China’s credit cuts will send seismic tremors around the world

Economic growth


China map a

Monday’s Interesting Quotes post highlighted how China’s leadership clearly recognise they have a massive debt problem, as detailed in the blog’s recent Research Note.

Further evidence for this was provided by yesterday’s bank lending figures, which showed total lending down 19% versus March 2013 at Rmb2.07tn ($333bn), and the lowest increase in money supply since 2001.

This makes it critical for companies and individuals to try and prepare themselves for the impact of the earthquake that is likely to hit the global financial system:

  • China’s demand will no longer be the growth engine for major industries such as energy, mining, chemicals, autos
  • They have relied on it to boost sales and profits, as Western markets have remained flat since the Crisis began
  • China will also boost its exports in a wide range of sectors in order to preserve jobs – its number 1 priority
  • Together, these developments will cause a major deflationary shock across the world

The earthquake will also create major second-order effects as it develops.  Critically, it will provide the jolt that will move the West into deflation.  This is inevitable, due to the West’s own demographic deficit in demand.  China’s policy shift will simply provide the necessary external shock to make this happen.

In turn, this shock will change Western mindsets – just as the OPEC oil embargo of 1973-4 created the original inflationary mindset.   Forty years ago, as oil and other prices doubled overnight, people suddenly realised it made sense to borrow as much as possible.  The inflation caused by the imbalance between supply and demand meant items would be more expensive in the future, whilst debt would reduce in value in real terms.

Today, of course, we now have too much supply and too little demand – the reverse of 1973.  The collapse of fertility rates along with increased life expectancy means yesterday’s ‘demographic dividend’ has become a ‘demographic deficit.  China’s credit cuts will make people realise it is instead sensible to postpone purchases as prices will be lower in the future.  They will also try to repay debt, as it will become more expensive in real terms.

Another critical transition will follow from this:

  • Income will become the key metric for consumption again
  • ‘Wealth effects’ from increased asset prices will disappear, further reducing demand

The real estate market provides a good case study for this development.  Forty years ago, before the BabyBoomer-led SuperCycle began, mortgage lenders imposed strict limits about a borrower’s earnings in relation to house prices.  Thus 3x to 4x earnings was normal.  But then UK lenders, for example, began to relax this limit, believing that low interest rates made property more affordable.  Thus lending limits instead often became linked to 80% of total price.

This change allowed house prices to rise dramatically, creating the phenomenon of the ‘wealth effect’.  In turn, this generated massive spending power.  As prices rose, people could essentially use their home as a cash machine, and could spend beyond their incomes.

But as and when real estate prices start to fall, this support for consumption will disappear.

As we argued in Boom, Gloom and the New Normal, people’s focus will then move to ‘needs’ rather than ‘wants’.  The essentials of life – water, food, shelter, health and mobility – will be the areas for profitable growth.  Affordability and Design for Cost will become the key metrics.

The problems we now face were not inevitable.  Policymakers could have easily avoided them.  They simply had to recognise that people are the fundamental driver for the economy, not monetary policy.  As future historians will recognise, ‘you can’t print babies’.

The West’s rising debt burden is the penalty we will now pay for their mistake.   As the blog will discuss tomorrow, their stimulus programmes have simply created the illusion of recovery, based on the temporary wealth effect from rising asset prices.  China’s policy shift will likely be the catalyst for this to become obvious.

CHINA GDP & HOUSING MARKET UPDATE.  Q1 GDP growth of 7.4% highlights, once again, China’s unhealthy dependence on property development as its main growth engine.

An extensive and detailed Wall Street Journal report yesterday highlights vast overbuilding in China’s Tier 3 and Tier 4 cities as a result of the stimulus programmes.  It says prices are now starting to fall quite rapidly, with developers cutting offer prices by 40% in some cases.  Official data shows new property construction fell 25% in Q1.

With total housing activity contributing 23% to GDP last year, according to Moody’s, the blog continues to believe that “Zero GDP growth at some point in the next 2 – 3 years would seem to be a prudent Base Case“.



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