China: A New Level of Concern–Rebalancing is Not Working…

As you know, printed above, the China’s transition to a more balanced economy has been one our major macro themes, as laid out in our 2016 Macro review. Success or failure on transition has implications for asset classes across the globe. Based on the latest information, it seems a successful rebalancing is in major jeopardy. Desperation is in the air, it seems.

Chinese leaders are adding more debt in attempt avoiding the pain of vital rebalancing of their economy. They are adding more risk, increasing the probability of a serious financial crisis, for the short-term benefit of keeping the existing growth model afloat.

“Bank loans are at a record high, monetary policy has shifted to a “slight easing bias”, reserve requirement ratios have been cut, eight government ministries have pledged to support the industrial sector and down payment ratios and taxes have been reduced in the real estate sector,” according to the Financial Times.

We already knew about the massive overcapacity in a world of stagnant aggregate demand. The new piece of information we didn’t know was the Chinese services sector—the place expected to pick-up the slack from the morbid capital investment growth model—is floundering.

Professor Michael Pettis has been way ahead of the analyst curve on China, pointing out growing enormous imbalances years before others starting recognizing the problem. Prof. Pettis has written books on the subject, I have read them. The risk flowing to the global economy if China’s transition goes right are real and many; but if the Chinese leadership gets it wrong, it likely means a severe financial crisis will be unavoidable.

Part and parcel to the success China making the much needed transition i.e. rebalancing to more domestic sourced growth, away from the capital investment-cum-export model, was predicated on the transfer of wealth from the government to the household sector no matter what GDP was reflecting. In other words, even a successful transition will push GDP growth down into low single digits, but as long as Chinese consumer income was growing, China could make this transition with minimal domestic unrest.

So the recent chart from the Financial Times reflecting Consumer Confidence about future income is a major red-flag—“future income expectations turned negative at the end of 2015 for the first time since the PBOC survey of 20,000 bank depositors started in 2001, according to the FT.

It would be a multi-year process to work off the malinvestment in key industries, State Owned Enterprises (SOEs) and infrastructure, but given the secular change in the global economy (global consumers reducing their own leverage), this process was the only path to avoid a Japanese-style bust which could lock the country into many years of deflationary prison.

In his blog post from November 29th 2015, Prof. Pettis is slightly optimistic about the relative income growth, but even then he believed it would take many years for true rebalancing to be achieved [my emphasis]:

“…the gap between the growth in household income and growth in GDP, which is at the heart of rebalancing, is clearly reversing. After decades in which GDP growth sharply outpaced the growth in household income – and, with it, consumption growth – we must see this reversal, so that the growth in household income exceeds GDP growth by enough that the consumption share of GDP can return to healthy levels.

But the gap is not narrowing quickly enough to rebalance the economy by the end of President Xi’s term in 2023.

If we assume that disposable household income is currently half of GDP, eight years of real GDP growth of 6.9% and real disposable household income growth of 7.7% will only raise the household income share of GDP to 53.1% in 2023, a little more than 3 percentage points higher and still below its 21st Century average and leaving China as dependent as ever on investment and the current account surplus. At this rate it would take 25 years for disposable household income to raise by 10 percentage points of GDP, which I would argue is the absolute minimum consistent with real rebalancing.

Even if the gap were to narrow twice as quickly as it is currently narrowing (i.e. if the growth in household income exceed the growth in GDP by 1.6 percentage points) it could easily take 10-15 years for China to adjust sufficiently that its economy can return to sustainable growth. Unless there are far more radical policies implemented to speed up the growth in the household income and consumption shares of GDP, in other words, (and this basically means stepping up the transfer of wealth from the state sector to the household sector), at the current rate we are not going to see sufficient rebalancing for at least 10-15 years.

But does China have 10-15 years? The maximum adjustment period, as I’ve long argued, is largely a function of the country’s debt dynamics. Beijing can keep growth high enough that unemployment is held to acceptable levels only as long as debt can grow fast enough both to…

i. Roll over the large and growing amount of debt whose principal and interest cannot be serviced from earnings generated by whatever project the debt funded, and

ii. Fund the required amount of additional investment or consumption to generate enough economic activity to keep unemployment from rising.

There are really three policy choices here for China: 1) Continue to increase debt to sustain growth despite all the attendant problems it creates; 2) accept rising unemployment as a way to increase economic efficiency; or 3) transfer increasing shares of wealth to the household sector. For now, China seems to be choosing path number one—increasing debt; despite the fact we know real earnings growth for companies inside China is being smothered by the existing high debt burden and given the global economic backdrop, where now many analysts are calling for a global recession, additional investment is unlikely to produce the type of efficiency gains—because of the lack of external and internal demand–required to keep unemployment in check.

Despite the core problem of rebalancing, China’s increasing stimulus just might lead to a near-term rally in commodities and commodity currencies—given the Pavlov-like reactions of the investment community. But if this stimulus course continues, with no corresponding change in global growth, crisis is the best bet.

The question of course is: How long will these stimuli a la rising debt in China last?

We don’t know the answer. But we do suspect overtime the US dollar will receive another major global risk bid as the potential for crisis grows (the New Zealand dollar is our favorite short play outside EM currencies; pairing the Aussie short against the Japanese yen is our favorite cross on China crisis). What should we watch for to suggest Chinese desperation is rising to the danger zone? 1) Money flow out of China; 2) continued crack-down on dissident voices within China; 3) increased aggression in the South China sea by Chinese naval forces in conjunction with whipping up attendant nationalism over the fabrication that China has historical claims (more in this in an upcoming promotional piece); 4) a real decline in Chinese household income; 5) faster than expected decline in the value of the yuan; and 5) emerging market contagion.