By John Richardson
MYTH No 1 about China is that the rise of its middle classes guarantees a prosperous economic future. No need for a Plan B we are told. Just follow the money by investing in lots of autos and other manufacturing capacity, often “high end”, and everything will be fine – along with, of course, all the petrochemicals needed to make these goods.
Then we have our second myth: The idea that because Chinese consumption of petrochemicals is so much bigger than a decade ago, the slowdown in its economic growth doesn’t really matter. This simply doesn’t add up because:
- Some petrochemicals companies have assumed, say, 7% growth for a particular product in China this year when 3% or even lower is likely. So they will miss their growth targets, and so will end up disappointing their investors. This is the result of a failure to distinguish between real GDP growth and the official numbers, which we have known for a long time are “man-made” and so unreliable. Signs that real growth was falling below the official growth data emerged as early as January 2014.
- Sure, yes, volume-wise, all of China’s petrochemicals markets are a lot bigger than they were a decade ago and so, missing targets aside, growth of 3% or less in 2015 and beyond will still generate the need for a lot more extra tonnes. But the Plan B we need here is that China might well choose to virtually stop importing petrochemicals and polymers, such as polyethylene and polypropylene (PP), by dramatically increasing its own capacities. It has the coal feedstock to do this, and perhaps the political will.
A third myth that I discussed last week was the notion that demand growth in the rest of the emerging world will be sufficiently strong to entirely replace the growth lost as a result of China’s economic rebalancing. The economic ripple effects of events in China is one immediate reason to dismiss this third myth. So is all the data on petrochemicals consumption levels in China versus all the rest of the developing markets combined. See the PP chart below:
Just to hammer home this point again, do the maths and you will find that even in the most optimistic of circumstances petrochemicals consumption in Latin America, Southeast Asia, the Indian subcontinent and Africa will take many, many years to catch up with China in volume terms. That’s if it can be realistically expected to catch up at all.
Myth No 4: China’s politicians are somehow uniquely gifted – and so this is yet another reason to believe that things will soon settle down in China and everything will, more or less, return to numbers
The great news is that these first fourth myths are rapidly losing all credibility.
So should be the case with today’s fifth myth, which is that China’s has huge foreign-exchange reserves that it can use to bail itself out of its current crisis.
Last November, James Gruber, a Melbourne Australia-based financial journalist and former fund manager, wrote the following in an important research note on the unwinding of China’s “carry trade”:
The main argument that we hear against a China carry trade unwind is that the Chinese government will not let it happen and it has US$3.9 trillion in foreign exchange reserves to handle the issue.
It is astonishing how often this type of argument is repeated. It is worth keeping in mind that though China has these assets, it also has a whole lot more in liabilities – debts of close to US$24 trillion, up $15 trillion since 2008 alone. Thus these debts dwarf China’s foreign-exchange reserves. Note also the 3Q decline in reserves, which may be a portent of things to come.
Another way to look at this issue is via measures of foreign reserve adequacy. For example, China’s forex reserves relative to money supply (M2) stand at 21%. By contrast, the forex reserves of the Asian Tigers averaged around 35% of money supply when their currencies collapsed in 1997.
Since Gruber wrote his research note, China’s foreign-exchange reserves first fell to $3.7 trillion in June (see the above chart) and have since declined to around $3.6 trillion.
And around $1 trillion of China’s $3.6 trillion of remaining reserves were described as “illiquid” by the asset manager and macroeconomics expert Felix Zulauf in a 29 August article in Barron’s – the investment newsletter.
(As an important aside, Zulauf is with Gruber in thinking that one of the reasons for the recent Yuan devaluation was to prevent further erosion of reserves. Because of capital outflows, China had been running down its reserves in order to keep the Yuan stable against the greenback. “The government concluded that a currency regime change was needed to prevent a further loss of foreign-exchange reserves,” wrote Zulauf).
And here is another reason to abandon Myth No4. Lucy Hornby, in a 1 September Financial Times article wrote:
China needs Yuan trillion ($1.1 trillion) to clean up soil pollution, equivalent to [around] one-third of its entire foreign exchange reserves, if it uses practices developed in the US and Japan.
That’s just the soil, though. China needs to also clean up its water and air. China’s government has estimated that the overall environmental clean-up will cost at least $1 trillion over each of the next five years.
“But what about China’s very-high personal savings rates?” I can hear people say.
Absolutely, this is a great opportunity as China moves from an investment-led to a consumer-led economy. But this is going to be a slow and difficult process, and here are just two reasons why:
- China needs to disassemble and then reassemble how local governments finance themselves, as the land sales method is now bust. It is only when this has been completed that local governments will be able to afford decent nationwide pensions and healthcare systems, land reform and liberalising the Hukou residency permit system. And it is only when has been completed will people feel confident enough to spent lots more of their savings.
- Unless China can foot the bill for its environmental clean-up, many more people with high personal savings levels – i.e. those who are part of the rich middle class – will leave the country.
We are at a critical stage now. Denial of the difficulties ahead needs to stop. Only then can new strategies be drawn up that take advantage of the tremendous future growth opportunities in China.