China's GDP Growth Ponzi Scheme

Surprise, surprise. China’s GDP growth for the third quarter came in bang on the consensus estimate of 7.4%, the slowest rate of growth in years. But the market liked it because on a quarter-on-quarter basis growth was 2.2%, up from 2% in the prior quarter. So on an annualised basis, the Chinese economy grew at a fast 8.8%.

Or did it?

We mentioned yesterday that the published numbers are a farce. They tell you what the Chinese Communist party wants you to know — that they are in control and everything is going according to plan.

For example, here’s the introduction to China’s GDP release from the National Bureau of Statistics of China:

‘In the first three quarters of 2012, faced with the complicated and volatile economic environment at home and abroad, the CPC Central Committee and the State Council committed to the general tone of progressing steadily, correctly handled the relationships among steady and comparatively rapid economic development, the adjustment of economic structures and the management of expectation on inflation, paid more attention to maintaining steady growth, carried out the proactive fiscal policy and prudent monetary policy, and made great efforts in policy presetting and fine tuning. As a result, the overall national economy realized steady development with some positive changes: the economic development stabilized; structural adjustment speeded up and people’s livelihood continued to be improved.’

So there you have it, The Party has it all under control…nothing to see here, go about your business.

And the bluster seems to have worked. Based on yesterday’s data release, everyone now seems to think that China’s growth rate has ‘bottomed’ and it’s back to business as usual from here. John Garnaut’s article in The Age nicely encapsulates this cosy little world view.

Garnaut’s reporting from China is normally good, but here he just reports the ‘facts’ as dished out by China’s central planners. To really get a grip on what’s happening in China you have to look behind the facts. So as a counter to the mainstream view, which is one that the media will no doubt run with for the next few days, have a read of this. It’s analysis from one of our favourite China watchers, operating out of Hong Kong.

The gist of the analysis is that the numbers really don’t make sense. That there are other important indicators that suggest China’s GDP growth should (or could) be much lower. For example electricity consumption growth is nearing 0% year-on-year.

So the task of today’s Markets and Money is to show you why China’s supposedly better-than-expected data is not what it seems. And especially for Australia, it means the ‘pain’ has only just started.

Allow us to explain.

The whole point of this ‘engineered’ Chinese slowdown is to rebalance the Chinese economy. That is, rebalance away from property and ‘fixed-asset’ related investment, and more towards domestic growth. The third quarter China’s GDP data suggests that is not happening at all. In other words, the rebalancing has not even started.

For the three months to September, fixed asset investment grew at an annualised rate of 17.6%. That’s slower than annualised growth for the first three quarters of the year of 20.5% but it’s still very robust and much faster than overall growth. This means that fixed asset investment as a percentage of GDP is still growing — exactly the opposite outcome of what China says it’s trying to achieve.

Or take real estate investment. In the first three quarters of the year, real estate investment grew at an annual rate of 15.4%. That’s a big slowdown from the same period last year (when annualised growth hit 32%) but it’s still in excess of overall GDP growth, which means property investment as a percentage of China’s GDP still remains stubbornly high.

In other words, China’s rebalancing has not even started. The process of rebalancing is underway, in that growth rates for real estate and fixed asset investment are coming down, but they need to slow much more for actual rebalancing to occur.

China can spur growth again easily if it wants…but it will be unstable growth. It will cause even greater transition problems down the track.

This is the issue that most people don’t understand about China. That is, rebalancing the economy requires much, much slower growth in the commodities intensive sectors of fixed assets (roads, railways, empty cities, etc) and real estate, and much faster growth in domestic consumption.

Given that much of China’s household wealth has actually financed the investment boom, turning off the funding tap (to encourage spending instead of saving) would prove disastrous.

Xiao Gang, Chairman of the Bank of China, recently wrote an op-ed piece for China Daily that focused on this financing of the investment boom. Much of it occurs through China’s ‘shadow banking system’, which consists of ‘Wealth Management Products’. They are off-balance sheet vehicles sold by the banks to households and could be as large as nearly US$2 trillion. Gang writes:

‘Chinese banks work closely with trust companies or other entities by packaging trust loans into WMPs, offering investors a higher yield than conventional bank deposits can. These products are mainly sold by commercial banks either at their branches or online. Many of the funds that were obtained through these channels went into real estate development, infrastructure projects, the manufacturing sector and local government financing vehicles. Banks are playing the role of “middlemen” between the recipients and investors.

‘There are more than 20,000 WMPs in circulation, a dramatic increase from only a few hundred just five years ago. Given that the number is so big and hard to manage, China’s shadow banking sector has become a potential source of systemic financial risk over the next few years. Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations.

‘Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.

‘China’s shadow banking is contributing to a growing liquidity risk in the financial markets. Most WMPs carry tenures of less than a year, with many being as short as weeks or even days. Thus in some cases short-term financing has been invested in long-term projects, and in such situations there is a possibility of a liquidity crisis being triggered if the markets were to be abruptly squeezed.

‘In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme. Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs could weigh heavily on formal banks’ reputations, because many investors firmly believe that banks won’t close down and they can always get their money back.’

They’re some pretty strong words from a bank Chairman currently enjoying the benefits of the Ponzi. It just goes to show the deep-seated natures of the problems unleashed by a credit boom. We explained how it all came to pass in our China’s Bust report.

The thing to keep in mind when looking at headlines about China’s so-called ‘revival’ is that this is a long term problem. More importantly for commodity exporters like Australia, China’s economic adjustment has not even started in earnest.

As is the nature of these long term trends, there will always be a short term counter-trend or argument to deal with along the way. But don’t be misled. Keep your eye on the big (underlying) picture, because worries about China’s growth trajectory will surface again…maybe later this year…maybe in early 2013.

If you want some specific investment ideas about how to avoid the fallout from this structural change in China’s (and by implication, Australia’s) economy, check out Dan Denning’s latest report on the subject.

The bottom line here is that if you’re betting on China, you’re betting against history. No nation in history has ever had such unbalanced economic growth (that is, investment accounting for around 50% of GDP). In the instances that came close (the notable examples are Japan in the late 1980s and the US in the late 1920s) the aftermath was not too pretty…

Have a great weekend!


Greg Canavan
for Markets and Money

[Ed note: In the US Declaration of Independence, Thomas Jefferson wrote that ‘all men are created equal’ with unalienable rights that include ‘Life, Liberty and the Pursuit of Happiness.’ This was the inspiration for Kris Sayce to launch a new FREE twice-weekly eletter.

He’s called it the Pursuit of Happiness. His free eletter is different from the Markets and Money because it covers the non-financial issues we don’t usually talk about here. So if you like the sound of an eletter that talks about life, liberty, health, retirement and the pursuit of happiness, Kris’s new eletter will be just what you’re after. To get Kris’s new FREE eletter, please click here to sign up for free…]

From the Archives…

Still Bullish on China?
12-10-2012 – Greg Canavan

Global Economy Health Check
11-10-2012 – Satyajit Das

Super Clueless For Your Retirement
10-10-2012 – Nick Hubble

An Investment Strategy for the End of Australia’s Lucky Run
09-10-2012 – Dan Denning

How The Fed’s Forecast Fallacy Leads to Stagflation
08-10-2012 – Nick Hubble

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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3 Comments on "China's GDP Growth Ponzi Scheme"

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Good article, and true-‘China’s growth trajectories worries’ will surface again in 2013, especially on the demographics front. The collection of pekingneses, poodles and pugs we call ‘politicians’ in Australia will, of course, not see this prolem until it is too late. Aussie investors should be very careful about the information on Asia and China when the ‘Asian Century’ white paper is released as I bet it will not contain the full demographic problems all of Asia and China face and the damage it will do to Australia’s economy when the Asian population ages and declines faster than what our politicians… Read more »
“if you’re betting on China, you’re betting against history” Greg my bet mirrors yours in a longer term (decades)sense but I have not joined in the imminent China collapse chorus of the last few years. And I could easily be wrong I admit. Some websites from Chinese capitalists are very adamant the imminent collapse crowd are only looking at the worst parts of the China story and ignoring some fundamental differences with the west. I know they are not running a market economy with small government but China does have the means of production and the commodities access and the… Read more »
truth and integrity

We are in the process of a global crash that has been occurring for over 20 years; maybe 35 years since Bretton Woods disbandment.
Real wages and life styles have not improved.
All comments above are true. The Baltic Dry Index is still near it’s lowest in 13 years or 9% what it was five years ago. The index did boom 6 to 10 times immediately prior the financial crisis. All these figures appear highly inflated.
GDP figures in all countries would be negative because money transfers are more than 50% and sometimes 1000% productivity.

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