I don’t usually pay much attention to quarterly GDP releases but China’s Q3 report is interesting for two reasons. One, it’s completely consistent with an economy that hasn’t meaningfully rebalanced away from a heavy reliance on government-directed investment spending, despite years of talk from Beijing. Fifteen years after Premier Wen called the economy “unstable, unbalanced, uncoordinated and unsustainable”, economic growth is as lopsided as ever.
Second, real growth in China in the 3rd quarter was a mere 0.2% qtr/qtr. Beijing always massages these numbers (polite term for ‘invent’) to make them fit whatever story they want, so it’s reasonable to wonder whether the Chinese economy actually shrank in Q3. The 4th quarter is off to a bad start with terrible floods and widespread power shortages hampering growth while the critically important property sector has virtually ground to a halt outside of the major cities. If this were any other country, economists would be talking about increased risk of an outright recession. Because this is China, it almost certainly won’t happen and even if it did, Beijing would never admit it.
Nonetheless, regardless of what happens in Q4, investors must remain cognizant that the Chinese economy cannot continue indefinitely to generate almost half their GDP by building stuff. Just because it seems impossible to predict HOW growth will be rebalanced, doesn’t mean we can ignore the fact that someday, somehow, it WILL be rebalanced.
Premier Wen Jiabao made his famous “unbalanced” proclamation in early 2007. He expressed concern that the Chinese economy was massively over-reliant on debt-funded investment spending and cheap exports. Two years later, Lehman went bust and Beijing unleashed a wave of investment stimulus so massive it kept the entire world economy from recession – but pushed things even more out of whack in China.
Casual observers tend to view rapid Chinese economic growth as being something of a miracle. It is not. In China, investment spending makes up ~ 40-45% of GDP versus ~ 20-25% or lower for every other economy in the world. China grows at 6% or 9% or whatever the target is, because investment spending — on infrastructure (roads, subways, airports, high speed rail), property (condos, office buildings) and factories for building stuff – is almost half the economy and it increases at the same or often much higher rate than the overall economy. China doesn’t grow rapidly because of exceptional productivity growth, it grows rapidly because of exceptional investment spending (both the level and the rate).
Investment spending is easy for Beijing to manage. Need an extra 2% growth? Mandate all provinces spend a extra few trillion Yuan on rail or roads or other public investment by the end of the reporting period. In China there’s no such thing as an infrastructure project that isn’t “shovel ready”! All of this goes right into GDP. Japan and the other Asian economies who developed ahead of China, also relied heavily on investment spending and also had an investment share of GDP of ~ 40% for a very brief period before declining to the ~20-25% level (at which point growth slowed sharply, typically as a result of a financial crisis). No economy in the history of the world has maintained 40-45% investment share for even five years, let alone the fifteen-plus year investment boom seen in China.
So how much progress has been made on rebalancing since the GFC? The answer is not much except with respect to trade. After allowing the Yuan to appreciate, China’s current account surplus has shrunk from a peak of ~ 10% in 2007 to less than 2% of GDP in recent years. Total leverage in the economy (total debt to GDP) stopped rising for a couple years but during Covid jumped from ~250% to ~275% of GDP (as per BIS). Investment spending made up 43% of GDP in 2020 which is down from the absolute peak of 46% in the years after the GFC (see chart above) but is still crazy high at 2-3x every other country in the world.
So what happened in China in the year-to-date period through September? Investment spending (fixed asset investment) grew ~ 7% while consumption grew ~ 4%. I.e., no rebalancing. It’s easy to glance at these quarterly releases and eyeball whether rebalancing is occurring. Rarely is investment spending growth less than total GDP growth.
Why does this matter? The fear is that if you are spending 2-3x what everyone else is spending on infrastructure, construction of condos, and manufacturing capacity, the odds are high that a lot of that is being wasted. And even if what HAS been spent was not wasted, it’s reasonable to question how it’s possible to continue allocating 45 cent of every dollar of GDP towards investment given what they’ve already built without massive “malinvestment”.
The Chinese have built the worlds longest high speed rail system. That will obviously stimulate growth by reducing travel and shipping costs between cities. But infrastructure is very expensive to maintain. If the economic benefit of a HSR project is less than the cost to build it AND maintain it (and financing costs), even though it pumped up GDP when it was built, the net effect is negative.
The same is true vis a vis condo construction. The Chinese government has released figures showing that 20% of urban residential properties are vacant (so we assume the real number is bigger) – this against a backdrop of a shrinking/aging population. It’s hard to fathom how it can possibly make economic sense to continue this epic condo building binge. Xi Jinping seems to agree given his tough stance forcing ginormous property developer Evergrande into bankruptcy. But if property-related spending declines, where will GDP growth come from?
In manufacturing, the situation is equally concerning. Post Covid and Trump trade wars and twenty years of rising factory wages and we see foreign companies moving production OUT of China to diversify the risk of trade wars, to lower costs, or because the operating environment for foreigners has become more and more challenging. Chinese manufacturing costs are now significantly higher than in Vietnam and other less developed nations. China is spending massive amounts on newer technologies and advanced manufacturing but it’s hard to see how the sheer magnitude of investment in new high-tech factories and technologies can offset less new investment by foreign producers, less investment in heavy-industry heavy-polluting industries (cement, steel, coal, etc.), and less investment in low-tech light manufacturing (shoes, toys, etc.).
Recession risk? In China?!
Finally, going back to the Q3 economic release, it showed the Chinese economy is currently barely growing (or worse) in the face of multiple significant headwinds. The most significant of these in the short term is widespread power shortages which are expected to last through the winter. In addition, Beijing is forcing a deleveraging in the gigantic overbuilt property sector.
On top of that, Xi is reining in the private sector in a “rectification” campaign to ensure all companies are fully supportive of the CCP and contribute to national “equity” (and hand over all data to Beijing). No one knows how extensive this crackdown will ultimately be but it’s certainly a negative for growth in the short term. If this were any other economy, one would assume substantial risk of recession. Since this is China, we can be confident that their Q4 GDP release will show continued growth — either because of monetary stimulus, yet another surge in fixed asset investment, or if all else fails, creative accounting.
Over the last 15 years, many in the West (including yours truly) have predicted bad things for the Chinese economy and we’ve all been made to look foolish. So human nature being what is, most have simply given up predicting anything about China. But things that can’t continue forever… don’t. Investors should force themselves to consider the possibility of a recession or systemic crisis in China — however unlikely that may seem based on the last 20 years and however impossible it may seem to forecast when and how it happens. Some of us are old enough to remember when America was past it and we all needed to copy the Japanese way. Three decades of stagnation later and it’s hard to remember why we ever thought that.