The Unbalancing China Equation

The Unbalancing China Equation

May 9th Financial Post column:-

Financial Post & Pacifica Perspectives

By now most investors have a pretty strong grasp of the problems facing the US. These problems range from massive US debt, unemployment, depressed real estate, and the list goes on. Conversely, the image of China as a country with a supercharged economy and seemingly no real challenges on the horizon is perhaps only partly true.

With that out of the way, a somewhat contrarian perspective to the China/US comparison might be in order. To be specific, few investors seem to be considering the challenges facing China

On the economic front, China has a real estate problem of its own that might make the US real estate debacle seem like small potatoes. It is estimated that the country has over 60 million empty residential units. To put this number into perspective, 60 million empty housing units is enough to provide a single home to each and every man, woman, and child in Canada and Australia. There would still be more than enough homes left over to provide an additional residence to the entire population of Los Angeles.

What is important, however, is that much of these units are selling for far more than the average Chinese wage earner can afford – creating a serious supply overhang. In addition, according to estimates from state sources, the government will be beginning construction on an additional 36 million homes in an effort to drive more sustainable housing.

Yet, with the central government’s inability to control local governments addicted to revenue from real estate, development continues unabated. China has attempted to tighten monetary policy to control the growth, but with little success. The Chinese central bank now seems to be caught between a rock and a hard place. If it continues to tighten monetary policy to reign in the speculative excesses that have built up in the Chinese economy, it risks a rise in unemployment and endangering political stability. If it chooses to allow the economy to run unchecked, it risks even greater inflation down the road and certainly political stability will be compromised.

Vancouver Housing Bubble

Most investors look at Chinese construction activity, imports of commodities and a laser like focus on “growth at any cost” as an all clear signal to load up on commodities. It seems almost comical as investors project today’s Chinese economic statistics into the future indefinitely. With that precarious justification, many investors seem to haphazardly buy metals such as copper with reckless abandon – thinking they are hitching their wagon to China’s economic rise.

To put it in perspective, the world saw record copper prices in recent weeks. This was despite copper inventories at the London Metals Exchange (LME) reaching all time highs and recent reports out of China that many developers were purchasing copper to secure more financing from Chinese banks. The reason they do this is because some banks are reluctant to lend using real estate as the only collateral.

Some observers have said that China can solve any economic challenge that comes its way by using its incredible $3 trillion of foreign exchange reserves. While that has helped paper over other problems in the past, one can also point to Japan in the 1980s – which held the largest foreign exchange reserves at the time. Yet twenty years later, it is still mired in problems relating to its real estate induced bubble popping.

Recognizing that so much of the Chinese economic growth rate is based on construction activity, the central government is making efforts to stimulate other areas of their economy. One key goal is stimulating growth within the country via consumption by Chinese citizens, thereby reducing reliance on exports to developed countries. However, this strategy is being met with muted success so far but it must be recognized that this challenge will take time.

The banking situation in China is also a concern. The bad debts piled up on the books of Chinese banks are staggering. Yet the state continues to allow many Chinese banks to proceed without having to face up to the issue. If the government made Chinese financial institutions clean up the books, many of the banks would have to turn to state intervention for capital infusions. This is not unlike what the US faced – but in the case of American banks, the government handouts have almost all been repaid and at what can be considered a blinding pace.

The Chinese authorities have tried to cap the lending by banks even as Fitch Ratings warned last year that the first six months of 2010 may have seen over US $200 billion in bank loans being issued using off book loans in order to stay within government limits. This sort of secrecy and sketch bookkeeping makes it difficult to gauge the state of the economy.

The central government in China has tried to undertake some reforms but it is proving tougher than they might have expected. Last month, as the government once again tried to cut fuel subsidies to help slow inflation, truck drivers launched a forceful and bold protest in Shanghai. Significantly, the government backed off and agreed to at least cut some fees and levies for the truckers.

An even more surprising challenge relates to demographics. It is estimated by Chinese demographers that China’s population is set to peak in 2015 to 2030 – depending on the accuracy of population data published by the government. In addition, the ageing of Chinese society is expected to weigh on its economy in the coming years – more so than in most countries.

The most compelling observation that the China equation is not balancing isn’t hidden within the London Metals Exchange or in the far corners of Jiangsu or other Chinese provinces. The biggest disconnect arises from the Chinese’ Shanghai Composite Index itself. Stock markets are incidentally a place that is difficult for most government agencies to manipulate for any sustained period of time.

The gains on the Shanghai stock market aren’t mirroring the reported economic growth figures. Remember, it has been reported that the Chinese quarterly GDP growth rate has been no less that 9% since 2006, with the only exception being the drop to a very respectable 6% at the bottom of the financial crisis. However, the chart demonstrates that Chinese stocks are at the same level they were in June 2009. While other global markets continued to climb out of the depths of the 2008 recession, Chinese stocks found no meaningful trend. In fact, the Shanghai Stock Exchange Composite Index fell 24% between April and July of last year.

So what is China to do? It seems there are no easy answers. But from this perspective, China’s challenges are at least if not more significant than those of the United States.

Legal Disclaimer

This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.

Copyright (C) 2011 Pacifica Partners Inc. All rights reserved.

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