CHINA AND THE WORLD IN CRISIS
Another week of market panic. Another long, damaging week for all those who borrowed short term liquidity in order to invest or lend in the long term. No end in sight for the unprecedented, convulsive seizing of interbank and money markets. No counterparty is trusted, no credit history adequate. But the worst could be yet to come. And it will come if trade partners refuse to conduct physical transactions with each other. Such a threat, meted out last week by China’s state owned enterprises to one of Australia’s iron ore producers induced Kevin Rudd, Australia’s Mandarin speaking Prime Minister to pick up the phone and call China’s Premier. The necessity for such government interventions illustrate just how fragile the global trading system could be. The unraveling of the hitherto flourishing trade routes could make the recovery of our decimated savings so much more difficult if not entirely impossible.
THE END OF THE CHINESE BUBBLE
As the dramatic events of global market meltdowns and banking collapses are unfolding, some commentators are still holding on tight to the hope that the savings accumulated in current account surplus countries will somehow save the planet’s economy. After all, the central banks of Asia and Middle East have for years been gobbling up US Treasuries and agency bonds, helping to suppress US interest rates and facilitating America’s housing bubble. This seemingly unquenchable appetite for the single staple meal of US debt kept afloat the over-leveraged American ‘consumer of last resort’. Some are now hoping that the trillions of dollars worth of US government paper accumulated in the East could be somehow unlocked to unfreeze the clogged LIBOR and see the lending resume globally.
But such a scenario could now prove overoptimistic as the ‘savings-surplus’ economies are slowing down as well. The precipitous drop in the oil prices is draining the wealth of Petrodollar economies at a record pace. Just this week, we have learned that the Russian oligarchs had registered a combined loss of $230bn over only four months. Last week I wrote about China’s exports predicament. With China’s largest export market – Europe – now tipping into recession, further contraction in this sector should be expected. But there are other, even more potent drivers leading to an unpleasant screech in the Chinese brakes. The mid-cycle, downward trend in China’s real estate market, although not directly related to America’s credit problems, is highly worrying. And what makes China’s economic deceleration worse is that all the three endowment factors have over the last year seen coincidental sharp price increases: coastal labor (due to legislation), capital (caused by tight lending quotas) and land (owing to land hoarding and speculation).
HOW DO WE KNOW THAT CHINA IS SLOWING?
When the Chinese government moved to reinvigorate domestic economy back in 2002/2003, much of the internal growth came through unprecedented expansion in fixed asset investment (FAI). As a result, FAI rose to 41% of Chinese GDP. The relative magnitude of this contribution is apparent when compared to the importance of domestic consumption (36%) and net exports (8%). As much as 50% of urban GDP growth comes from FAI. Critically, real estate represents a quarter of fixed asset investment (compared to 30% manufacturing and 11% transport). At its cyclical peak, 10% GDP growth has been associated with 20% FAI growth, translating into unprecedented demand for steel and raw materials. It is in the consumption of energy and basic raw materials that we can now detect just how severe China’s slowdown really is. Year on year rate of growth in fixed asset investment has fallen by 6%, construction output by 10% and residential property by 16%. As of last month, annual decrease in growth was 6.2% in energy, 4.6% in iron ore, 3.5% in cement. Coal consumption growth has fallen 4%. Previous troughs in those subsectors occurred between 2001 and 2005, but did not coincide. This time they do.
Power demand in particular is a good indicator of real GDP numbers, even though the ratio is falling slowly with the phase-out of the most energy intensive industries. In 2000, the ratio of electricity consumption to GDP was 1.5:1, but it is now closer to 1:1. And if so, this particular indicator looks scary; China’s electricity demand growth was barely above 4% in August, and sharply down from spring. Some of this breakdown could be caused by insufficient coal deliveries to power plants and cash flow problems of electricity generators unable to pay for the fuel.
Optimists point to increased infrastructure development, but even if accelerated, it is unlikely to substitute for the material hyper-intensity of real estate development of the recent years.
HOW IS IT POSSIBLE THAT THE WORLD IS CHANGING ITS VIEW ON CHINA SO QUICKLY?
The realization of just how serious China’s problem is has dawned on us late, very late. Indeed, until my recent trip to China I had been holding out a hope that the negative stream of data could be attributed to several one-time, seasonality-distorting events. “Excuses” for the pause in apparent growth indicators were aplenty. Olympic priorities had apparently trumped the need to keep the economy racing, resulting in large-scale absenteeism in favor of ‘patriotic’ TV screens or the net surfing. Despite the aspirations of traditional numerology, 2008 has been hardly a “lucky” year with its earthquakes, snowstorms, floods and recurrent health scares and, at least officially, “disasters led to the slowdown in the economy”. Year on year comparisons were also complicated by the twin impacts of renminbi appreciation and the introduction of the new, rigid Labor law.
There is little doubt that at least some of these factors added to the economy’s cyclical maturity and weak external environment, but there are more disturbing, structural reasons as well.
The 2005-07 excesses in construction and property investment were caused by low or negative real interest rates, which led to capital misallocation, excessive capital expenditure and speculative investment in stocks and property. Having failed to develop a proper social security system, the government relied on pump-priming to keep the labor-intensive machine going. It is worth remembering that each time the Chinese administration is overhauled on the occasion of a new 5-year plan, fiscal pump-priming boosts fixed asset investment. Such economic stimuli are in China functional equivalents of pre-election spending by incumbent governments in democratic countries. Even though no one gets elected by the Chinese population, the mobs have to be pleased.
Such big fiscal boosts last between 6 and 9 months. Importantly, the last one was introduced in October 2007 and this means that capacity growth in some manufacturing sectors significantly lagged the (falling) demand cycle. Whereas demand peaked late 2007, capacity expansion continued into the second quarter of 2008, further distorting the perceptions of China’s allegedly unstoppable growth.
Finally, there is the stock market. Having lost 67% over the year, Shanghai index is occasionally propped up by the government in effort to re-establish confidence in the market, but the aggregate price to earnings ratios are still at multiples of around 20 times, hardly a bargain for bottom feeders. More ominously, some 30% of the 2007 earnings of the listed companies were in cross-investments. When Ping An Insurance announced its results for the first half of 2008, its losses were 20% higher than its (negative) income, due to additional investment losses.
It is also a good testimony of the magnitude of the slowdown that the typically flow-boosting natural disasters (snowstorm and earthquakes) did little to stimulate the economy. The data on Sichuan reconstruction is curiously sporadic, as if it was another state secret. Or are they all rebuilding their lives with local bamboo?
NOT ONLY CHINESE PROBLEM
At the height of China’s property bubble, the cost of construction was about 1/3 of the value of a new house. The remaining 2/3 were divided into the profit, taxes and permitting. The price of land used to constitute 30% of overall costs in 2005, but its share doubled in the last three years. Such supply side constraints led to low concentration of urban construction, absurd valuations and cheap execution. Construction quality is generally very shabby and ‘cutting corners’ was the way for the developers to absorb the costs of land, labor, cement and steel.
The growth of Chinese investment and its role as the marginal consumer of all sorts of raw materials was largely responsible for the huge increase in commodity prices globally. The dragon’s ferocious collapse is now taking a toll on the resource sector of the global economy, pulling in its wake the economies of Latin America, Africa and Australia. Although the liquidity problems of Chinese construction firms and steel producers could be the main reason for the slowdown in physical transactions, we could be at the cusp of something much more ominous. Since the massive market sell-off began, almost a quarter of the global wealth has been wiped out – in savings, assets and other forms of capital. When the extinction of wealth is so widespread, so deep and so fast as this time, cooperation to stem the ravages may be more difficult to achieve. Instead, we are facing the classic dilemma of the tragedy of Commons. And so, for about two weeks now, Chinese customers have been refusing to pay their bills and honor purchase commitments signed with counterparties from India to Indonesia to Australia.
Some ten years ago, I learned this lesson myself. At that time, my firm decided to sign a contract with a Chinese transportation company. We happily returned from Beijing, with a document officially signed by Mr Wang, a senior official of that company. Over weeks and months we found communication with the Chinese partners increasingly difficult and there were no signs of delivery on the contract. When we finally intervened, it turned out that Mr Wang had left the company. Back in Beijing, we eventually managed to see his replacement, Mr Hu. We sat down in oversize armchairs arranged side by side, sipped green tea and exchanged pleasantries. When I finally asked Mr Hu about the contract, he glanced at me with a look of a bored anteater and snapped: “but this paper signed by Mr Wang. Mr Wang no longer work here. You should not think this paper important”.
CERTAIN THINGS NEVER CHANGE
As the first news came about Chinese state owned enterprises breaking long-term contracts with Australian suppliers, I was reminded of the 18th century letter that the Chinese emperor wrote to King George of Britain. Here’s what he wrote:
“You, O King, live beyond the confines of many seas, nevertheless, impelled by your humble desire to partake of the benefits of our civilization, you have dispatched a mission respectfully bearing your memorial. To show your devotion, you have sent offerings of your country's produce. In consideration of the fact that your Ambassador and his deputy have come a long way with your memorial and tribute, I have shown them high favor and have allowed them to be introduced into my presence.
Swaying the wide world, I have but one aim in view, namely, to maintain a perfect governance and to fulfill the duties of the State: strange and costly objects do not interest me. If I have commanded that the tribute offerings sent by you, O King, are to be accepted, this was solely in consideration for the spirit which prompted you to dispatch them from afar. Our dynasty's majestic virtue has penetrated unto every country under Heaven, and Kings of all nations have offered their costly tribute by land and sea. As your Ambassador can see for himself, we possess all things. I set no value on objects strange or ingenious, and have no use for your country's manufactures. It behoves you, O King, to respect my sentiments and to display even greater devotion and loyalty in future, so that, by perpetual submission to our Throne, you may secure peace and prosperity for your country hereafter”.
As Chinese real estate slump impoverishes realtors, construction companies, cement and steel producers, it can be expected that the losses will be pushed further up the value chain, even if that creates potential legal or diplomatic ripples. With the global depression looming, ‘beggar thy neighbor’ tactics may yet become our daily staple. The age-old traditions of business conduct in China will be of no help in trying to save international, rule-based cooperation. Instead, one should wonder why the Chinese state has not yet embarked on a buying spree of its own. If Russia can purchase Iceland, why couldn’t Australia be sold to PRC? Such a realignment of relative power in the Pacific basin could yet prove to be the ultimate outcome of the free markets’ current seizures.
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Next week, I’ll probe the intricacies of the system which underpinned the extraordinary tale of real estate bubble in China and took the global markets for an unprecedented ride.
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