China And The Fed: Still Back To Front

Investmentmyth

By John Richardson

THEY are still getting it the wrong way round.  Both the Financial Times and The Economist, have said over the last few days that weaker prospects for emerging markets are mainly the result of Fed tapering.

We continue to think that this might be partly because of the great “unknown, unknown” that surrounds China’s economic rebalancing. If you don’t adequately understand something, focus on what you do know, what you can more firmly quantify and that way you run less of a risk of  being wrong.

Another factor could be that most of us have grown up in a world of a spectacular and steady Chinese growth.

Take petrochemicals as a pretty good example, given that it supplies raw materials to so many downstream manufacturing industries.

China’s high-density polyethylene (HDPE) consumption was around 4m tonnes in 2003, according to ICIS Consulting. In 2013, it had reached approximately 9m tonnes.

And the country’s linear low-density (LLDPE) consumption was just 2.5m tonnes in 2003 but by 2013 it had more than doubled, again according to ICIS Consulting.

So why should the future be any different?

Putting this together, the total logic might be something like: “OK, we don’t really understand what’s going on, but it’s worked out fine in the past and so it will do so again.”

This is very unsound and risky thinking.

The good news is that a couple of weeks ago, the FT outlined the risks attached to this outlook, via an article authored by Ruchir Sharma, Head of Emerging Markets at Morgan Stanley Investment Management.

“It is hard to find a prominent economist who forecasts a significant slowdown, much less a credit crisis,” he wrote.

The consensus view was built on the idea that because China had always found its way through big economic problems in the past, it would do so again, Sharma added.

“China has hit its ambitious GDP growth targets so consistently that many analysts can no longer imagine a miss,” he continued.

“Consensus forecast is for annual GDP growth to hit 7.5% this year, right on target, and to continue at an average rate of 6-7% for the next five years.”

Sharma worries that this consensus view is largely based on the idea that China can avoid a debt crisis because it has high domestic savings rates, a big current account surplus and huge foreign-currency reserves.

But he argues that:

  • Taiwan suffered a banking crisis in 1995, despite having foreign exchange reserves that totalled 45% of GDP, a slightly higher level than China has today. Taiwan’s banks also enjoyed low loan-to-deposit ratios, but that did not avert a credit crunch.
  • Banking crises also hit Japan in the 1970s, and Malaysia in the 1990s, even though these countries had high domestic savings rates of around 40% of GDP.

“Looking back over the past 50 years and focusing on the most extreme credit booms – the top 0.5% – turns up 33 cases, with a minimum credit gap of 42 percentage points,” he added.

Among these 33 nations, 22 had ended up facing credit crises.

“Today, China’s credit gap continues to grow and it is now the largest ever recorded in the emerging world, having risen since 2009 by 71 percentage points, taking the total credit burden up to 230% of GDP,” he wrote.

“Before China, the five worst credit binges had come in Thailand, Malaysia, Chile, Zimbabwe and Latvia, all of which saw the credit gap grow by 60 points or more. All five suffered a severe credit crisis and a major economic slowdown.”

Richard Iley, Chief Asia Economist for BNP Paribas, added in a late January research note: “Frequently unfinished real estate developments and white elephant infrastructure projects [in China] have seen the credit efficiency of growth plunge, while serial overcapacity in basic industries has led to ingrained industrial deflation.

“PPI [producer price index] inflation has now been negative for 22 months, with the latest survey suggesting that deflationary pressure is re-intensifying.”

Iley added that:

  • Debt service obligations were rising to an unsustainable level because of excessive borrowing and the slowdown in GDP growth.
  • Despite what he said was a “barrage of media headlines”, there was little, if any, evidence of rebalancing towards more consumption-driven growth (see the above charts).
  • As a result, the Chinese economy appeared to have suffering from the worst of two worlds over the last two years: slower growth and more extreme investment dependence.

He agreed with Sharma when he wrote: “The self-limiting argument is that, because the Chinese authorities have been able to exert an impressive degree of control over cyclical volatility for many years, this will necessarily continue to be the case. This argument manages to conflate bad economics, poor history and unsound logic.

“The key lesson from the global financial crisis was that long periods of stability sow the seeds for bouts of future instability.”

Chinese authorities did retain considerable ammunition – such as high reserve requirements and a strong central government balance sheet – to ride out the problems, he said.

But the economist warned that the “rising financial fragility of the economy, its still-widening imbalances and its fading ability to generate strong cash-flow growth all suggest that the degree of macro ‘control’ seen in the past will be increasingly hard to maintain.”

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