Hard Landing?


Over the past month, the Chinese economy depressed global markets with several negative figures. In a global economic climate where slow and sluggish growth is starting to be accepted as the new normal, China has always been the safe haven of dependable robust economic expansion. However, the pace of China’s growth has slowed over the past several years and the data received over the past month has spooked investors that China’s transition from a developing to a developed economy may end in a massive failure. To put it into simpler terms for you movie fanatics out there, China’s economy is like the bus driven by Keanu Reeves in the hit thriller Speed. If it slows down below a certain speed, it will explode and end horribly wrong for everyone on board. For those of you who haven’t seen it, here is a summary of the movie in 5 seconds. The following video may contain some explicit content.

China may not have one of the most untalented actors in Hollywood to keep its economy in the right pace, but it does have the Chinese Communist Party in sole charge of the Chinese economy. Will they keep China on course? We’ll have to wait and see. I will discuss my own analysis and opinion on the state of the Chinese economy soon, but first let’s discuss the data that filled the tickers with red arrows over the last month.

The first data point is retail sales, which displayed a year-over-year increase by 11.8% in January and February and combined. 11.8% growth may seem to be a tremendous figure, but take a closer look at the graph below and you will notice that it is quite low compared to historical data. In fact, I failed to find a graph that goes back that far, but 11.8% is the slowest pace of increase in Chinese retail sales since 2004. Some experts have speculated that Chinese Premier Li Keqiang’s recent movement to crack down on corruption and extravagant spending is the reason for declining consumption. I will soon explain why I don’t think that is the main reason.

china-retail-sales-annual

The second data point which also added to the panic regarding China is industrial production. Chinese industrial production witnessed a 8.6% year-over-year increase in January and February combined. Once again, 8.6% is a dream figure for most developed nations but as the graph below proves, China has been accustomed to rapid industrial growth over the past several years. The latest figure of 8.6% is the slowest figure that China has seen since 2009. Another disappointing figure from the Chinese.

china-industrial-production

Continuing the negative trend, on March 8th, it was announced that the consumer price index (CPI), which is a general indicator of inflation, expanded by a meager annual rate of 2% in February. Like many nations, following the financial crisis of 2008, the Chinese government opened the floodgates and unveiled a large monetary stimulus package to revitalize their economy. Even though they succeeded in keeping the economy on the path of rapid growth, inflation rose significantly throughout this period. As the graph below shows, inflation peaked at around 6% in 2011. However, it has consistently fallen since that year and has reached an alarming rate of 2%. Why is deflation alarming? If consumers are aware that prices are rapidly dropping, they will save and prefer to consume in the future. This is because they are aware of the fact that in a deflationary climate, their money will be worth more tomorrow than it is worth today. Why buy a BMW today when you know the price will drop tomorrow; right? A decrease in consumption due to deflation can lead to a slowdown in economic growth, which is what investors fear might happen to Chinese economy. (On a side note, this is also becoming a serious problem in the Eurozone as well)

china-inflation-cpi

Finally, on March 7th, Shangai Chaori Solar Energy Science & Technology, a solar-cell maker, became the first Chinese company to default on its corporate bond, adding to the scare about the Chinese economy. After being bombarded with a heap of bad news from China, pessimistic investors responded as emotionally as Keanu Reeves, and rushed to sell their Chinese stocks.

So what is the current condition of the Chinese economy? The economy is the foundation of the Chinese Communist Party’s (CCP) authoritarian rule over China. Their largest way of affirming their rule has been that they have been able to engineer rapid economic growth and transform China from a poor rural nation to an urban developed nation. Given the importance that the CCP has placed on the economy, if it falters, then the government is bound to lose its legitimacy to a certain point. Before we determine if the CCP will be able to keep the bus that is the Chinese economy at the right speed, we have to take a closer look at the key characteristics that define it.

So what is the current condition of the Chinese economy? The economy is the foundation of the Chinese Communist Party’s (CCP) authoritarian rule over China. Their largest way of affirming their rule has been that they have been able to engineer rapid economic growth and transform China from a poor rural nation to an urban developed nation. Given the importance that the CCP has placed on the economy, if it falters, then the government is bound to lose its legitimacy to a certain point. In order to determine if the CCP will be able to keep the bus that is the Chinese economy at the right speed, looking at a few data points isn’t enough. We have to take a closer look at several important trends on a larger scale.

Urbanization

The Chinese economy has been in the process of maturing for over two decades now. Throughout this period, it boomed in two ways; by developing the country’s underdeveloped infrastucture (ie. roads, bridges, telecommunicaiton), and by putting underemployed peasants to work in better jobs at urban factories. Just like in England during the Industrial Revolution, a rural and isolated low income nation has been on the path to become an urban and middle class nation that is connected to the rest of the world. Initially, this process yields incredible economic growth as the rural population, especially in a country with such a large population as China, urbanizes and occupies jobs in more productive sectors such as services, technology and industry. To stay consistent with the Speed references, China’s rural population is the gasoline that keeps Keanu’s bus running. However, China is approaching what is know as “the Lewis turning point”, which is the point when underemployed farmers have already left the farms and new immigrants to the cities do not add to productivity. The slowdown in China’s population growth has had a big effect on the gradual decline in urbanization. Mao Zedong, renowned Chinese historic leader, encouraged Chinese woman to have six children, which boosted the Chinese workforce in the 1980s and 90s. After Mao’s death in 1976, party leaders turned against his ideals and institute the One Child Policy in 1979. The result of this policy is that only 5 million people between the ages of 35-54 will join the Chinese labor force this decade, versus 90 million in the previous decade. Many factors about the Chinese economy remain a mystery, but one thing is certain, China’s fountain of youth is about to run dry.

china-economy-working-class-production-line

Cheap Labor

Mass urbanization of rural Chinese workers to the cities also allowed the Chinese economy to take advantage of cheap labor costs. Because these workers used to barely make a living in rural towns, they were willing to work for very low wages in the early stages of China’s transformation. However, the transformation process is reaching its latter stages. Cheap labor costs used to be the main reason why China attracted so many foreign companies and was able to maintain its status as a net exporter. “Losing jobs to China” was a phrase used by many Western politicans. But now, the cost of labor in China has risen compared to other developing east Asian countries such as Bangladesh and Indonesia, and skeptics believe it is a matter of time before China loses its advantage on labor. The graph below displays the steady rise in Chinese manufacturing wages since 1998.

china-wages-in-manufacturing

Consumption

Many economists agree that as China’s economy matures, it will be rely less on exports and will instead be driven by domestic consumption. This belief draws its roots from the idea that until now, personal savings have been intentionally raised by the govnerment in order to fund the spending on large scale investment over the past decade. Once the savings rate drops, China will export less but the Chinese people will spend more. I approach this idea with suspicion. Over the last 30 years, Chinese consumer spending has increased at almost an average rate of 9%. This rate faster than the rate generated by Taiwan and Japan dring their peak growth years. China may also be known for being home to many cheap knock-off brands but global luxury brands are now operating in China as well. In 2010, Rolls Royce sold more cars in China than it did in Britain for the first time. In my opinion, the data just doesn’t prove the notion that the Chinese government has been intentionally keeping consumption down. If the consumption is forecasted to make up for the recent drop in Chinese investment and industry output, then recent indicator pointing to a slowdown in retail sales could be a major issue for future Chinese economic growth.

rr_china_1

The Future

China is much diferent than the country it was just severaly years ago. A significant Chinese middle class has emerged risen and now demands better social services, cleaner air and less political corruption. Due to the slowing economy, the CCP consistently has set a lower target for the annual GDP growth rate, with the latest being at all time low of 7.5%. In the latest annual session of the National People’s Congress, premier Li Keqiang placed economıc growth as a secondary objective and vowed to crack down on corruption and pollution. In fact, looking at China reminds me of Japan in the 60s and 70s. Following WW2, the Japanese economy also grew at a rapid pace and was also driven mainly by exports. Many Americans feared of Japan ovepowering the United Stats on the global economic stage. However, Japan was forced by the United States to appreciate its currency against the US dollar, which contributed to Japan’s gradual slowdown and eventual economic crisis.

In all honestly, I do not understand the mystery behind the future of the Chinese economy. The pessimists are as wrong as the optimists. China is obviously in the middle of transforming from a developing market to a developed and matured economy. Thus, China still has a lot of room to grow, albeit at a slower rate.  Low inflation also means that the Chinese Central Bank has more room to expand the economy with monetary easing. The recent data are symptoms of this transformation and the fact that the state is gradually releasing its hold on the economy and allowing more free market functions to operate. The default of Shanghai Chaori Solar Energy is a sign that free market principles are gaining a foothold in the Chinese economy. This is a very small company, and in an economy dominated by companies propped up and supported by the government, a bond default is a good sign. The days of +10% Chinese growth are past us.  If China moves to a 6-7% growth rate in the coming years, it might appear that China is entering a recession. However, this will hardly be a cataclysmic event. The Chinese economy is now so big (over $9 trillion) that even at a 6% growth rate, China will still be the largest contributor to global growth in the upcoming years.

breakout-nations_apr172

On a final side note, I gathered much of the information and developed my personal opinion on the Chinese economy after reading Ruchir Sharma’s book, Breakout Nations. I advise you to read through it if you want to get a better understanding of the countries that are seen as the next big players on the global economic stage.

“The biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.”
– 6th Chinese Premier Wen Jiabao (2008)

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