, representing the second consecutive month of accelerating money supply growth.

Loan growth for the month came in at 1.01 trillion yuan (around US$160 billion), well above expectations of around 800 billion. As you can see in the chart below, net new loans (the blue bars) have grown strongly since bottoming out in late 2011.

Money Supply Growth and Loan Growth

Increasing debt levels is an easy way to promote economic growth. But it says nothing about the quality of that growth. If you look back a few years, you can see the result of the explosion of debt in China. There is spare capacity everywhere…from steel to cement to railways to airports to residential property…and shopping malls.

Click on this link and scroll down to see yet more examples of newly built and absolutely empty shopping malls in China.

In other words, like a lot of the stuff that goes on in China, economic growth has been manufactured. Economies should start with providing people with the freedom to do what they want (within reason…or within the law to the extent the law is reasonable). The result of all this human action is economic growth.

In China, the bean counters start at the other end. They start with economic growth and work backwards. The result is a whole bunch of activity and output that is not really useful to anyone. It’s the curse of the command economy.

This renewed increase in bank lending and growing debt is dangerous for China. In a recent blog post, Professor Michael Pettis from Peking University discussed China’s options for rebalancing growth away from the debt-fuelled investment model towards greater consumption:

Every country that has followed a consumption-repressing investment-driven growth model like China’s has ended with an unsustainable debt burden caused by wasted debt-financed investment. This has always led either to a debt crisis or to a “lost decade” of very low growth.

At some point the debt burden itself poses a limit to the continuation of the growth model and forces rebalancing towards a higher consumption share of GDP. How? When debt capacity limits are reached, investment must drop because it can no longer be funded quickly enough to generate growth. When this happens China will automatically rebalance, but it will rebalance through a collapse in GDP growth, which might even go negative, resulting in a rising share of consumption only because consumption does not drop as quickly as GDP.

I must stress that I am not saying that a collapse in growth must happen, or even that it is likely to happen. My argument here is only that if the unsustainable rise in debt isn’t addressed and reversed, China must eventually reach its debt capacity limit, and this will force a catastrophic rebalancing.

So while the market cheers the short-term impact of renewed monetary loosening and resurgence in uneconomic loan growth (debt growth), keep in mind this represents China moving away from its rebalancing goals.

All those who think China can simply ratchet up its growth by lowering interest rates and firing up loan growth are wrong. This old mode of economic growth basically subsidised exporters and the banks (via the provision of cheap capital) at the expense of the household sector.

That’s why consumption as a percentage of GDP is in the low 30 per cent range, while investment is around 50 per cent. And it’s what caused an investment professional to reflect after a recent visit to the Chinese mainland:

The pace of development (i.e. capital misallocation) across the country is simply mind-boggling. Perhaps some second and third tier cities really do need three state-of-the-art high speed train stations? Perhaps the Chinese people really do just shop on weekends leaving massive furniture malls completely vacant Monday through Friday? And perhaps spending more than half of your GDP on “investment” (relative to 16% in the US and 40% during other historical emerging market credit bubbles) is not representative of one of the greatest economic imbalances in history?

China’s savers are a financially repressed lot. They can’t move their funds out of the country, interest rates are lower than inflation, the stock market is well off its highs and property prices are falling too.

Increasing consumption will mean undoing much of the financial structure that has existed for decades. Doing so might prove a long and painful task. Not doing so will only risk a much larger crisis in the years to come.


Greg Canavan
for Markets and Money

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Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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Is it possible that China’s GDP is made up of more consumption but because everything is off the books and cash based it is not accounted for? Not to undermine the overall argument but the imbalance seems too high to be true.

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