The great fall of China

On Shanghai street corners, China’s bull market is raging. With Chinese stock indexes up more than 130 per cent in just one year, the masses are rushing to get in on the action. Last week, more than four million Chinese opened new stock-trading accounts. Investors, many of them novices, have borrowed the equivalent of a quarter of a trillion dollars (up 50 per cent in three months) to play the market. Meanwhile it’s not unusual to see crowds gathered around sidewalk stalls where self-professed market experts offer stock tips like this: “When a Communist Party chairman takes office, I buy stock in companies from his hometown.”

Given the exuberance, you might think China’s economy is in great shape. But, in the eyes of Anne Stevenson-Yang, a highly regarded China expert, the situation is dire. As she recently warned at a conference organized by the Center for Strategic and International Studies, China faces one of two paths: either a drawn-out economic malaise, “a whimper,” or an acute crisis, “a bang.”

The director of research at J Capital, a firm whose clients are international investors, Stevenson-Yang is regularly sought for her understanding of Chinese industries and the health of its economy. She has lived in China for more than 25 years, where she’s earned a reputation for her extensive on-the-ground research. And what she’s seeing flies in the face of the stock-market hysteria. “The striking thing about China,” she says in an interview, “is how depressed everyone is.”

According to the official government statistics, China’s economy has slowed significantly. The country reported GDP growth of seven per cent in the first quarter, the slowest pace in six years. While officials deny a so-called “hard landing” is on the horizon, they increasingly acknowledge the challenges facing the economy.

Yet many observers doubt even the government’s sluggish GDP estimate, and believe the economy is in much worse shape than its leaders admit. For example, Cornerstone Macro, an independent U.S. research firm, pegs China’s economic growth at closer to three per cent. Stevenson-Yang also dismisses China’s official seven per cent rate. “There’s no Chinese person and there’s no Chinese government official who buys [the official statistics],” she says.

Stevenson-Yang marshals considerable evidence to make the point that there is a substantial gap between reported GDP and what’s really going on. Steel demand fell in 2014 and is expected to fall again in 2015. Cement demand is also dropping. Consumer spending is another sign that China’s economy is likely far weaker than the official numbers suggest. According to China’s National Bureau of Statistics, retail sales are growing around 10 per cent per year. Yet, when J Capital looked at publicly traded consumer companies in China, it found that, by the third quarter of 2014, aggregate sales had actually fallen six per cent year-over-year.

Suspicion that China’s GDP is misreported is not new. Back in 2010, Wikileaks published a memo written by the U.S. ambassador to China, who recounted a conversation with Li Keqiang, then a top Communist Party official in northeastern China. Li apparently told the ambassador he only looked at three pieces of information to assess the health of the local economy: rail freight volume, bank lending and electricity consumption. The official GDP figures, Li is reported to have said with a smile, were “manmade” and “for reference only.” Of note, Chinese electricity consumption fell by 2.2 per cent in March compared to the year before.

To understand why the Chinese economy is in trouble now, it’s helpful to understand some of the large imbalances that took hold during the boom of the last decade. Patrick Chovanec, chief investment strategist at Silvercrest Asset Management and a former professor at Tsinghua University in Beijing, explains that China has overwhelmingly relied on exports for growth, with the country producing far more than it consumes. That worked fine until the financial crisis hit.

By 2008, Chovanec notes, “a lot of the countries around the world, particularly the United States, but also within Europe, could not afford to go into greater debt and to consume more than they produced.” That spelled trouble for China’s export juggernaut. To offset this decline in external demand, Chovanec says China merely “doubled down” on an already rampant investment boom, creating huge overcapacity in everything from housing to infrastructure. Much of this investment was unnecessary and is now unprofitable.

One key aspect of the investment boom, China’s rampant growth in new home construction, seems to have peaked alongside the nation’s real estate bubble. House prices and property sales are in decline, as are construction starts, indicating less construction activity in the future.

China isn’t simply saddled with too much capacity. It’s also feeling the weight of a massive increase in debt that was used to finance its overinvestment. As a result, Stevenson-Yang argues, new loan growth is simply being used to service existing debt rather than help the real economy grow.

China’s grim fortunes spell serious trouble for Canada’s resource economy, already reeling from the recent oil price crash. Prices for metals, energy and potash could be hit again if China enters a tailspin, particularly if investors who’ve bet on a recovery in resource prices bail en masse. Australia is a cautionary tale, when it comes to relying on China to support commodity prices. Iron ore, a quarter of Australian exports, has crashed due to oversupply and lacklustre demand for steel by China.

If there’s any respite, however brief, from China’s economic reckoning, it could come from an unlikely source: its stock market bubble.

For its part, the government appears to be actively encouraging the bull run, in part through favourable comments in state-owned media. A cut in the amount of reserves that banks are required to hold has also been seen as a way to boost stock prices. This has given rise to claims that authorities are trying to create a “wealth effect,” in which rising stock prices leave people feeling richer and spur them to spend more money and boost the economy.

Patrick Chovanec suggests the bubble may also be designed to allow debt-stricken companies to recapitalize themselves. Even so, he says, the authorities are playing with fire. Saddling individual investors with overpriced shares is ultimately counterproductive, preventing the economy from rebalancing toward more consumer-oriented growth.

Asked about her earlier claim that China faces either a bang or a whimper, Stevenson-Yang is growing more pessimistic. “I have to say that I’m kind of in the bang side now,” she says, lamenting that there were other policy choices officials could have pursued. In her view, the government’s efforts to juice the market only serve to heighten the risks.

Sure, she admits, the bubble is making some people rich and allowing companies to finance themselves. “On the other hand, it’s pretty dangerous.”