Individually, growth in the individual economies of Brazil, Russia, India, [The People’s Republic of] China and South Africa (collectively the BRICS nations) has skyrocketed. However, their collective success is largely down to the blistering, double-digit growth of the PRC. By 2010, the PRC had overthrown Japan’s reign of 40-plus years as the world’s second-largest economy as exports boomed. From barely a blip in global manufacturing in 1990, today the PRC occupies around a quarter of the world’s output. Growth was further boosted in 2008 as Western demand for Chinese goods faltered on the back of the financial crisis, prompting the launch of a gargantuan government investment spending spree, one of the largest the world has ever seen.
Have the Good Times Stopped Rolling?
Admittedly, the PRC’s recent growth puts it in a whole separate category when defining ‘good times’. It speaks volumes when last year’s growth of ‘only’ 7.4%, a rate most governments would sell their grandmothers for, disappoints. Though 7.4% growth on last year’s GDP means a greater value gain than double-digit growth 10 years ago due to the economy being far larger now, 2014’s growth was the worst for almost 25 years.
Chinese dragons aren’t typically depicted with wings, but humour me for a moment. A barrage of issues have clipped the great dragon’s wings at a time headwinds faced by this majestic beast were already causing an economic slowdown — 7% is the official forecast for 2015.
Recent infrastructure investment has included the world’s largest hydroelectric plant; the reservoir retained on the Yangtze River by the Three Gorges Dam is vast, yet in northern PRC water stress looms. The north is home to the country’s capital and its 21 million plus residents, as well much of its farmland, but the PRC’s water is concentrated in the south. In the parched north, agriculture and high population density slurp up water at an alarming rate. Entire rivers are vanishing. Those left are notoriously polluted; some can’t even be used for irrigation. Over and above leaving people and crops thirsty, with some water supplies being unfit for even human contact (i.e. washing), let alone consumption, the costs to health dent GDP growth.
What’s more, the energy sector is thirsty — water cools the growing legion of power plants necessary to fuel the PRC’s economy and washes the coal firing many of them. The US’s shale boom glugs huge quantities of water per well, injecting it at high pressure to fracture rocks and release their contents. The PRC also has notable shale reserves, but imitating US success, boosting GDP and domestic energy production, will require water from somewhere.
The recent construction boom has poured money into residential building projects to house an increasingly urban population, but developers got overenthusiastic. ‘Ghost cities’ of unsold dwellings dot the landscape. Property sales have tanked and new housing starts are in the doldrums. It may take 3 to 5 years of property sales at current levels to clear current oversupply, repressing property prices and construction investment for years. Meanwhile, a side effect of this boom has been inefficient urban sprawl — Beijing is currently on its seventh ring road, such is the pace of its expansion — costing productivity.
Over-investment is a major factor in the PRC’s rising tide of debt. Government, corporate and household debt amounts to over 250% of GDP, admittedly below many developed countries but far above other developing economies. Government debt is a major part of this, especially after its recent investment spree.
Companies are also heavily indebted, with corporate bond issuance being one of the many ways companies are accruing ever-growing and ultimately unsustainable debt. Yet companies feel safe doing this; Chaori Solar’s fate after it became the first Chinese company to default on its onshore corporate bonds in March 2014 further boosted confidence. By that October, Chaori Solar’s investors were cheered to hear Great Wall Asset Management, a state-owned bank established in the late 1990s specifically to buy toxic assets from the PRC’s four major state-owned banks, would bail them out.
The cost of the assumption that even the riskiest investments come with a cast-iron government guarantee is spiralling debt as good money is shovelled after bad instead of being used to fund growth. The Chinese Government’s tight rein on banks — previous hints at a credit crunch have been met with stern demands that banks loan more — exacerbates oversupply of credit but prevents a credit crisis.
The PRC’s huge foreign exchange reserves (24 times the UK’s) and its banks’ reserves of around 3 trillion yuan provide it with a vast rainy day fund. Despite this, Chinese banks, books filling with bad loans and dealing with the mounting costs of investor bailouts, may start to decay from the inside. Zombie loans and corporations will drag themselves onward, fingers clenching for ever greater handouts of yuan. Not even the might of the PRC’s economy and enough foreign exchange to fill the world’s swimming pools can bail out every single Chinese firm, debtor and bank which runs into trouble in the future. If companies are not allowed to fail without incurring a cost to the state, debt will rise and the economy will continue to slow.
The PRC’s growing middle class has international companies salivating at its vast untapped potential, but spending by these households is currently far more important domestically. For the PRC, much rides on households’ ability and willingness to spend as it attempts to shift from investment and manufacturing to a consumer-based economy. Chinese households save rather than spend, although the Government’s recent moves towards offering social security benefits could make consumers feel comfortable saving less.
The repercussions of this shift from manufacturing towards domestic consumption have been felt globally. On weaker Chinese manufacturing output and demand, commodity prices have slumped in recent months, not just oil but all the other raw materials (copper, iron ore, coal) the PRC once had an insatiable appetite for. Brazil, Indonesia and Australia are among those hit hardest, but many countries are affected.
Moreover, manufacturing output is weakening not only on this desired shift towards a consumption-based economy, but also due to rising wages. Manufacturers are moving to countries with cheaper labour, often the PRC’s southerly neighbours.
Birth Rate vs the Stock Market: A Race to the Bottom
The PRC’s demographics are another headwind. The age of its population is becoming worryingly top-heavy. The one child policy of the late 1970s succeeded in its aim of curbing population growth, but the cost is that the PRC’s working age population peaked in 2012. From here on out, unless there is a serious fertility boom, the economy will be held back by a growing ratio of older Chinese, born when multiple children were permitted, to the working age population, who were born with the one child policy in force.
Government trials are granting couples where at least one parent is an only child the permission to have a second child. But needing notarised approval to reproduce has, understandably, done little to fan flames of passion in Chinese bedrooms. The average woman of childbearing age has 1.4 children, below the 2.1 required for the ‘replacement rate’, which would stabilise the population. Furthermore, the one child policy played a part in sex-selective abortions and other discrimination against newborn girls, skewing sex distribution. More eligible bachelors in the PRC are now seeking brides than there are brides to go round; this itself is a major hindrance to future population growth.
Meanwhile, underlying economic turmoil has been a factor in the PRC’s recent stock market crash. A record-breaking bull run from the summer of 2014 saw the Chinese stock market surge with a speed and trajectory that sparked grim recognition in anyone who had studied US markets before the Dot Com bust. This is partly because the Government has loosened monetary policy to stimulate the economy after 2014’s ‘disappointing’ 7.4% growth. The reserve capital banks must hold has been cut, freeing up money for lending, and interest rates have been trimmed (November 2014 to May 2015 saw three interest rate cuts). This saw leverage — borrowing to buy shares — rocket.
The bull run ended suddenly, perhaps even spectacularly. $3.5 trillion, around a third of the country’s entire GDP, was wiped out in less than 4 weeks to mid-July 2015. Investors, wary of their leveraged position, rushed to exit and repay their loans.
The Government moved to prevent a liquidity drain and support the stock market; after all, it had recently encouraged investors in to pep up a market mired in the doldrums since the 2007 crash. Stocks were suspended, sales by big shareholders banned, initial public offerings scrapped and short-sellers threatened. Central bank-backed share buying schemes were cooked up. Restrictions on pension funds and insurers investing in stocks were removed, freeing a potential $800bn to invest.
This worked — for a time. Then, on 27th July, the Shanghai Composite stock market saw its second-biggest fall ever, sinking by 8.5% on weaker-than-expected economic news. The following day saw similar losses and the inexorable trend is still downwards.
Though big investors are still barred from selling, retail investors continue to stampede to exit. As mentioned, Chinese households are big savers; the soaring stock market seemed a lucrative option. Yet many have lost money by being late to the party. Having piled in at the market’s peak, many are worse off despite the market remaining far higher than last year — even post-crash. Fortunately, the percentage of household wealth tied up in the stock market is still low, so consumer spending shouldn’t be too adversely affected. Still, it has come as a blow.
Continued government support for the stock market is an expensive promise, especially given the stock market lost a third of the PRC’s entire economic output in less than 4 weeks. Any support will be largely forged on yet more debt. It also essentially guarantees permanent bubble conditions and creates the same moral hazard as the investor bailout in Chaori Solar. What’s more, what will the Government do about monetary policy? Looser monetary policy encouraged investors into the stock market in the first place, but continued hints of a slowdown may warrant further loosening still to keep the Chinese economy on track, creating further tacit support for an overinflated stock market.
Will the Dragon Soar Higher than the Eagle?
Not so long ago, it seemed a given that the PRC would overtake the US, becoming the world’s largest economy. Yet although its economy is already larger than the US by purchasing power parity, it still has some catching up to do in terms of its current value in US dollars. The World Bank places the PRC’s GDP at $10.36 trillion in 2014, some way behind the US’s $17.42 trillion. Growth in the PRC, though still impressive, is slowing — ‘the new normal’ rate of growth is generally regarded as around 7%; growth in the US, meanwhile, is accelerating.
The PRC has come a long way since 2000. Despite this, the top is still just outside of its grasp and its endeavour to reach this summit will be hampered as it is buffeted by headwinds of increasing force, some of which are sourced from within.
Michael joined the company in October 2010 and works as Key Note's Lead Writer. He specialises in producing our range of financial services and insurance titles.