China: A Brief History Of Denial

Business, China, Company Strategy

I’ll be posting less frequently this week – today, obviously, Wednesday and also on Friday – as I  am on leave. 

By John Richardson

RoadHERE’S a brief history of the last seven years of denial about China, the root cause of which is, I think, the fact that most people cannot remember anything but a constantly booming China.

First of all, capitalism with Chinese characteristic was thought to be a fantastic success at the height of the Global Financial Crisis (GFC), when it was favourably compared with the Western free-market model.

You read, time and again, how China’s leaders had beautifully managed their way through the darkest days of late 2008 and early 2009 thanks to a huge economic stimulus package.

Far too few people questioned how on earth it was possible for bank lending to be tripled in the space of one year (2009) without major misallocations of capital taking place.

Then, as the extent of the inevitably huge misallocations of capital began to become more and more apparent from 2011 onwards, the narrative changed a little.

The majority now accepted that China’s leaders might have erred a bit. But they still believed that, on the whole, the money had gone to the right places because it had created hundreds of millions more middle class Chinese.

People also assumed that what being middle class meant in China was similar to what it means in the West, even though the Chinese government’s own data on average income levels has consistently told us something very different.

Next, from early 2013 onwards following the appointment of a new set of Chinese leaders, a third dominant narrative emerged, which went something like this: “These new leaders don’t mean what they say about reform. There is nothing really that wrong with China’s economy, anyway, which cannot be fixed by another few round of government stimulus”.

So we ended up with the bizarre notion that the worst things got, the better the economic prospects – i.e. the worst the data on slowing industrial production and falling real estate prices etc., the more likely it was that the government would blink and launch a stimulus programme that would return growth to” normal levels”.

Another problem here was that what was thought to be normal growth was based on the extraordinary increases in consumption that occurred following that earlier giant post-GFC stimulus programme.

As 2013 gave way to 2014, though, a few people began to wake up to the fact that China’s new government actually meant what it kept saying over and over and over again: That economic reforms would be unrelenting, and would result in a very painful economic adjustment.

The full extent of the misallocations of capital also become more apparent as 2014 progressed, including the government’s own admission in November that $6.8 trillion of investment had been wasted. “Ineffective investment in 2009 and 2013 came to nearly half of the all of the money invested in China’s economy during those two years, the government also admitted in November.

As the drip of bad news on bad spending turned into a flood, a high watermark came in February of this year with the release of a study by McKinsey.

China’s debt had quadrupled from $7 trillion in 2007 to $28 trillion in mid-2014, said McKinsey. The consultancy also concluded that at 282% GDP, China’s debt burden was larger than that of the US or Germany, with half the loans linked to the cooling property sector.

The consensus at last shifted to recognising that a slowdown was underway which would and could not be reversed by another round of economic stimulus.

But most people added a caveat, which went roughly as follows: “So what if China only grows at 6% or 7% a year? This will be from a much bigger base than a decade ago, and so, in volume terms, this will mean a huge amount of more consumption. “

This thinking ignored the government’s own admission that headline official GDP growth numbers were largely a fiction. It also ignored evidence that real growth had slipped into the low single digits, as some provinces in China actually began to see negative growth.

Some commentators were then enormously cheered by the stock market rally, which began in June 2014 but gained much more momentum in the first five months of this year. I heard stories of how this represented a new “wealth effect” that would create many millions more Chinese with income levels at or above Western middle class levels.

Some people even suggested that this wealth effect would entirely replace reduced growth in consumer spending that had resulted from the weakness in the real estate sector and tighter lending conditions.

But a quick Google search has long provided evidence that only a small percentage of the Chinese population – about 7% according to official government data – trade in stocks. Just 20% of Chinese household wealth is tied up in equities, with more than half of household wealth in more liquid cash or bank deposits.

In contrast, the Federal Reserve estimates that nearly 14% of individual Americans own stocks directly, while a Gallup survey calculates that 55% of Americans own stocks through a variety of investment vehicles.

This is the good news about the slump in China’s stock markets over the last few weeks. If the declines were to therefore continue, the dampening effect on Chinese consumption is unlikely to be that great.

The even better news, though, is that the fall in equities in China seems to have made most people realise that there will no quick and easy solutions to China’s economic challenges, as Paul Hodges and I have been arguing since 2011.

I just hope that this latest shift in the consensus stays in place, even if China’s stock markets recover all of their lost ground.

If not, then we are going to waste more valuable time that should be spent right now in dealing with the New Normal.


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