Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 29 January 2013

New Year Detox: Hopium Shots and Kool-Aid (Part-III - China)

The Myth of China's Infinitely Sustainable Growth

The third hopium induced hallucination which has made a comeback at the start of this year is China’s infinitely sustainable growth. Recent data have reinforced the market’s belief that China managed a successful soft landing and is now headed towards a muted (if it can be called that) growth of 7-8%. To put these expectations in perspective, when the US reached a GDP level comparable to China now (circa $7.3trn) in 1995, the average growth it could manage despite “irrational exuberance” in the next 6 years before the dotcom crash was around 4% with the maximum being 4.87% in 1999. While it is true that countries which develop later develop quicker because of technological advancements which enable them to leapfrog but expecting the pace of growth to double in less than two decades is a bit optimistic to say the least.

However, merely stating that growth rates look optimistic is not a sufficient argument. It needs to be backed up by data. This leads to the first problem in investigating this permanent-growth story: Establishing the credibility of data. Economic numbers from China are notoriously suspect. Conspiracy theorists assume perfect manipulation while an unsuspecting market assumes perfect accuracy. The truth as usual lies somewhere in the middle. An academic paper (Carsten H, China’s Economic Growth Statistics: Trustworthy in the Long Run, Less So in the Short Run, APARC Dispatches, Oct 2004) states that actual annual growth rates can lie anywhere within a 1.5-3% band of the announced official growth rate. However these deviations mostly cancel out in the long-run. A more recent study (featured in FT Alphaville here) has found that China’s growth rates seem to be rounded-up. Therefore to celebrate, as the markets did, on a number which beats expectations by a slender 0.1% requires a stiff drink of Kool-Aid.

Even if one considers the numbers to be accurate, the question of sustainability still remains to be answered. Although the lopsided and ultimately unsustainable nature of China’s growth is universally acknowledged but in an Orwellian twist this knowledge sits alongside the contradictory belief of China’s perpetual growth. The rationalising factor which makes such doublethink possible is the hope of a “rebalancing” where private consumption takes over from investment as the primary GDP driver. Unfortunately this hasn’t happened and nor is it likely to without a major mishap. The inequality of wealth and absence of a safety net leading to forced saving amongst the majority preclude any sudden boost to consumption. Moreover, directed development and symbiotic relationship between the government and wealthy elites have caused a gross misallocation of capital (popular stories about ghost towns are just one part).

This misallocation has been sustained by the increasing leverage in the system. Unsustainable companies and projects are being artificially kept alive by advancing them more and more credit. It is this misallocation and increasing leverage which have made high growth a necessity. Growth is required to validate asset prices otherwise the entire system of Ponzi finance crumbles down1. Since consumption cannot do the trick, massive and ever increasing doses of investment spending are required to achieve the desired growth targets. Investment spending has become a tiger which the Chinese elite dare not dismount.

History shows that whatever is economically unsustainable will eventually end. China is no different. The unsustainable Chinese credit boom and financial vulnerabilities of the system have been documented in an eloquently argued white paper published by GMO (Feeding the Dragon: Why China’s Credit SystemLooks Vulnerable). It is highly recommended to anyone trying to dispel the hopium haze.

China at some point is going to experience not just a hard landing but a crash landing. The strains may be showing but the trouble as ever is predicting when it is going to occur. Given the difficulty in discerning what is actually going on within the Chinese economy, one can only conjecture based on extraneous factors. An obvious one is global growth. A resumption in global growth pushes the day of denouement further into the future while a western relapse brings it forward very quickly (due to diminishing marginal returns to credit and investment and greater systemic leverage). A more subtle factor is confidence in Chinese authorities to keep the game in play. In this respect, capital outflows, kryptonite to any Ponzi scheme, may be the canary in the coalmine.

The year has started with a bang with global stock markets making new highs, risky yields compressing further and safe havens being sold. A wall of money has cascaded down sweeping aside disappointing data and smothering returns. Every day the denouement is postponed is a day which gives credence to those arguing that the inevitable will never happen. It is a bit like concluding that since someone hasn’t had a cardiac arrest today and appears healthy, they never will have one despite their unhealthy diet. Or at least they won’t have one in the near future. Economics is a long game which requires the player to eschew Kool-Aid. The short-termist Mr Market with his predilection for hopium and Kool-Aid plays it very poorly indeed. This time he has risked everything on the central bankers throw of dice mistaking their fatal conceit for omnipotence.

1. Growth being a requirement for the Party to maintain power is a mistaken assumption since autocracies can easily exist without economic growth.

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