In the US on Friday, the S&P500 surged to a new record high, presumably because there’s not a lot to worry about. The Fed looks like maintaining its US$85 billion per month liquidity pump and the US government is without debt limit for a few more months at least. It’s party time.
Oh, and let’s not forget China’s contribution to the latest price melt-up. On Friday afternoon it released better than expected economic growth numbers. The economy grew 7.8% in the three months to September 30, reversing a mid-year slowdown that had China’s leadership completely freaked out.
So how did this reversal come about? By reverting to the old tried and true growth model of infrastructure lead investment. According to the Financial Times, fixed asset investment accounted for a whopping 56% of GDP growth in the third quarter:
‘The Chinese government has been talking for years about rebalancing the economy to unleash more consumption and it has made some progress toward that goal, but over the past few months it fell back on investment to head off the risk of a slowdown.
‘Investment in fixed assets such as rail lines and apartment towers accounted for 56 per cent of the country’s growth in the third quarter.’
To the casual observer, China’s metronome-like economic growth rates (generally bang on target) must make it seem like the central planners really have it together. But to a student of Austrian economics like us, the make-up of the economic growth is frightening.
A few years ago when China’s credit bubble started inflating and its economic growth became increasingly led by fixed-asset investment (think apartment blocks, railways, airports etc) alarm bells started to ring about the long term effects of such growth. When investment as a percentage of GDP hit 50%, China had breached all historical precedent, eclipsing Japan and Korea in their earlier industrialisation eras.
Now, a few months after trying to engineer a slowdown (which wasn’t successful) China has had to rely on investment for growth on an even greater scale. The amount of malinvestment going on in the Middle Kingdom is mind-boggling.
We know there are a lot of proponents of the ‘build it and they will come’ economic model. That there are millions of ‘poor’ Chinese moving from the countryside in need of housing and basic infrastructure. But this is not how economic structure evolves. Or at least it’s not how it evolves without encountering major problems.
China is effectively repressing household expenditure (domestic demand) and using their savings to build state-directed infrastructure. However these assets – because they are state-directed and not a natural consequence of real demand – are not producing economic returns.
When that happens, the assets turn ‘bad’, or ‘impaired’. That’s because the income produced by the asset is not enough to cover the cost of servicing the debt required to build it.
So why aren’t you seeing rising bad debts in China? Well, one way to avoid bad debts is to increase borrowing to such an extent that it masks any problems. Instead of an asset providing the income to pay for itself, why not just take on more debt to pay the interest bills?
Why not indeed. In September, China’s total system credit growth was US$230 billion (for the month, not annualised), down from August’s massive US$260 billion growth…but on a year-to-date basis (around US$2.3 trillion) it’s still running about 20% above 2012 levels. And don’t forget in 2012 credit growth hit historic highs in response to the 2011 slowdown.
So 2013 credit growth is roughly 20% greater than 2012’s already record levels…
The gargantuan level of credit growth is flowing through asset prices and creating a huge bubble in Chinese property. That it hasn’t deflated yet is only because we’re seeing greater and greater credit growth. It’s the world’s largest Ponzi Scheme.
In 2013, China’s credit growth is on track to expand at more than 35% of GDP. You don’t get that type of growth without experiencing major malinvestment. It’s been happening for a few years too, which will just make China’s adjustment to more balanced economic growth even more difficult to make.
When will this adjustment happen? Well, China is different in that the State, not the private sector largely determines the pace of credit growth. If the State is supplying, the private sector will lap it up. As far as the Chinese people are concerned, for the past few years the State has given them one giant gambling opportunity. ‘Here’s the capital, go and speculate.’
So China just may be able to go through 2014 with even greater credit growth and head off the inevitable. We didn’t think they’d go to such extremes in 2013, so don’t ask us whether it’s possible to drag this boom out for another year.
But it’s all about probabilities…and we’d suggest the probability of yet another year of even greater credit growth in China is quite low. Nothing’s impossible in this screwed up financial world, but the prudent observer should be pretty worried about where China is going.
The Weekend Financial Review interviewed one such prudent observer – an Aussie managing the US$80 billion First Eagle investment fund in New York – and he had this to say about the situation:
‘"The underlying concern is that you have had a series of ‘fake prices’. First, the price of money has been faked through central banks lowering interest rates to artificially low levels. Second, the most important exchange rate in the world- between the US dollar and the Chinese renminbi – has been a quasi-pegged currency."’
‘The US dollar reserve standard has led to "white elephant malinvestment in creditor countries like China with excess construction and manufacturing capacity that wouldn’t have existed were it not for the exchange rate"’
The US-yuan peg is perhaps the source of the world’s largest economic distortion. But the biggest issue is why we still persist with an economic system that grants the US dollar and US government debt as reserve asset status. It’s a system that guarantees booms and busts…speculation and poorly allocated resources. It’s a system that’s now into its fourth decade and it’s starting to become unruly.
That it will end is not in doubt. How it will end is the question. Will China make a move to avert a socially destabilising credit bust and thus utilise its growing gold resources, or is the system so full of mutual dependencies it will just blow up in its own way?
We don’t know, but we’ll have a crack at exploring some of these issues this week…
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