Comstock Partners, Inc.March 13, 2014
China Can Drag Down The Global Economy
Geopolitical events such as the Ukrainian crisis come and go, but the economic and financial problems in China have far wider market and financial implications. Today, China officially released a slew of disappointing economic results that confirm our previous suspicions about that nation’s increasingly fragile foundations. This follows the recent surprising news that China’s February exports were down 18% (still a weak plus 2.4% adjusting for the Lunar New Year). Coming on the heels of last week’s first ever mainland corporate bond default by a Chinese company, the possibility of an unravelling of China’s massive debt leveraging has become a stark reality threatening economic growth not only in China, but in the rest of the world as well.
The new economic results indicate that the slowdown in Chinese growth is quite widespread, hitting sectors such as retailing, manufacturing, housing, and investment. Year-over-year production for January and February (combined to dilute the effect of the Lunar New Year) rose 8.6%, lower than expected, and the weakest since 2009. Fixed asset investment was up 8.6%, the lowest since 2002. Retail sales increased 11.8%, the slowest since February 2011. In the real estate sector, residential and commercial property sales were down 3.7% with construction starts down 27.4%.
The aforementioned corporate bond default was by a solar company, and was the first by a Chinese company in 17 years. Further exposing the ongoing credit problems, another Chinese solar company had its bonds suspended from trading today by the Shanghai Exchange after reporting losses for the second consecutive year. The default and suspension reflect an extremely important change of government policy to allow defaults after years of bailouts of risky customers by the government and state-owned banks.
Under previous policy, investors assumed that they had an implicit guarantee that they would always be bailed out, and, as a result, corporate bonds outstanding soared tenfold since year-end 2007. Since the loans were considered virtually risk-free, weak borrowers were able to borrow large amounts of money at relatively low rates. That is now bound to change, as it seems clear that Chinese corporations will now find it more difficult to borrow and that their interest rates will be higher.
At its recent annual economic policy meeting, Chinese officials set a goal of achieving 7.5% growth in the current year, down slightly from last year’s 7.7%. However, in a carefully monitored Q and A session, Premier Li admitted that “this year’s challenges are severe.” He acknowledged that defaults are likely after years of bailouts. When asked about the official growth target of 7.5%, he stated that “We are not pre-occupied with GDP growth”, a tacit admission that the target may not be reached.
The problem is that China is facing a dilemma it has not previously dealt with. The nation is facing onerous credit and debt problems and serious imbalances in their economy that may be hard to manage without reducing growth. Chinese authorities have recognized for some time that the economy was excessively dependent on export growth and heavy industry and that the domestic consumption sector was relatively weak. Now it is trying to shift from exports and heavy industry to consumption-led growth, while, at the same time, trying to rein in overly excessive debt and credit, particularly in the so-called shadow banking system. It is widely recognized that the change will benefit long-term growth and stability, but could be harmful in the short- term. Therefore, for the first time, the government may find it exceedingly difficult to control their growth rate.
Chinese leaders are well aware of the need to keep employment growing at a high enough rate to keep the populace in line and avoid rebellion. Therefore, they cannot afford to let economic growth lag too badly, and, most likely, would be forced to turn on the credit spigot again if that should occur. The problem is that this could create further credit problems and delay the implementation of the necessary economic reforms. The key takeaway is that the Chinese government is no longer in complete control of both their growth rates and credit conditions, and that a hard landing has become more difficult to avoid.
Another key aspect of the current situation is the severe slowdown in exports that reduces China’s need to buy massive quantities of raw materials, mostly from nations that are heavily dependent on the sale of such materials for their own economies. This is already evident in the substantial drops in the prices of commodities such as copper and iron ore. Copper prices have declined below the $3 level for the first time since July 2010. Therefore, the slowdown in Chinese growth will probably result in a slowdown in global growth as well, including the U.S.
In sum, we think that the economic and financial situation in China is negative not just for them, but for the rest of the world as well. Although the consensus seems to believe that the U.S. is decoupled from these problems, we have heard that argument before, and it has never been valid. At current levels, the U.S. stock market is priced for something close to perfection, and not for the problems we see ahead.