As China Sneezes, Will the World Catch Cold?

Posted on September 20, 2012


Slow growth could help China’s economy, but hurt mining, supply chain and investors

Over the past three years, there has been a remarkable transformation in global perceptions about the sustainability of Chinese growth. As Europe faltered and the US fought a massively oversupplied housing market, China managed to sail through difficult global economic conditions and seemingly avoided the difficulties that ensnared much of the West.

In 2010, the world was convinced that Chinese economic growth would save the world. China had grown to become the world’s second largest economy and many extrapolated this trend to the day that China would be larger than the United States. Few questioned this belief, and investors titled their portfolios towards assets that would fare well in a world of strong continued Chinese growth.

The sustainability of China’s high growth rates is now being questioned, and with good reason. Headline GDP growth was 7.6 percent in the most recent quarter, the sixth straight quarter of slowing growth.

Chinese officials at the highest levels regularly comment today about measures to support continued growth. Benchmark interest rates were cut in June and July, and while real estate markets have recently demonstrated some resilience, prices remain – on average – below last year’s levels and inventories are noticeably high. Recent earnings reports from multinational corporations continue to confirm the official data: China is slowing, with significant implications.

The credit-fueled investment boom is ending, with serious ramifications for the supply-chain to China. The short of it is that China has simply built too much stuff, and while it will eventually need the currently empty malls, buildings and infrastructure – one can even add entire cities to this list! – demand for the raw materials used to build them will plunge. Given that approximately 75 percent or so of recent Chinese GDP growth has come from capital investing, building less stuff in China has the potential to cut growth rates to the low- or mid-single-digit range.

While the list of casualties may be quite long, three of Wall Street’s favorite investments appear particularly vulnerable; two other expected “casualties” may actually stumble through without much pain.

FIGURE 1. Big consumer: Investors fear that China’s purchases of raw materials will plunge.

As a result of its building boom, China has had a domineering influence on the market for industrial commodities. The magnitude of Chinese demand on selected industrial commodities is noteworthy: more than 60 percent of global demand for cement and iron ore, more than 40 percent for steel and aluminum in 2011. Inspired by strong growth in demand for their products over the past several years, many mining companies have embarked on multiyear expansion projects – with an underlying assumption of continued growth in Chinese demand.

Reduced demand from China combined with expanded supply will lower prices. Consider iron ore, selling for ~$50/ton in 2007. In 2011, it was trading for ~$200/ton at one point and was recently quoted ~$110/ton. If the Chinese building boom busts, demand for iron ore, a key input in steel-making, will surely plunge. Iron ore could revisit the ~$50/ton price point, if not lower. In general, however, it’s conceivable that India and other emerging markets could pick up the slack capacity of what are fundamentally scarce resources in the long-run – more than five years).

Australia, in particular, is in the cross-hairs of a slowdown in Chinese investment spending as it’s a major supplier of key industrial commodities – bauxite, alumina, gold iron ore, lead, zinc, uranium, aluminum, brown coal and more.

Years of strong growth from China have also led to a continued influx of immigrants participating in the booming mining business, resulting in inflationary pressures in both labor and housing markets. Many of the Australian mines have expanded to meet an expectation of continued Chinese demand growth.

FIGURE 2. Trouble ahead? The Australian dollar appears vulnerable against declines in raw-materials prices, left, and the mining industry, right.

The risk of commodity weakness infecting Australia’s banking and housing finance system is quite high because most mortgages are kept on the books of banks. Investors should exercise caution when investing in Australian assets — be they equities, debt, or even the Australian dollar (Figure 2). As a relatively high-yielding option in a low-yield world, Australian sovereign debt has benefited from strong inflows of yield-hungry capital. Mid-single digit yields, sufficiently attractive to date, may not appear adequate in the face of currency declines exceeding the yield.

A material slowdown in China would affect other emerging markets despite arguments about decoupling. Even if one believes that the real economies of the emerging markets have decoupled due to domestic consumption drivers – though in China, for instance, consumption accounts for about a third of GDP (versus more than 50 percent in both India and Korea) – it’s clear that the financial markets remain interconnected. In fact, if anything, the emergence of exchange-traded funds and other pooled investing products has created greater financial interconnections than ever before.

Further, the mere fact that India, China, Russia, Thailand and other developing countries are pooled into a single asset class known as “emerging markets” connects them via portfolio managers that view them as linked. If Russia were to fall by 20 percent, for instance, and all other markets were flat, emerging-markets managers would find themselves overweight non-Russia markets. Indiscriminate selling might follow as portfolio managers rebalanced, generating the financial contagion all desperately sought to avoid.

In addition, approximately 25 percent of the S&P 500’s earnings is directly derived from emerging markets, with a large amount (perhaps around 20 percent), coming indirectly from emerging markets. Unfortunately, this means that multinational corporations may soon find that earnings are harder to grow than previously expected.

While it is not impossible, it seems unlikely that the world is about to descend into a multi-decade debt-deflation spiral. Some areas may not be so vulnerable.

Paradoxically, China probably won’t be a severe casualty of a massive deceleration in investment spending. Social stability is on the top of Chinese leaders’ minds, particularly as the country goes through a leadership transition. They will deploy all resources at their disposal to prevent social unrest that might emerge from slower economic growth.

And even if the country grows GDP at roughly 3 to 5 percent per annum over the next decade, that’s impressive growth that will result in a significantly larger middle class: Consumption as a percentage of GDP is destined to rise, creating winners amidst the wreckage and placing the Chinese economy on a more resilient foundation.

Several commodities are not as affected by the China factor as industrial commodities, specifically agricultural and energy commodities. The middle classes of India and China are growing rapidly, even if GDP rates slow in these countries, and accompanying this growth is demand for animal protein and transportation fuels. Families, accustomed to adding some chicken or pork on top of their rice for dinner, are unlikely to cut back to just rice.

Likewise, the demand shock to energy is growing as individuals go from riding bikes to mopeds, to motorcycles and cars. Such demand trends are unlikely to reverse. Hence, the globe can anticipate higher prices for food and fuel commodities for the foreseeable future.

Last year, most analysts expected the Chinese economy to eclipse the US economy within 10 years. The combination of a rapid Chinese slowdown and a US renaissance driven by American agriculture and natural gas, i.e, food and fuel, may in fact push the crossover date out by years, if not decades – making analyst credibility perhaps the most visible of casualties.

Vikram Mansharamani

If you don’t think China is the biggest story of the 21st century, I’ll have what you are having. My cheekiness stems from plain, cold facts: the rest of the world is retreating from economic expansion, but China is investing, building, acquiring as if there’s no tomorrow. Some experts reckon it will overtake the US as the global superpower by the end of this decade. I am told that one glimpse at Shanghai skyline, and New York suddenly looks provincial. The Communist nation has the largest monetary reserves, cheap labour, cheap capital and voracious appetite for the world’s resources. China’s three big state-owned oil companies have become the largest investors in Africa, taking stakes in energy and infrastructure ventures. In his recent Newsweek column, historian Niall Ferguson said China should get proactive and seek an end to the bloodshed in Syria because it has more at stake than the US does.

However, circumspection is the need of the hour, says Jonathan Fenby in his new book, Tiger Head, Snake Tails: China Today, How it Got There and Where it is Heading. The tenebrous aspects of Chinese prosperity – blatant human right violations, Internet censorship, rampant corruption – cannot be hidden even behind the Great Wall of China. And we are not even getting deep into recent specifics like train crashes, shoddily built schools crumbling during an earthquake, Bo Xilai and his family, Chen Guangcheng, Liu Xiaobo, Tibetan repression, Foxconn, etc.

Mr Fenby, a journalist for the last four decades, who also had a five-year editorial stint at South China Morning Post, draws his assiduous compilation of facts and figures from experience and farraginous journalistic sources. Mr Fenby starts with a quick assessment of Chinese economic expansion and what it augurs for the country and the rest of the world. In a terrific chapter titled “Mega-China”, Mr Fenby explains the malevolent nexus between First World companies and Chinese sweatshops. In 24 pages, Mr Fenby masterfully reveals how the Chinese boondocks are emerging as bottomless pits of misery and stress disorders. And there seems to be no end to these hideous practices.

A couple of days before the launch of Apple’s blockbusting iPhone 5, there were newspaper reports of how college students masquerading as interns were made to work long hours in order to expedite deliveries. Earlier this year, Steve Jobs’ successor Tim Cook paid a visit to China to pacify the nuts and bolts of the Apple wheel. Mr Fenby exposes how China’s heroic claims of financial inclusion are part true and part illusory. The fruits of the progress appear to be reaped by the 300-strong Central Committee of the Chinese Communist Party and their lackeys. Those living in cities are well off, but villagers are bearing the brunt. The Chinese are prodigious savers because the country’s health system is one of the most expensive in the world. The demographics are slated to fall exponentially, thanks to the Party’s myopic one-child policy. This is being called the 1:2:4 syndrome: one child will have to take care of two parents and four grandparents.

Mr Fenby dedicates the middle part of the book to China’s history over the last two centuries and how things came to such a pass. Right from the First Opium War to the Tiananmen massacre, Mr Fenby crams in too much for the reader. Oxygen is really at a premium in a chapter titled “Shadows of the Past”. Whether he is talking about the trials and tribulations of Chiang Kai-shek, the rival in the mid-20th century to Mao Zedong, or the Rape of Nanjing or the Great Famine perpetrated by Mao, Mr Fenby shows a journalistic brilliance few can match.

In the last one-third of the book, Mr Fenby discusses where China is heading. The facts are so chilling that you might want to have a hot shower after reading them. Chinese double standards on the global stage are charted out well and are a lesson in realpolitik to whoever wants to deal with this largely opaque nation.

With a transition due later this year, China’s presumptive next leader, Xi Jinping, will have his task cut out. The post-Deng Xiaoping consensus of devising policies on which everyone can agree will only harbour more torpor in the nine-person Standing Committee.

That said, Tiger Head, Snake Tails is not unimpeachable. Mr Fenby hardly touches on how foreign companies are treated to Chinese paranoia. And this is where he falters because that continues to be a blind spot in Western journalism. Also, the Google fiasco doesn’t attract Mr Fenby’s attention that much. “Reading the economic pronouncements of the Chinese government is like kremlinology,” lamented one UK-based hedge fund trader in the Financial Times. Yes, China sidestepped the 2008 crisis pretty well, but a massive housing bubble is waiting to burst. In the past decade, China has invested $4 trillion in housing, but 65 million homes remain vacant.

Mr Fenby offers wishy-washy remedies at best. More than lifting the draconian hukou system, which Mr Fenby advocates, what Mr Xi would have to do is raise energy taxes and cut military spending, instead of playing to the gallery — as the current fracas with Japan over South China Sea amply displays. Still, do read this book. It isn’t every day that you get to read something that would help you to cheat your way through a degree.

J Jagannath

Posted in: Economy, Politics