The China Syndrome... - Dead Cats Bouncing: Making Sense of the Markets

The 1970's disaster movie of that name posited that if a nuclear reactor core in the US went into meltdown, it would exit somewhere in China. In economic terms, it's happened. As US consumers see their wealth evaporate, desert shopping malls and the savings ratio tops 5%, it's no surprise that the trade deficit has tumbled to its lowest level since October 2002, leaving Asian merchandise exporters in a state of panic. Chinese trade has imploded in recent months, as indicated in the chart below. This despite aggressive export rebates and a depreciating Yuan. About half of China's imports are components and sub-assemblies used to produce exports, much of which is imported from the rest of Asia. Therefore, Asian imports function as a leading indicator for Chinese exports, which look set to accelerate their decline in coming months.

The one upside for China is that the local added assembly value is very low (about 5% for an iPod for instance). Overall, although China's gross exports are 40% of GDP, the net value-added content is about 20% and much of the financial loss from lower volume Chinese exports is transmitted to Taiwan, Korea and Japan where more of the end-value is created (see second chart below). Having a relatively backward economy has its upside.

However, with global consumer demand contracting, structural Chinese overcapacity will have to decline. Chinese consumption as a share of GDP is just 35%, half that recently seen in the US and has actually been in decline for a decade. Until a comprehensive social safety net is constructed, current high savings levels look set to be sustained and it's hard to see a sharp increase in net domestic consumption. In any case, the huge gap in per-capita incomes between China's population and that of its main export markets means that there is limited scope for export substitution. In any case, most of the country's deposit savings aren't help by households (China's household savings rate is at 20% of GDP similar to India's) but by small companies. China’s remarkable savings rate at just under 50% of GDP is directly a function of its primitive financial sector.

Small and medium-size enterprises, which employ 80 per cent of workers, have minimal access to financial servicesbecause the sector is dominated by four large banks that primarily serve large private companies and SOEs. The smaller businesses’ lack of access to financial services retards their growth, curbs employment and exerts downward pressure on wages. In effect, the skewed financial structure in China means that small and mid-size companies have been subsidising big corporations and the urban middle-class via low wages and interest rates. Without a fundamental change to that situation, re-balancing China's growth model will be very difficult. China's net exports accounted for about 20% of GDP growth when the economy expanded 11.9% in 2007 and 9% in 2008, according to JPMorgan estimates. In total 8% of the Chinese workforce is directly employed in export manufacturing (although there is obviously a multiplier effect). Despite the net export being dependence being 20% rather than the commonly stated 40% as noted above, 50% of net investment is going to the production of more capacity/machinery to produce even more exportable goods. The rest of investment is in residential construction (where values are tumbling) and infrastructure investment (the focus of the latest stimulus plans), which is generating marginal economic returns. Pouring ever more concrete is the strategy that failed so miserably in Japan in the 1990's.

The current policy of forcing state-owned banks to lend and firms to spend/invest ever more will ultimately only increase the size of nonperforming loans and the amount of structural excess production capacity. The irony is that this plan is capital rather than labour intensive at a time when unemployment will soar. In China, the apparently strong growth in credit currently is driven by firms borrowing cheap to invest in higher-returning deposits, not to invest. The strange 'crawling dollar peg' Chinese currency regime means that monetary conditions are largely determined by net inflows or outflows via the trade account, and although the capital account is closed, liable to sudden flows of 'hot money' betting on Yuan revaluation last year, and now the opposite. In that light it is worth noting that the February trade surplus was just $4.8 billion, a fraction of the $33 billion average monthly surpluses of the past six months (and $39.1 billion for January).

At the recent National People's Congress, Chinese PM Wen said that China's GDP growth target this year was 8% (that lucky number...), that there would be nine million new jobs created, five trillion Yuan of additional loans, and tax cuts of 500 billion Yuan. In fact, ever since that $590bn stimulus plan announced last November, there has been a vigorous debate in official circles as to the best strategy. One focus of debate is the plan to stimulate rural consumption of items like white goods with cheap loans, which many Chinese economists see as reckless given low rural incomes and rising migrant unemployment. Many observers underestimate how close to political crisis China came last Summer faced with soaring inflation and factional infighting, saved by the sudden plunge in commodity import prices. The real risk this year will be social unrest stemming from rural unemployment, or more specifically unemployed rural migrants remaining in the cities when the government wants to disperse them widely to the provinces. In 2009, the labour force will increase by 24 million in urban areas of whom 7 million will be recent college graduates. Even if that official target of 9m new jobs is somehow achieved, 15m more urban jobless look inevitable in 2009 with a minimal social safety net (in China, 1% of GDP growth creates roughly 650,000 new jobs).

China has reached a point where official policy is having perverse effects such are the inefficiencies of its hybrid state/private system of resource (mis)allocation. As the budget deficit runs to 3% on so far announced stimulus plans (and that's assuming 8% growth, which is heroic), the country is running out of options short of a whole-scale abandonment of the strategic model of development it has pursued for the last 20 years. Ultimately, the key consideration for policy makers debating the new composition of the Chinese economy will be retaining the Communist Party's dominant role within it and society at large at all costs.