Tuesday, May 27, 2014

Dear Investors: Because of Its Size, China’s Problems Are Yours, Too

I have long argued that it will take a sizable shock to switch the current “risk on” investment climate to one of “risk off.” The robust US stock market persists even though the housing recovery has stagnated, labor markets remain weak, consumer spending is subdued and the US Federal Reserve continues to taper its securities purchases. Yet a financial crisis in China could well be the trigger that persuades investors to pull in their horns.

China is the world’s second-largest economy, even if it remains an economic pygmy, with $6,091 in per-person gross domestic product in 2012, compared with the US’s $51,749. Its global importance was magnified when North America and Europe shifted their manufacturing to the Middle Kingdom. That shift made China the primary importer of raw materials and exporter of manufactured goods.

China’s size and impact on the global economy mean that China’s problems are now the world’s problems. No single issue is likely to cause a major crisis, yet in combination they certainly could.

The first and biggest problem is slowing economic growth. Until 2008, China had accelerating double-digit real GDP growth. Then the recession and retrenchment of US and European buyers knocked growth down to 6 percent — a recessionary rate for China.

In 2009, China pumped huge amounts of stimulus into its economy, equal to 12 percent of GDP or twice the size of the US’s stimulus package that year. China’s version largely took the form of bank lending, which pushed growth back up to double digits but also fueled inflation and a housing bubble. The Chinese government responded with various fiscal and regulatory restraints, and growth dropped back toward its 7.5 percent target (if you believe China’s vastly inflated numbers).

More important, manufacturing is declining. An index compiled by HSBC Holdings shows manufacturing at 49.7 in May (a number below 50 indicates a contraction). Manufacturing, construction and utilities account for 45 percent of China’s economy, compared with only 17 percent in the US. It stands to reason that, if manufacturing is declining, the economy is barely growing. The comparable US index is running above 50 — and the US economy is growing at only about 2 percent annually.

Rapid economic growth covers a multitude of sins, especially in a developing country like China where it’s needed to provide jobs and improve living conditions. In contrast, slow growth magnifies economic and social ills. Slow growth also favors those with political power instead of creating a bigger pie that benefits many.

In contrast to the long-term goals of promoting consumer spending, remaking state-owned enterprises and liberalizing interest rates, Chinese officials have recently resorted to the same-old, same-old: infrastructure spending and easy money. Rail and road investments jumped 22 percent in the third quarter of 2013 versus a year earlier. The government plans to spend $23 billion on five new rail lines and to boost spending on China’s electric grid by 22 percent.

The government also plans to spend more on public housing — 7 million units compared with the five-year-plan’s 5 million to 6 million units. The fiscal deficit, meanwhile, will jump 12.5 percent to accommodate new spending for social services, the environment and the military.

The coming economic transition the government is planning is the second big challenge. After the recession, Chinese leaders realized their earlier growth model — with an emphasis on exports and the infrastructure that supported it — wasn’t working. Most of its exports were bought by Americans and Europeans. But as those economies continue to deleverage and grow slowly, the game has changed.

Now, Chinese leaders want to shift from export-driven to domestic-led growth.

But in promoting a consumer-led economy, China is way behind the goal post. The latest data from 2012 show that consumer spending only accounted for about 36 percent of GDP, far behind the developed countries. Even emerging economies are faring better: Russia’s consumers make up 48 percent of GDP; India’s are 60 percent and Brazil’s 62 percent.

The government knows that to increase consumer spending it must increase incomes and reduce savings. Chinese households don’t have much of a safety net to fall back on, so they save almost 30 percent of their income to cover health care, retirement and education. In 2010, the government planned to offer basic medical care to all Chinese by 2020. But that’s still six years away, and basic care in China is very basic. In some regional hospitals, the highest-trained medical person is a practical nurse.

Minimum wages in major cities are rising about 25 percent a year. Although that raises incomes, it’s also pushing labor-intensive manufacturing to cheaper locales, including Bangladesh, Pakistan and Vietnam. At the same time, fewer Chinese are moving from the hinterlands to coastal areas for work. Instead, they are finding local jobs that pay less but the cost-of-living is much lower. Still, the government is encouraging migration to increase the ratio of higher-earning urban residents to 60 percent by 2020 from 53 percent in 2012.

The move to a consumption-driven economy is bound to be inefficient and disruptive, especially to politically powerful factions. The result could be social disruption and slower economic growth throughout the decade or so of transition.

An increased emphasis on building up its military force and a more aggressive posture in the Pacific region are the third issues China and the world face. China believes that, as a world economic power, it must have a major military presence. The government’s budget calls for a 12.2 percent increase in spending in 2014, much greater than the 7.5 percent GDP growth target, yet in line with past increases. Defense spending — $132 billion for 2014 — is more than double the 2007 level (although some experts believe China vastly understates its defense spending).

China’s military outlays are only 22 percent of the US’s $608 billion, but China’s costs are much lower. And while China’s spending grows rapidly, President Barack Obama is calling for a $400 million cut in defense outlays in fiscal 2015. China’s official military budget also excludes big-ticket items such as arms imports and military components of its space program.

One danger sign of a more muscular military sector is the ongoing spat with Japan over disputed islands in the East China Sea, which may have oil under them. China is also in a dispute with Vietnam over China’s deployment of an oil rig into South China Sea waters that both countries claim.

Then there is the problem of a nuclear-armed and unpredictable North Korea. China probably worries a lot about North Korea and its volatile dictator, Kim Jong-un. But China no doubt likes to have the Hermit Kingdom as a buffer against a militarily strong South Korea.

I’m not predicting major conflicts in Asia any time soon. Still, rising nationalism in China and Japan, to say nothing of Russia, is a concern.

A. Gary Shilling, a Bloomberg View columnist, is president of A. Gary Shilling & Co., a consultancy in Springfield, New Jersey.


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