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China: Counting The Cost Of Wrong Analysis

Business, China, Company Strategy, Economics, Environment, US
By John Richardson on 21-Jan-2015


By John Richardson

VERY few people listened when I warned in November 2013 that China’s economy was about to enter a “New Normal” as a result of the biggest about-turn in economic policy that China had seen for at least 20 years.

A few more people took heed of a clear indication in January 2014 that this momentous, world-shaking change was underway.  The indication came in the form of lower credit growth. When you drain the engine of fuel, it doesn’t tend to run as well.

But still, a lot of sceptics insisted I had got this wrong. They argued that the worse the data got on new credit creation, deflation and industrial production etc. became, the more likely it was that China would resort to an “old-style” economic programme.

I kept writing about how this was simply impossible. Xi Jinping and Li Kieqiang had no choice but to press ahead with their reform agenda because an old-style stimulus programme would just kick the can down the road. What was the point in throwing more money away on economically worthless, environmentally ruinous projects?

My point was that this would only make tackling deflation, bad debts and terrible water, air and food-pollution problems even harder. Xi Jinping and Li Keqiang had also staked their entire political credibility, and probably their political survival, on pressing ahead with their reforms.

This was no short-term cynical, political calculation by XI and Li of the kind we are so familiar with in the West. I genuinely believed then, and I still believe now, that they are visionary leaders with a long term carefully thought-out plan. They are leading China in the right direction.

I thought in February of last year that the arguments that Paul Hodges and I had researched and developed together had finally won the day, which came as a big personal relief to me. I have a lot friends in the chemicals industry who I want to see do well.

What made me wrongly believe that a turning point had been reached was a one-hour BBC documentary by one of its senior editors, Robert Peston. His travels through China supported our view that over-investment in China represented in even bigger risk to the global economy than US sub-prime.

Instead, though, I kept reading and hearing of how China’s rising middle class and increased urbanisation meant that there was nothing to worry about – and kept shaking my head in bewilderment.

Yes, there were a few debt problems, people conceded, but nothing that China wouldn’t be able to very easily overcome. This meant that all the projections, based largely on 2008-2013 trends, of strong economic growth, and thus stellar chemicals-demand growth, were still more or less justified.

But I contended that this ignored:

  • The “wealth effect” from excessive credit creation that had come to an end. Take away this wealth effect and you are left with per capita urban income levels that were just Yuan 29547 ($4769) in 2013. Being middle class in China is vastly different from being middle class in the West.
  • Demographics. The legacy of China’s one-child policy is an ageing population and a declining working-age population. This will radically reshape the nature and scale of consumption over the coming decades. It is also resulting in the closure of low-cost manufacturers as wage costs soar and is placing a huge fiscal burden on the government. All these problems can and will, I think, be solved, thanks to Xi and Li’s policies. But this will take many years. In the meantime, demographics simply have to be a major drag on growth.
  • The environment. People are quite rightly nothing short of furious about China’s chronic pollution problems, which represent an existential threat to the country’s future. They cannot carry on like this. Hundreds of thousands people a year are dying prematurely from air pollution, water pollution and unsafe food. Again, I firmly believe that these problems can and will be solved – and that the process is already well underway. But it will take time, a lot of time. In the meantime, I have consistently argued that economic growth will have to be lower.

You simply cannot dismantle a whole economic growth, and then assemble an entirely new one, without expecting major disruptions.

“The good meat is gone; all that are left are the hard bones to chew,” said President Xi in April of last year.

I felt that this confirmed my three bullet points above. It underlined just how hard the economic transition was going to be.

Time and time again during 2014 Xi and Li, and other senior government officials, should have the left the world in no doubt whatsoever that very difficult times lay ahead. Their comments could not have been more crystal clear and consistent.

But still, far too many people chose not to listen, including during the World Economic Forum in Tianjin in September of last year.

“Premier Li Keqiang failed to offer global business leaders any fresh solutions to the Chinese economy’s slowing,” wrote the South China Morning Post in an article on his speech at the event.

“He disappointed his international audience by failing to offer any new ideas for dealing with a deepening property market slowdown or tackling funding bottlenecks for businesses.

“Many participants left the conference room halfway through the opening ceremony, something rarely seen when a top government leader representing the world’s second-largest economy speaks at a high-profile forum.”

But whilst far too many people outside chose not to listen, those who live and work in China have taken every bit of notice of this radical change in government policy.

In October it occurred to me that perceptions of future growth prospects had been deliberately changed by Beijing. By reducing the appetite for the wrong kind of borrowing, the government hopes that this will help reshape the economy. But of course this again means slower growth in the short term.

Still the denial continued until as late as November last year. The decision to cut interest rates was seen by some as a welcome return to the Old Normal of old-style economic stimulus.

But this was nothing short of a shameful failure of serious analysis. It ignored the economic reform objectives behind the decision to lower borrowing rates whilst at the same time liberalising how deposit rates are set.

This analysis also ignored an abiding truth for 2015: That you can play around with liquidity, but if individuals and banks are taking a lot less risk, then the economy has to further decelerate.

There must surely be no doubters anymore.

Global Oil and other commodity prices have collapsed, largely because of the slowdown in China.

And the world now confronts a deep deflation trough – again largely as a result of events in China.

Just how far the consensus has shifted is typified by this Wall Street Journal article, which was published yesterday.

Yesterday also saw the announcement by the government that official GDP growth in 2014 was the lowest in 24 years.

The number was in itself of little value, as even Premier Li has told us that official GDP numbers are largely a work of fiction. Last year’s supposed 7.4% growth rate is likely to have been a great deal higher than real growth.

But what really mattered about the announcement was that the government took the figure in its stride – and again emphasised that China was facing an economic “New Normal”.

I worry that chemicals companies which failed to heed all of this evidence, from November 2013 onwards, might be the same companies now sitting on heavy raw-material inventory losses. I just hope that they can pull through this crisis, more or less intact.