If you plan for a year, plant a seed. If for ten years, plant a tree. If for a hundred years, teach the people. When you sow a seed once, you will reap a single harvest. When you teach the people, you will reap a hundred harvests.
—Kuan-Tzu (Taoist, died 645 BC)
China is a big country, inhabited by many Chinese.
—Charles De Gaulle
The world’s hopes for economic growth now revolve around a resurgence in China. The IMF recently upped their forecast for China, and now expects GDP growth to be 7.2% in 2009. In a similar move, the IEA issued a bullish oil demand forecast, saying that it expects global crude consumption, led by China and other emerging-market states, to grow 1.4 million barrels-per-day (mb/d) to 85.2 mb/d in 2010. Everybody, including those predicting our imminent demise from an inadequate oil supply, is gung-ho on China.
I have my doubts about these stories, and so does Hugh Hendry of Eclectica Asset Management. The Financial Times spoke to Hendry on July 5, 2009 about why he is bearish on China. What Hendry said makes a lot of sense.
… [people think] China is very much [like] Santa Claus. China … has the prospects of bestowing all of us gifts, and the gift of a great escape [from the global recession]. And I dramatically … want to take that on.
China, I believe, and the Asian surplus [savings] countries, are the most exposed, the most vulnerable, in this whole episode. And while that sounds fanciful, I can point to the even more dramatic correction in their trade statistics, in their stock market, etc. And the flaw that they have is that they’ve swapped a dependency on foreign capital for a dependency on foreign demand. OK? There’s no change, as I see it, between 1998 and today. Secondly, I believe that this presence of leveraging by households, and the corporate sector, where we [in the United States] took leverage [debt] to something like 4 times the GDP of the country… what we were doing is, we were overstating the size of America, by bringing [in] future consumption and spending it today… So, it’s almost as if Bernie Madoff were responsible for the accounting of [U.S.] GDP. And if he’d been responsible, he would have overstated it.
Now, I think that China looks like an investor in a Madoff fund. [They] bought into a [scenario] which was fictitious. Now, if you go back to 1989 in Tokyo, at the height of the bubble [in the Japanese stock market] and you looked at the projection of nominal GDP [in Japan] looking forward, it was a continuation of 5 to 6% per annum in perpetuity. The reality, however, according to the post-bubble difficulty, is that nominal GDP expanded as 1% per annum, which created an enormous surplus capacity, which has destroyed the profits of the corporate sector… Now, that’s my feel, that China and its contemporaries have built productive capacity, not only to service a $14 trillion economy [in the U.S.], but to service an economy in America which they believed would be $20 trillion in 7 years time… My fear is that it could be closer to $15 trillion… so I see China as a deep out-of-the-money, call option on America. China only has a chance of succeeding if the American economy proves to bigger and bounces back. And I don’t see the prospects of that happening.
[My note: GDP is gross domestic product, the value of all final goods & services in a given country. This is my transcript of the video interview with Hendry, but you must actually watch the video (and others) to get a sense of just how smart this man is.]
Hendry’s contention that the newfound “wealth” fueling ever greater debt & spending in America was illusory should no longer be controversial. It was indeed a ponzi scheme in which we spent—borrowed from—future income to pile up immediate gains, just as Madoff found new investors to pay steady 12% dividends to older ones. All these schemes have now collapsed. See my essay Bad Signs, New Bubbles (and other articles referenced therein) for some related commentary.
China is now in trouble to the extent to which they were caught up in our foolish behavior. Indeed, China was almost as complicit in seeding the meltdown as Wall Street was. China and the United States have been referred to as the G2, and for good reason.
The dysfunctional symbiosis between the two countries should be a familiar story by now: Americans consume more than they produce, the Chinese produce more than they consume. Americans are spendthrift, the Chinese are frugal. The Chinese make the stuff Americans buy. Americans run large trade deficits, while the Chinese have a large trade surplus. The Chinese manipulate the value of the Renminbi (the Yuan) to keep the imbalance going. The Chinese buy our debt but will not abandon the dollar to protect their investment—Chinese purchases of U.S. Treasuries have actually accelerated over the past year, but not at the same rate as we have grown the debt (Figure 1).
Figure 1 — From the New York Times’ China Grows More Picky About Debt, May 20, 2009. Note the middle panel showing the rise of China’s purchases of Treasuries in 2008-2009.
Let us accept the reasonable premise that the American economy is going nowhere for a long time to come. Thus, the rampant consumption half of the China-America G2 equation is kaput. We need to get a sense of the extent to which the Chinese economy can be decoupled from the American economy. So, the question is how much can the Chinese economy grow independently of dismal economic performance in the United States (and Europe, Japan, etc.)?
To show why Hendry’s argument that China is not Santa Clause makes sense, I need to bore you with the size of the Chinese economy, their trade balance with the United States, and the recent dramatic drop in their exports. Truly, economics is a dismal science.
China On The Ropes?
No one seems to know (to a reasonable approximation) just how big the Chinese economy is. Last February, Euromonitor reported, based on a World Bank survey, that the size of China’s economy had been overstated by 40% in 2005. The revised number, based on a purchasing power parity (PPP) adjustment of GDP, was $5.3 trillion. Some economists make a much lower assessment.
Take China. At its most basic level, GDP is the total market value of final goods and services a nation produces in a given year. Andy Xie, a Shanghai-based independent economist, puts China’s GDP at $4.1 trillion to $4.3 trillion. Xie isn’t alone. Some put the figure at $4.4 trillion…
Xie’s calculations are as follows. China’s exports were about $1.4 trillion last year, while total labor income was about $2.4 trillion, capital income was about $550 billion and government income was about $600 billion. Then he subtracts about $800 billion to account for the depreciation of roads, properties and other facilities.
[My note: The Chinese economy is approximately 1/3 the size of America's according to Xie's estimate.]
The overall size does matter, because if China is going to lead us to the Promised Land, they must be able to generate enough additional economic activity to fulfill that promise. We see from Xie’s breakdown that China’s net exports added $1.4 trillion to China’s GDP, which is about 33% of the total. We can take that as a relative share regardless of the overall size. How are China’s exports doing? Black Swan Capital believes it is China Panic! Time.
Figure 2 — China’s exports month-to-month percent change, official statistics since September, 2008. Jack Crooks of Black Swan LLC. says “China is dead in the water without exports. They are in panic mode. That is why they are flooding their economy with massive amounts of capital and suppressing any hint of [dissent] everywhere. That is why they have chased out the major financial news outlets, and forced them to take all cues from the state. But no matter how many bridges they build, excess capacity they expand, stock market propping they do, dollar reserve currency jawboning they employ, or internet sites they shut down, it doesn’t change the fact that exports have crumbled and until Mr. US Consumer starts buying again, it will get worse instead of better.”
Crooks may be exaggerating a bit, but not by much. China’s export income is going downhill rapidly. The decline is consistent with Hugh Hendry’s view that “China … and the Asian surplus [savings] countries, are the most exposed, the most vulnerable” to the economic meltdown. But why has the IMF raised their GDP forecast for China? Why has oil consumption rebounded (Figure 3) from it’s January/February low?
Figure 3 — China’s oil imports, a partial update to a chart I used in my Trouble With Oil Down the Road, published on October 22, 2008. At that time I was still predicting phenomenal growth in non-OECD oil consumption up to 2011 and beyond. Now I am not so sure. The most recent data is from Platts.
The Chinese “demand” surge after February was partially due to stockpiling while prices were low, but they must now build additional storage facilities to expand their strategic reserves (Reuters, March 9, 2009).
China plans to build a second-phase strategic reserve that will nearly triple the first batch to 280 million barrels [from 100 million barrels] by 2011, and industry executives have said the current storage capacity has already become a hurdle to bringing in more imports.
China’s massive stimulus program (taken as a percentage of GDP) accounts for most of the increase in their oil consumption and estimates of higher (7.2%) economic growth for 2009 (Business Week, April 22, 2009).
Things are looking up for Xugong Group, China’s largest heavy machinery maker. Driven by Beijing’s five-month-old $586 billion fiscal stimulus, sales of its bulldozers, wheel loaders, and construction cranes reached an all-time high in March, a spokesman says…
Across China, steelmakers, cement producers, and construction companies are seeing sales soar as Beijing’s stimulus plan opens the spigot on funding for railways, airports, and power plants. The economic surge isn’t just about earth-moving. The Shanghai stock market is up 35% so far this year, one of the fastest-growing bourses in the world. The long slumbering property market is showing signs of a revival, with sales volume growing 29% in seven of China’s biggest cities including Beijing, Shanghai, and Chongqing in the first two months, says Jing Ulrich, managing director of China equities at JPMorgan Chase in Hong Kong, though prices have not yet recovered. And in March auto sales grew 27.2%, following a cut in taxes on smaller vehicles that took effect on Jan. 20 and helping first-quarter sales grow a respectable 3.9%.
Apparently, the stimulus is so large that China’s GDP is growing over and above huge export losses. But is this strategy sustainable? China is flooding its domestic market with new loans. We all know what happens when you do that.
China’s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom. New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.
The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation’s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.
“Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “Expect credit to slow dramatically in the second half [of this year].”
Veteran China watchers like Michael Pettis do not believe that China’s short-term stimulus strategy can be sustained without causing more problems than it solves. The longer term solution for China requires them to make the transition from savings & exports to a more balanced economy that enables more domestic spending & imports.
Doing the Right Thing
Western observers seem to be unanimous in their view that China must re-balance their economy. Here is Martin Wolf of the Financial Times talking about how the world might crawl out of the Great Recession.
You want expanded demand in the rest of the world. Well, who are [in] the best position to expand demand? Obviously countries with very strong balance of payment positions, with very strong current account surpluses and reserves: countries like Germany, Japan, and China. [If] they don’t expand demand relative to supply, then I think we have the danger of chronic excess capacity in the world, chronic deflationary pressure. In other words, the whole world starts looking like Japan in the 1990’s: that’s sort of my worry…
[My note: Hugh Hendry, voicing Wolf's fears, refers to a state of "chronic excess capacity" in China. Capacity was built-up to service a future exports market which is very unlikely to exist.]
So we do have to expand demand. Now [to] understand completely, we take the case of China, which is simply the most important single country … they can’t change the structure of their economy, the structure of demand, overnight, except through a massive fiscal boost, which is what they’re now doing, they’re engaged in a huge investment program, and in the short-run that’s the right thing to do. In the long-run, however, it is right for the Chinese to try and absorb more of their production at home and re-balance their economy with more service production which would generate actually many more jobs. They have not done a good job of generating jobs recently, because their development path has been quite capital-intensive, much too much dependent on investment and household disposable income is only 40% of GDP which is why they’re not benefiting fully. So what I suggested … is [that] China should forget having a GDP target, instead of having an 8% growth GDP target, it should have a real domestic demand target. It should think of its policy in terms of generating real domestic demand, [and] GDP will follow.
Wolf’s key point for our purposes is that China “can’t change the structure of their economy, the structure of demand, overnight.” This indisputable observation lies behind Hugh Hendry’s take on China’s medium term economic prospects, which he regards as rather dismal outside of the enormous stimulus they are currently applying. But what does “long-run” mean? Surely a significant expansion of Chinese domestic income & demand will take a decade or more.
University of Maryland professor Peter Morici’s Recalibrating U.S.-China provides a thorough review of the issues facing the U.S. and China if they are to break out of the dysfunctional—the New York Times suggests “codependent”—economic relationship shown in Figure 4.
Figure 4 — Balance of trade between the U.S. and China from Peter Morici’s Recalibrating U.S.-China. On the left the blue bars show China’s rising trade surplus with the United States. On the right the blue bars show America’s growing trade deficit with China. The last year shown is 2008, and no doubt the trade balance is changing in 2009. See Morici’s paper to see the graphs at full scale.
I recommend reading Morici’s paper for an in-depth analysis of what needs to happen to put both economies on a sound footing. The bottom line is that the trade imbalances shown in Figure 4 need to be adjusted so as to be in rough equilibrium.
Rome Wasn’t Built In A Day
Nouriel Roubini’s RGE Monitor forecasts 7.0% GDP growth in China in 2009 and 7.7-8.0% growth in 2010. While such growth rates seem high to those living in the United States, these anemic numbers worry the Chinese leadership because their economy is not expanding fast enough to provide work for the many millions entering their job market each year. RGE Monitor notes that domestic consumption is holding up due to the stimulus from a low base of 36% of GDP, but “China is not able to take up the global slack stemming from increased savings by the U.S. consumer.” Diminished exports and high unemployment will continue to be a drag on Chinese economy over (at least) the next few years.
I often think of oil demand in the United States and China (taken together) as a zero-sum game. China’s expanding industrial capacity requires ever more oil, while America’s shrinking capacity means that China consumes the oil we would have consumed had we not become a “service” economy. While America’s real estate expansion—now over, I think—has required more and more oil in the transportation sector, we did not see a concomitant increase in our shrinking manufacturing sector. China stepped in to fill the production gap, so their oil consumption grew rapidly. If America’s industrial capacity (to service both domestic consumption and exports) were to expand in future years, oil demand in that sector would also grow.
If the zero-sum view is correct, putting the two economies on more wholesome footing would not significantly change the overall oil demand growth picture over the long term. This is yet another reason that the peak demand view of CERA, Energy Secretary Steven Chu, and others is complete nonsense. The only way China & America (again, taken together) have reached peak demand is if both countries experience, each in its own way, a “lost decade” (now longer) as Japan did in the 1990s. This is actually a possible outcome. However, CERA and Dr. Chu think we’ve reached peak demand but will still enjoy vigorous economic growth. That’s the nonsense part of the story.
I started with Hugh Hendry’s plausible view that China overshot the mark in building up capacity to service export markets (in the United States, Japan, and Europe) which have now collapsed. Thus, China now needs to turn their economic focus inward, not outward. It is not clear that China has fully absorbed this lesson. Their complaints about the unstable dollar being the world’s reserve currency are valid, but miss the main point.
China was enjoying double digit GDP growth during the years when their oil demand was surging. With their economic growth slowing, I expect China’s future oil demand growth to be below trend (Figure 3). In the longer term, Chinese oil demand will substantially depend on re-balancing their economy vis-à-vis the United States. Until such a time as China develops its domestic market and implements monetary reforms (e.g. letting the Yuan float), their economy and oil demand will not return to pre-crash growth levels. China’s economy will not see sustained double digit growth again unless substantial re-balancing takes place.
Restructuring the Chinese economy will take many, many years—Rome wasn’t built in a day.
Thus I take issue with the IEA’s (currently) bullish view of oil demand growth in China in 2010. I also do not see how a depressed world economy will drive a surge in oil demand in 2010, or in 2011 or, depending on how things go, in 2012-2013. However, oil prices may rise significantly because prices have an unfortunate tendency to reflect excess liquidity in the market rather than supply & demand fundamentals. At some point in the coming decade, we will revisit the oil shock of 2007-2008. (See the postscript).
The future is always impossible to predict, but my general view is that the future looks worse than the present, not better, unless the world’s major players make a conscious effort to change course. The need for change is reflected in the problems facing China (and the United States) that I have described. Thus the G20 leadership, who will meet in Pittsburgh in September—only a few miles from where I’m sitting—need to define & implement policies to change the way the world works instead of posing for group photos and eating beef au jus.
I’m not going to hold my breath waiting for the G20 to depart from business-as-usual.
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Lest we forget this strong possibility, I casually throw Figure 5 on the table for your thoughtful inspection…
Figure 5 — Ka-Poom! The economies of China and the United States are coming more into balance some years from now only to be blown up by Peak Oil