China: A Growth Story

The Great Wall

After the Tiananmen Square protests of 1989, China, lead by President Jiang Zemin and Premier Zhu Rognji, took advantage of economic policies put in place in the 1979 post-Mao era of market and social reform. Subsequently, the PRC experienced an economic boon that pulled 150 million people out of poverty, and sustained an average annual GDP growth rate of 11.2% up through last year. This is the China we know today. The fast-growing behemoth that has dominated the last decade both financially and politically. But unfortunately China's final story may be a cautionary tale on the pitfalls of being  overdependent. Jump past the break for the scoop.


Back during the Great Recession of 08', as the world experienced a complete collapse of global commerce, China's export performance responded by going from 26% annualized growth in July 2008, to a 27% contraction only seven months later. GDP dropped to the low single digits, a practical standstill by Chinese standards, and a reported 20M migrant workers in the export-led Guangdong province lost their jobs. China was effectively in recession. They needed to come up with a solution, and quick. In an investment based economy like China's, high growth is like oxygen. Without the massive creation of jobs China has experienced the last two decades, household creation would grind to a halt. All the excess population created by the last 20 years of economic prosperity would be pushed into poverty. China would have collapsed under the weight of social unrest spurred by unemployment. So, in a "new deal" like plan, Beijing lent over $1.7T to local governments to undertake infrastructure projects and build dozens of "ghost cities" which remian mostly unpopulated. Check out this Al-Jazeera piece profiling one such "ghost city", Ordos.

The result has been artificially adding fuel to the already white hot Chinese real estate market and creating what many fear to be a 08'-like property bubble of their own.  Fixed investment in China is now at an unprecedented 50% of GDP, and when you have 6%+ inflation, a looming property bubble and banking crisis, and, add to that, a European sovereign debt boondoggle further threatening export growth, you can see why last weeks fears of a "hard landing" seem quite justified. I'm not quite so pessimistic. Let me explain.

I'm sure some of that $1.7T in local government loans is bad paper, but just how much is "toxic", and how well the banks can absorb potential losses is being exaggerated by the lame-stream media  With rural-urban migration expected to exceed 310M people over the next 20 years, I see the excess inventory in housing being gradually absorbed over that period of time. Plus, banks have ample liquidity to handle any bad loans on the books. The loan-to-deposit ratio is about 65%, almost half what is was pre-crisis.

The property bubble is a little more worrisome. Beijing has tried to dampen speculation by raising down payments to 50% on second homes, and 100% for third homes, but all this has done is curb speculation. Housing prices are still quite elevated which highlights the affordability issues facing China's emerging middle class. Set that aside though as my point made previously applies. With 15M people going urban every year, I don't see property demand waning anytime soon.

The most serious risk to China's soft landing is inflation. Administrative measures to curb food inflation by cutting fertilizer costs and removing bottlenecks to increased supplies of pork, cooking oil, and vegetables, seem to be working. Also, in an effort to curtail excess bank lending, reserve ratios have been lifted nine times in the past 11 months. Finally the PBC raised it's benchmark policy rate to 6.5%, .3% more than the August headline inflation number. Food inflation should recede further and the headline rate should start to creep closer to the 3% core (non-food) rate, resulting in the equivalent of "passive monetary tightening" in real (inflation-adjusted) terms---just what the inflation-prone Chinese economy needs.

This slowdown may be just what the doctor ordered as the increasingly unbalanced Chinese economy can no longer sustain 10% growth. If we get a nice soft landing around 8% it should relieve much of the excess resource consumption, labor-market bottlenecks, excess liquidity and mounting inflation. But China must be aware that the sustainability of their export-led growth model is in question. First the US in 08', and now Europe, have threatened to derail the Chinese growth machine in violent fashion. If they fail to alleviate their dependence on exports, a monumental collapse could be in their furutre. China must implement the pro-consumption initiatives laid out in it's recently enacted 12th Five-Year Plan. What's made China such a compelling growth story is their ability to be nimble and adapt to changing economic conditions, something our country is not setup for. China has learned from our mistakes and learned well. It's now time to put those lessons to use.