FSO Editorials

Is China on the Brink?

by Thomas P. Au, CFA, Author & Market Analyst. September 15, 2006

China is now feeling the strain of almost a decade of torrid growth. Although there are plenty of worrisome signs, the conventional wisdom is that things will be fine through the 2008 Olympics. I have a slightly different view of the timing of a pullback in that country's economy, which could be especially bad, given likely upcoming developments in the United States (and elsewhere in the world).

One example of prevailing opinion is that of James Jubak, a street.com guest columnist, who thinks that the Chinese economy is headed for "a train wreck," having just passed "the point of no return." Cheap U.S money, operating through China's mammoth trade surpluses and dollar reserves, has fueled a steroidal double-digit GDP growth that has even the local authorities worried. The result is that key industries such as cement and steel are seeing profit plunges because of price pressures caused by overcapacity. This is spreading to a number of areas, mainly the commodity producers dominated by state-owned-enterprises (SOEs), many of which are bankrupt in all but name, and are propped up by outstanding bad loans from state banks.

I disagree with Jubak about one important thing though, in my belief that the crisis in the Chinese economy will not take place in 2009, after the Olympics as Jubak opines; it will take place before, in late 2007 or early 2008. What has been driving the Chinese economy is not the 2008 Olympics per se, but rather the anticipation of the Olympics, which will mostly end in 2007. The infrastructure buildup in advance of the hosting of the games has been giving a one-time artificial, and foreign-based, stimulus to the economy, creating a gap that domestic demand cannot fill. By early 2008 on the other hand, investment for the Olympics will be winding down, as attention turns to last-minute fine-tuning of the event itself, likely causing a sharp drop in aggregate demand at that time. And markets often move on anticipation of major events, not necessarily on the events themselves. ("Buy on rumor, sell on news.")

Jonathan Laing raised some related concerns in a recent Barron's article. Runaway development is creating massive environmental problems, including calling into question the safety of air and water in much of the country. China needs five to six times as much energy to produce a dollar of GDP as the United States, so its energy use is now starting to approach ours, despite the vastly larger GDP stateside. And more of China's energy is from pollution-creating coal. And there have already been spot shortages of essential commodities such as water and electricity. Given the country�s overloaded infrastructure, it wouldn't take all that much to bring about a general shortage. Either this, or environmental problems, could quickly halt, rather than merely slow, growth.

In fact, one important question is how large is the size of the black hole of bad loans to SOEs, meaning how costly is it to keep the country more or less fully employed, thereby dampening social unrest. The official estimate of such bad loans is about $200 billion, an unpleasant, but manageable amount. But Ernst and Young did a study that initially pegged the true figure as closer to $900 billion, roughly the size of China's foreign exchange reserves (the world's largest), before the firm withdrew its findings under heavy pressure from the Chinese government. And as we learned from a painful experience with a company called Enron, America's accounting firms tend not to overestimate the magnitude of problems. My guess is that China's bad loans are north, rather than south of $1 trillion.

Moreover, there is widespread corruption at the banks that lend to the SOEs; officials at China's second and fourth largest state banks were recently arrested for embezzlement and fraud. Less dishonest, but only slightly less troubling problems include the lack of underwriting standards and regulatory oversight, because of the banks' social mission to prop up the SOEs, which provide the largest proportion of China's jobs (because the private sector is more efficient, and hence less labor intensive).

Moral hazard is clearly at work, as rapid growth encourages a "get rich quick" mentality, causing people to cut corners and bend the rules, creating widespread discontent among the hundreds of millions of people who are not participating in, and are fact harmed by, the recent "economic miracle." This is causing protests, riots, and other events that threaten social stability. In order prevent the details from getting out, China is passing laws forbidding the divulging of "government secrets," particularly those about natural or other disasters, especially when reports about bureaucratic incompetence are involved. Even printing a critical article like this one, while legal in the United States, might soon be illegal under evolving Chinese law. When a government goes out of its way to suppress the truth (as it did in the former Soviet Union), it is a sign that the truth is probably too bad to tell.

All this wouldn't seem so critical if it weren't for the fact that I believe that the United States will have a recession in 2007. This would be a result of our own, somewhat milder version of China's problems, which would start with the impending bursting of the consumer bubble (particularly in housing) caused by the Fed's earlier easing and more recent tightening. Under ordinary circumstances, the U.S. economy should begin a comeback in 2008, after a cleansing period, although whether that would be enough to elect a Republican President would be very much open to question. (The muted 1992 recovery from the 1990-91 decline was not enough to re-elect George Bush Sr.)

But the timing and degree of a prospective Chinese crash raises the stakes. In 1931, the United States was in a recession that then-President Herbert Hoover reasonably thought would soon end. The impending recovery was derailed by the collapse of the German economy, then the second most important in the world, not only because of its sheer size, but because of its connections to other countries in Europe. China's economy plays a similar "second most important" role today because of her ties in Asia and elsewhere, and because its swings are larger than those of other, nominally larger, economies such as those of Germany and Japan. If a collapse of the Chinese economy comes hard on the heels of a deep U.S. recession in 2007-2008, the result could be a prolonged slowdown of global growth such as we saw in the 1930s.

Contact Information

Thomas P. Au, CFA | Author & Market Analyst, R. W. Wentworth | New York City, NY | Email