- assets and using the proceeds directly or indirectly to boost household wealth.
- Beijing can indirectly transfer wealth from the state sector to the private sector by absorbing private-sector credit (a virtually guaranteed lost decade).
- Beijing can cut investment sharply, resulting in a collapse in growth, but it can mitigate the employment impact of this collapse by hiring unemployed workers for various make-work programs and paying their salaries out of state resources.
It will be a sight to behold if China’s central planners can successfully rebalance the economy away from the exhausted fixed-investment and export growth engines toward a truly consumption-led economy… but they are attempting something that has never been done before, and the odds (and the historical record) are not in their favor.
Irrespective of the chosen path toward rebalancing, growth is clearly decelerating across the Middle Kingdom… and even a modest slowdown will shake the world.
Source: Chen Long, “Testing the Reformers Resolve.” GaveKal Research, May 27, 2014
Our newly illuminated view via the China Beige Book leads John and me to believe that a pronounced slowdown (again, induced either by voluntary reforms or by an involuntary debt crisis) is now inevitable… suggesting that the real story surrounding China’s slowdown is really about the rest of the world, from its trading partners to leveraged investors in seemingly unrelated niches of our highly interconnected global financial system.
Our world is far more integrated today in terms of cross-border flows in goods…
China… services…
… and financial flows.
Source: James Manyika, Jacques Bughin, Susan Lund, Olivia Nottebohm, David Poulter, Sebastian Jauch, and Sree Ramaswamy, Global Flows in a Digital Age. McKinsey Global Institute, April, 2014.`
We rarely know in advance which hedge fund or mega-bank has massive, leveraged exposures to toxic markets or asset classes, but it is absolutely prudent to assume that at least one systemically relevant institution has over-gorged and over-leveraged on positive carry. That’s a fair assumption, since major central banks continue to promote bad behavior with negative real interest rates, large-scale asset purchases, and forward guidance that chaotically distort market signals.
Any kind of deflationary collapse in China could send a shock wave through the world’s hyperconnected and highly leveraged financial system, triggering extensive losses in European and American mega-banks and likely tipping the developed world back into a hard recession precisely when the central banking community lacks effective policy tools to soften the blow. As we all experienced in 2008, such a shock could effectively shut the door on global trade finance, unwind carry trades around the world, and trigger a sharp reversal in cross-border capital flows as international trade grinds to a halt.
That’s a worst-case scenario that could certainly happen, but it’s not the most likely scenario (thank goodness). However, China doesn’t have to experience a deep recession in order to disrupt global growth.
China is the world’s second largest goods importer, buying the equivalent of more than $1.7 trillion in foreign goods each year (compared to US imports of roughly $2.3 trillion). The Middle Kingdom imports extensively from its immediate neighbors in East and Southeast Asia but also does nontrivial business with Australia, Brazil, the United States, and Germany. (Note: The following analysis relies on 2011 trade data, which is the most recent data-set available in MIT’s online Observatory of Economic Complexity).
Origin of Chinese Imports, 2011
Source: Observatory of Economic Complexity, 2011
As a result, China accounts for nearly 28% of all Australian exports…
Destination of Australian Exports, 2011
24% of all South Korean exports…
Destination of South Korean Exports, 2011
19% of all Japanese exports…
Destination of Japanese Exports, 2011
14% of all Malaysian exports…
Destination of Malaysian Exports, 2011
12% of all Singaporean exports…
Destination of Singaporean Exports, 2011
12% of all Indonesian exports…
Destination of Indonesian Exports, 2011
and 6% from Europe’s export-led economic hegemon, Germany.
Destination of German Exports, 2011
Source: Observatory of Economic Complexity, 2011
If China’s GDP growth slows to 2–3% (a trend which may already be in progress), a corresponding decline in China’s appetite for commodities and other imports could fire a demand shock across all of these economies and even seriously impact Germany, which simply cannot afford a sudden disruption in its trade surplus if it hopes to preserve the euro system and keep its own banks afloat.
Considering the worst-case-scenario consequences for the world’s leveraged and interconnected financial markets, and the base-case potential for serious demand shocks to many of China’s suppliers, China’s slowdown represents a macro sea change – the kind we cannot ignore.
As John and I spoke with friends at his Strategic Investment Conference last week – brilliant people like Niall Ferguson, Ian Bremmer, Anatole Kaletsky, David Tice, Lacy Hunt, Dylan Grice, Grant Williams, Jonathan Tepper, Kyle Bass, Rich Yamarone, David Rosenberg, Raoul Pal, Neil Howe, and Jack Rivkin (to mention just a few) – we found everyone worried about China, and we spent late nights talking through the potential linkages.
Although the publicly available data can be murky, misleading, and inherently flawed, this is an area we must pay attention to in the coming months and quarters. China’s slowdown, deleveraging, and rebalancing are the most important macroeconomic forces in the world today… because they are the biggest unknowns.
We can get our heads around the risks in Europe, the United States, or even across the most fragile emerging markets; but it is impossible to know how long Beijing’s central planners can keep the investment boom going or whether they have any chance of keeping growth above 5% without precipitating a hard landing. That uncertainty leaves us with an incredibly wide range of possible economic outcomes (from a raging bull market in the case of a successful transition to a sharp collapse with global consequences when the credit-driven investment boom inevitably falters) and no way to intelligently assign probabilities. The situation in China demands close attention to risk in a world where very few investors are paying attention.
Remember: “China is like an elephant riding a bicycle. If it slows down, it could fall off, and then the earth might quake.”
Cross the River By Feeling the Stones
John here. Every time I go to Singapore I hear this story about Deng Xiaoping. It is said he came to Singapore in the late ’70s and saw the progress there under the leadership of one of the great men of the last century, Lee Kuan Yew. Supposedly he said something like, “These are Chinese people doing this. We can too.” He went back to begin the reforms that produced the results we see today.
In my opinion he is one of the most important of a small handful of leading figures of the 20th century. It is impossible to think of a modern China today without Deng Xiaoping.
Inheriting a country fraught with social and institutional woes resulting from the Cultural Revolution and other mass political movements of the Mao era, Deng became the core of the “second generation” of Chinese leadership. He is considered “the architect” of a new brand of socialist thinking, having developed “socialism with Chinese characteristics” and led Chinese economic reform through a synthesis of theories that became known as the “socialist market economy”. Deng opened China to foreign investment, the global market and limited private competition. He is generally credited with developing China into one of the fastest growing economies in the world for over 30 years and raising the standard of living of hundreds of millions of Chinese. (Wikipedia)
When we discuss the future of China, it is important that we develop some perspective. Go back to 1978 and the economic disaster that Deng Xiaoping faced. China was coming off the Cultural Revolution, which had seen Deng himself purged at least twice, forced into menial work, and his son tortured. The hard-core party elite saw Deng as a huge threat.
If in 1978 someone had shown you a photo of a city like Shanghai or Beijing today and asked you the odds of that happening within 36 years in China, you would have laughed at them. What if that someone had told you then that 250 million people would be moved from the country into the cities and modern jobs created for them? That some of the most important companies and richest citizens the world would be based in China? And that China would be the second largest economy in the world with the potential to become the largest not long thereafter? By this time you would be rolling on the floor laughing, tears in your eyes. Such a thing would have been impossible to imagine in 1978.
In a stroke of good timing, Worth has just thrown the following images up on Twitter:
a. Shanghai in 1987
b. Shanghai in 2013
(Readers can follow us on Twitter at @JohnFMauldin and @WorthWray.)
To get a sense of the history and significance of those times, let me direct you to a marvelous series of interviews with Lee Kuan Yew in his later years. For those who still want more, there is a marvelous biography of Deng Xiaoping called Deng Xiaoping and the Transformation of China, by Harvard professor Ezra Vogel. There are also YouTube videos with Professor Vogel.
One of the challenges faced by all those who attempt to do economic analysis is to keep our biases in check. All too often our forecasts agree with our personal beliefs.
I must confess that one of my cornerstone beliefs is that free markets are superior to centrally controlled markets. It is not just Hayek vs. Keynes, but Hayek vs. Marx. Westerners are still liable to consider China to be the same sort of command economy it was in the 1970s. But the China of today is vastly different, even though there are significant remnants of the centrally controlled economy. It is far too easy to see the growth of China in terms of centrally planned malinvestment based on leverage and construction and a real estate bubble of epic proportions that must end in tears. Such a stance dismisses the massive entrepreneurial and private-sector contributions that are at the core of the “Chinese miracle.”
In a very true sense, Deng Xiaoping slowly and thoughtfully introduced capitalism to China. And the Chinese have responded enthusiastically. The
