Why China Is All That Matters
09/27/2011 8:00 am EST
The Chinese government wants to cool its hot economy to prevent higher inflation, but what if it overshoots? The entire global economy is at risk. Investors, watch carefully.
Let’s be honest with ourselves, OK?
China is all that really matters for global stock markets.
If China’s economy slows more than expected in 2012—and grows at something significantly less than the 8.2% to 8.5% now expected—it won’t really matter what the Eurozone nations do about the Greek debt crisis or whether the United States stimulates its economy.
In 2012, growth in the world economy will slip far enough to throw the developed world into something very close to a recession, and global stock markets will suffer through yet another painful bear market.
In the short term—let’s say for October, November, and maybe December—what the United States and the Eurozone do matters.
If the United States, through some currently unimaginable political alignment, were to implement a significant program of government spending on infrastructure and tax cuts to stimulate the domestic economy, global stock markets would rally.
If the Eurozone countries manage to put together some credible package that kicks the euro debt crisis down the road into December and maybe into 2012, then global stock markets would rally.
But the rally wouldn’t last long if economic numbers and anecdotal news reports fed into worries about slower-than-expected growth in China.
On the other hand, if the evidence started to point away from the possibility of slower-than-expected growth in China, then a temporary rally on good news from the United States and the eurozone could turn into a lasting rally in global markets.
And I think that China is so central to global stock markets right now that good news on China’s growth in 2012 would produce a rally in global stock markets—and even to a degree in US and European stocks—even if the US didn’t do anything to stimulate growth and European nations wound up with a Greek default. (Although under that scenario, I’d still rather be underweight US and European markets.)
If all this is true, then the big question is, how real are current worries that China will slow more than is now expected in 2012?
China is slowing down
There’s no doubt that China’s growth is slower than it was.
China’s gross domestic product grew at a 10.3% annual rate in 2010. In the first quarter of 2011, that growth rate dropped to 9.7%, and in the second quarter it declined to 9.5%. Economic forecasts call for a further drop to anywhere from 9.0% to 9.3% for the third quarter.
This is exactly the kind of controlled slowdown that China’s government has been hoping to engineer in order to control inflation—which seems to have peaked at 6.5% in July—and to reduce speculation in the real-estate market. It would put China on a path for the 8.3% to 8.5% growth that the consensus is looking for as a bottom to China’s growth rate.
Just for the record, I agree with this consensus about China’s growth in 2012. But I also recognize that markets are on edge about China. So what are they worried about?
NEXT: 3 Worries of China Investors|pagebreak|
3 Worries of China Investors
First, even in the best of economic worlds, bringing an economy this big on a predictable glide path is extremely difficult.
Most of the time governments overshoot, loosening too much when they’re trying to stimulate, or tightening too much when they’re trying to slow growth. The latter is the worry in China’s case.
Second, this isn’t the best of all economic worlds. It’s unlikely that China’s government planners figured a global economic slowdown into their calculations when they were putting in place plans to raise benchmark interest rates or require higher down payments for third homes.
Third, China’s official statistics are like those of most governments, only more so—biased to make current conditions seem better than they are and often deeply contradictory. What if statistics and policies don’t really reflect or address what’s going on in the economy?
Let’s take those worries one at a time.
- China’s policies that were designed to produce a slowdown will overshoot.
If you look at the most recent numbers for real-estate prices, it looks as if China’s economy is right in the glide path.
Data released on August 18 show prices in 16 cities fell from their levels on July 16. In an additional 30 cities, including Shanghai and Beijing—which showed some of the biggest speculative increases during the height of the boom—prices held steady. In 24 cities, prices continued to climb.
Nothing in these numbers argues that we’re looking at a hard landing for China’s economy. On the other hand, the figures from the Chinese auto industry are worrying.
Auto sales in China climbed 6% from a year ago. That’s a significant slowing from the 32% annual growth recorded in 2010.
There are two particularly worrisome aspects to that number. One, production growth of 8.7% outstripped sales growth, meaning that the industry could be looking at a bigger future slowdown as carmakers try to match production to sales.
Two, much of the sales growth went to Japanese automakers that ramped up production to make up for sales lost to a shortage of parts and finished cars after the March earthquake and tsunami. Many Chinese automakers actually saw sales fall in August.
Beijing had introduced limits on vehicle registration, added urban traffic restrictions, and ended incentives to car buyers, in an effort to slow growth in the industry. These August numbers have all the hallmarks of an overshoot.|pagebreak|
- Chinese leaders weren’t thinking about the effects of a global economic slowdown when they designed policies to slow the Chinese economy.
To see what this worry is about, look at the HSBC/Markit Economics purchasing managers' index, released September 22. The index fell to 49.4 for September from 49.9 in August, for a third straight monthly decline. In this survey, any reading below 50 indicates that the manufacturing sector is contracting.
The big culprit was orders for exports. The survey showed new export orders falling faster than in August.
The fear is that slowing GDP growth, plus a slowing global economy that reduces exports, will be more slowing than Beijing’s planners counted on. And the added drag will slow growth more than expected in 2012.
A few caveats about this survey. It’s a preliminary study called the “flash PMI” that comes out before the more complete official number, which is due Friday. The flash PMI looks at a sample that tends to overweight small to medium-sized business, and underweight the large state-owned companies that are responsible for a good deal of China’s exports.
The official index hasn’t yet shown this big slowdown in exports. The full index came in at 50.9 in August, and has yet to fall below 50.
Also, the Chinese economy is less dependent on exports for growth now than it was in the last global economic crisis. In 2008, the year of the Lehman Brothers bankruptcy, exports made up 35% of China’s GDP, according to the World Bank. By 2009, the last year for which the World Bank posts data, the percentage was down to 27%.
That percentage rose slightly last year, but Beijing’s latest five-year economic plan places an increased emphasis on domestic-led growth, through such elements as a program to build huge quantities of low-cost housing and one to raise the minimum wage by an annual 17% a year for the life of the plan.
All this means that, while a global economic slump would have an effect on China’s growth, it wouldn’t devastate it.
How much would a global economic slump subtract from China’s growth? UBS, which cut its forecast for China’s export growth to 15.1% for 2011 (down from 18%) and 5.5% growth in 2012 (from 12%), estimates that the export slowdown would cut 1 percentage point from China’s GDP growth in 2012.
- All these statistics are made up anyway, and we can’t rely on China’s paper growth to bail out the real global economy.
No doubt about it, it sometimes feels like an exercise in “imaginary economics” to talk about the Chinese economy with this degree of precision. Some economists doubt that there’s much connection between China’s official numbers and what’s really happening in that economy.
I think it’s always good practice to check any government’s official figures against data from other sources. To my mind, the comparison doesn’t indicate that China’s offi cial GDP numbers are more cooked than official figures from the United States on inflation or unemployment, to take two examples.|pagebreak|
For example, in the second quarter, official GDP growth came in at 9.5%, down from 9.7%. Electricity consumption in August was up 9.1% from August 2010 and down 0.1% from July 2011. That strikes me as reasonably in line with the GDP numbers.
But we do know that there’s one area where the official numbers don’t accurately reflect what is happening in the economy. The People’s Bank has increased the official benchmark interest rate to 6.56%.
But that benchmark rate has absolutely no relevance for large numbers of small to mid-size companies, or for politically unconnected companies that are currently unable to borrow money. Even the underground lending market, where funds were available at interest rates of 25% or 35%, has stopped lending to many companies in this segment of the Chinese economy.
For big companies with access to state-owned banks and with local political connections, the tightening engineered by the People’s Bank has been a significant inconvenience. For the small and unconnected, it has meant a cash crunch that has just started to play out across China’s economy.
Given Beijing’s drive to limit lending to companies by investment vehicles affiliated with local governments, it is impossible at this point to know how far this cash crunch will extend.
For example, on September 23, Caixin Online reported that the local government of Wuhan had moved in to suppress a protest at a local manufacturer, Center Group. The company is apparently bankrupt. Having been cut off from bank loans, the company owes about $190 million to private lenders. And those private lenders, it seems, have decided not to throw good money after bad.
The shock waves from this are just starting to hit the Wuhan government. One Center Group subsidiary, Center Optical, paid 12 million yuan (about $1.7 million) in local taxes in 2010.
That result of monetary tightening and the way it ripples out into local government revenue—and then spending—isn’t yet mapped in the official statistics.
But I think it’s a mistake to assume that the manipulation of data or the lags and inadequacies of official data cut in just one direction.
Yes, they might understate the speed of any slowdown in the Chinese economy. But these gaps and lapses also hide many ways in which the Chinese government continues to stimulate its economy in clear contradiction to its stated economic and monetary policies.
Beijing has said repeatedly that it wants to reduce the flow of money from investment vehicles affiliated with local governments into the real-estate sector. Local governments have a vested interest in financing real-estate development, because the leasing of land provides a major source of revenue for strapped local governments.
From this perspective, it makes sense for a local government to provide loans to developers through government-affiliated investment vehicles—even if a project being funded is built on shaky economic foundations.
Beijing has rightly tabbed this alignment of interests as a major source of the cash that has fed the real-estate bubble in China. And the government has moved to control and reduce the practice.|pagebreak|
But that’s just one official policy. A recent meeting led by Premier Wen Jiabao also resulted in a policy that would encourage lending to “qualified” local-government financing vehicles for “public rental” housing projects. Banks and other financial institutions may lend to such projects directly or through qualified local government financial vehicles.
“The central government will continue to increase subsidies and the local governments also need to add financial investments,” said a notice on a government Web site.
This came just weeks after the China Banking Regulatory Commission banned banks from rolling over or renewing loans to local financing vehicles.
Your guess is as good as mine on how these two “official policies” net out for the Chinese economy.
Advice for Investors
So, where does this leave the poor investor who believes that nothing much matters but how slowly China will grow in 2012?
First, pay close attention to the official PMI report on September 30. In the current state of uncertainty, this number has the clout to move global stock markets.
Second, know that because we can't be certain about China’s growth in 2012 until 2012, for the rest of 2011 we’re left with markets that will react to every China data point, even though events in Europe and the United States are likely to decide if we get an end-of-the year rally.
Third, given that China-related uncertainty in global markets will last into 2012, the least-risky way to invest in China is to put your money in domestically-oriented Chinese companies, rather than exporters. But be prepared for lots of volatility in 2012 to test your convictions.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of June, see the fund’s portfolio here.