5 Ways To Profit From A China Downturn In 2014
But as Asia Confidential outlined in a recent post, the bulls' arguments are looking much weaker post two spasms of credit stress. And there are four crucial things that these arguments seem to ignore: 1) the investment-driven, debt-laden economic model of China simply isn't sustainable 2) extraordinary credit growth is yielding less and less benefit as investment returns deteriorate 3) the recent spikes in inter-bank rates and high-profile debt defaults (China Everbright Bank) and bankruptcies (coal mining group, Liansheng Resources Group) point to severe stresses within the financial system 4) the structural reforms are a long-term positive, but short-term net-negative for the economy.
It's important to understand how China's economy got to be so big in a short space of time. The speed of economic ascent has no parallel in modern times and it's been the result of a classic export-led growth model.
What this means is that China has been able to mass produce goods on an unprecedented scale given the appetite for these goods abroad. This has helped lift industrial investment well beyond the level which would be needed if it focused solely on the domestic market. And it's been aided by a key competitive advantage on the global stage: cheap labor. The end result has been that China has been able to suppress domestic demand and pour resources into investment.
The reason why this export-led model is unsustainable is that China now produces so many goods that the rest of the world cannot possibly absorb them all. China's gotten to big for its own good, in crude terms.
When the 2008 financial crisis hit, Chinese exports plummeted and the limits of the model became apparent. However, China cushioned the blow by implementing massive stimulus measures. In effect, it sunk even more money into investments, such as infrastructure, property and factories. The problem to this day is there hasn't been the end-demand for these investments. In other words, export demand has remained soft and domestic demand for goods hasn't been able to pick up the slack.
And a bigger problem is that the much of the investments via the stimulus were debt-financed, principally to state-owned firms. These firms were deemed less risky by banks.
That's created an issue for small firms which haven't had access to bank financing. Given reduced export and domestic demand, they've had to resort to financing from outside the banks, the so-called shadow banking system. They've had to pay much higher interest rates as a consequence. And it's widely known that the collateral used for non-bank financing is less-than-solid, on average.
As you may be able to see from the above, the export-led model which China has used over the past 30 years is running into a dead-end. What the new leadership is now trying to do is transition the economy towards more domestic consumption, so that it can perhaps make up for the drop-off in export growth.
The history of transitions from export-led models doesn't make for pretty reading. These transitions for Japan in 1973 and South Korea in 1991 led to sharp slowdowns in economic growth, as seen in the chart below.
Lastly, faith in the new leadership to deliver a successful transition appears misplaced. As noted above, we think Xi Jinping is the right leader to steer the country for the next decade. And many of his proposed reforms have merit and should help in re-balancing the economy.
However, the fact is that China has hemmed itself into a corner where there are limited solutions in the near-term. Cut back on credit-driven investment and GDP falls sharply. Keep the party going and risk a larger blow-up in the not-too-distant future. Moreover, the bulls conveniently downplay that implementation of structural reforms would be a net-negative for growth in the short run.
As for the argument that China can always use its foreign exchange (forex) reserves to provide further stimulus to prop up the economy, the people who purport this have little knowledge of basic economics.
If China were to use substantial forex reserves in this way, it would become a large net-seller of U.S. Treasury bonds. To prevent a spike in interest rates, the U.S. central bank would have to significantly step up purchases, funded ultimately by private citizens savings. Less of these savings would dampen U.S. consumption and ultimately, Chinese exports to the US.. In other words, a move by China to substantially cut forex reserves would not only be a disaster for the developed world but for China itself.
5 Ways To Profit From A China Downturn In 2014 - Forbes