Is China really facing the wall?

There are currently various articles in circulation discussing China and its imminent collapse. The key reasons given include:

• China’s stimulus was enacted so quickly that it must be wasteful — examples were given (the ghost town of Ordos and empty shopping centres) highlighting inefficient allocation of resources.
• Statistics are unreliable and unavailable.
• Overbuild of infrastructure — suggests all of China’s infrastructural needs are now catered for (or at least to the equivalent of a population 90% urbanised).
• If infrastructure spend is finished, then commodities are dead.
• China has started tightening — curbing bank lending, raising reserve requirement ratios and restricting property investments. Property stocks are collapsing, which in turn will hit consumption, which will hurt overall economic activity.
• A China slowdown will hurt resources, stocks and generally all emerging markets.

Many of the points above are valid in my view. Has there been wasteful stimulus spending? Yes. Are statistics poor? Yes. Do you believe commodity prices are headed south? Yes (but not before one last hurrah). And will a China slowdown hurt the global economy? Certainly yes.

If there is one main bugbear with the points raised, it’s that there seems to be a lack of understanding about China and the way China is governed and managed.

Rightly or wrongly, China is a centrally managed economy and attempting to apply rules that are applicable in more open and market-orientated economies doesn’t work particularly well.

There are plenty of books written about the horrors of central planning. But if you sit back just for one moment and consider how China has developed over the last 30 years, then I think one conclusion comes to mind — it” been extraordinary.

Never in human history have so many people been lifted above the poverty line in such a short period. Sure, there are ongoing issues with income inequality, with environmental degradation and with a lack of democracy to name a few. But in short, it’s hard to argue against the fact that they’ve done a pretty good job of things thus far.

If we cast our mind back a couple of years to the announcement of the huge Chinese stimulus package, the world was amazed by its sheer size and the speed at which they came up with it. Again we come back to central planning. A large chunk of the package was centred on infrastructure spend (rail, water etc) that had already been previously identified by the authorities.

They simply dusted off the plans and bought forward projects that they were going to do anyway. This is the reason the package was delivered with such speed. The second phase of the package was when the local provincial governments were encouraged to borrow from the banks to undertake their “pet” projects. This is where I would identify wasteful spending, and this is where, more recently, Beijing has been scrambling to turn the taps off.

However, if we go back to the main bulk of expenditure, is a fast rail network wasteful spending, or a 10-lane bridge?

I can tell you that I spent last week in China visiting quite a number of cities. I used the air, road and new high-speed rail networks. My trip would simply have not been possible 10 or even five years ago. I went on a high-speed rail journey that took two-and-a-half hours (down from more than six hours), costing less than $15. The train was full.

I visited a variety of gleaming new airports that seemed empty, but the planes were full. And I went on various expressways that I can’t even begin to say were underused. Let’s not even touch on the gridlock that is the streets of most Chinese cities. So is China’s infrastructure binge finished and wasteful? I would say the following:

Infrastructure demand is huge
China is still an infrastructure-deficient country. Sure, it’s possible to find crazy real estate projects that will remain empty for years (in Inner Mongolia!), and there has been some over-exuberance on the part of the odd retail developer. But for me this isn’t the real story.

China is spending huge amounts on its hard infrastructure, and there is simply no point in building out projects that will only satisfy today’s demand. So they build for tomorrow. Is that really so crazy? As an Australian friend of mine said to me in China, when they completed the Sydney Harbour Bridge in the early 1930s, did they really think they needed eight lanes to cater for 1930s demand? And to say that they’ve already built enough infrastructure to fully cater for the future is ridiculous. Just look at the provision of road, rail etc on a per-capita basis and compare it to other Asian countries, let alone Western nations and you can still see they have far to go.

Productivity through infrastructure
Everybody is focused on the huge costs of China’s infrastructure spend, but nobody seems to look at the other side of the ledger. This is the incredible productivity bonus that China gets from more efficient infrastructure. Let’s look at rail — imagine the benefit of being able to cut journey times by more than 60%. In addition, dedicated high-speed rail networks pull slower passenger trains off the older network, allowing an increase in freight transport. This is the sort of productivity boost that so helped the US in the 1950s.

So, we are generally very positive on the infrastructure build-out story. But before we get too carried away, there are certainly many issues in China that are far from perfect.

Property overheating
There is no doubt that property prices in the major cities in China are over-heating. Why is this? It basically comes down to two main drivers: liquidity in the economy and a lack of alternative investments.

Property in China normally isn’t driven by interest-rate moves, so once again we get back to the centrally controlled economy. Abundant liquidity (which they are trying to soak up) results from the huge trade surpluses and resurgent bank lending. Real interest rates are negative (deposit rates are lower than inflation). Cash therefore flows out of deposits into real assets — like property. This is entirely logical, especially when there are so few alternative places to invest (with the stock market successfully beaten down by policy concerns).

But is the property market a bubble that when burst will cause a collapse in commodities? The authorities have been pretty quick in introducing administrative measures to cool the market. They have not raised interest rates yet for fear of causing a more generalised slowdown.

We disagree that Chinese property is a bubble as all bubbles need one primary driver — leverage. There is simply no leverage in the property market at present, with cash being king. But a slowdown in developers’ activity will certainly not help the commodity complex, or at least when considering that over the last few years the stock-market performance of Chinese developers acted as a good leading indicator to commodity prices.

But there are two main counterbalances to the slowdown in construction activity of developers. Firstly, the key export sector is recovering rapidly and we are seeing a gradual pick-up in capex.

And secondly, the government has accepted it needs to re-enter the urban low-end housing market to ensure the adequate provision of low-cost, affordable housing to the masses.

There are extremely aggressive plans in this area, and to some extent this should help mitigate a slowdown in construction activity of the developers.

So finally I come to a more general picture of China. Looking at most forecasts of global growth in the coming decade, it is extremely clear that a large portion of this growth is expected to come from China. China’s contribution today is far larger than in the past, and it is for this reason that China matters.

A slowing China therefore causes global jitters, and not just to the commodity complex. The simple fact is that the stimulus package worked, and this, in combination with a rapid recovery in export demand, resulted in an economy that was getting too hot. On this basis, therefore, China’s actions (while unorthodox) to slow the economy should ensure more stable, long-term growth (warts and all).

I would also highlight that this slowdown we are currently seeing is a direct result of Chinese government policy, not yet something resulting from external factors. External factors could start to have an influence, and the crisis in Europe might actually help cool the economy, as lofty expectations of growth and inflation are tempered.