With all the daily spasms of the market due to Fed minutes, economic data, or oil prices, most investors are overlooking the big, red elephant in the room—that pachyderm is China. China is the world’s first or second largest economy, depending on which metric you look at and they have big problems.
The opening, or modernization, of the Chinese market in the 1970s brought forth the wonders that capitalism always does. The Chinese economy took off like a rocket. For decades, the Chinese focus was on infrastructure and exports, comprising fifty percent of gross domestic product. This worked well for a while; however, large imbalances were built up over several decades. These were exposed in the aftermath of the 2008 financial crisis. When the export market dried up, the imbalances were laid bare for all to see. A lack of domestic consumer demand showed the risks of export dependence. How did China react? Chinese doubled down on infrastructure investment, much of it unneeded, to keep the workers employed and the wealthy class happy. It was a classic example of misallocation of capital and very typical of top down directed economies.
This spending was fed by government spending and massive borrowing in the private and municipal sector, encouraged by Beijing. The Chinese debt to GDP ratio was driven upward to three hundred percent, well above the majority of the developed world. The double digit growth of the Chinese economy continued, as was demanded by investors and working class alike, hence the infamous ghost cities of China. Today, it is not uncommon to find cities with dozens of large apartment blocks dotting the landscape, basically empty, no people, no retails stores, no cars, nothing. China then tried to lay off a lot of this corporate debt in the ever increasing stock market. This again, worked for a while, but then as bubbles end, things came to a crashing halt with a massive decline in the equity markets.
The problem is there are no more magic rabbits in the communist party’s hat.The stimulus and debt binge after the financial crisis simply delayed the inevitable. China is in for a very rough landing. Although the government is still reporting an approximately seven percent growth level, many doubt these figures and believe the real number could be much lower. China could be heading for a very deep and long recession.
Bloomberg reports, If anyone doubted the magnitude of the crisis facing the world’s largest steel industry, listening to Zhu Jimin would put them right, fast. Demand is collapsing along with prices, banks are tightening lending and losses are stacking up, the deputy head of the China Iron & Steel Association said on Wednesday. “Production cuts are slower than the contraction in demand, therefore oversupply is worsening,” said Zhu at a quarterly briefing in Beijing by the main producers’ group. “Although China has cut interest rates many times recently, steel mills said their funding costs have actually gone up.”
How this scenario resolves itself remains to be seen. The Chinese government is very concerned with civil unrest and has gone to extreme measures to ensure the party keeps going. Arresting sellers in the recent market crash is one example.
China is going to have to struggle through a very rough period as it transitions to an economy where they market allocates capital instead of the national government. If they do not make this change, they are in for even worse economic stagnation. The elephant in the room is China.
L. Todd Wood is a former emerging market debt trader with 18 years of Wall Street and international experience. He is also an author of historical fiction thriller novels. His first of several books, Currency, deals with the consequences of overwhelming sovereign debt. He is a contributor to many media outlets and is a foreign correspondent for Newsmax TV. LToddWood.com