By Aditya Kumar Singh

From an economist’s point of view, China is an interesting case. From 1979, when China’s per capita income was few hundred dollars, people were very poor with starvation plaguing the masses, has seen a marked change to now in 2015, where it is the second biggest nation by GDP value. Under the leadership of Deng Xiaoping, who reformed the four pillars of the Chinese economy, namely agriculture, industry, science and technology; China has been growing at an astonishing rate of roughly 10% per year. That is equivalent of seeing the GDP double roughly every 7 years or a new “China” every 7 years (To give things a perspective, US economy hovers at 2% growth per year). This is a shining example of human progress at work, and in case of China, a growth example of what it achieved in 35 years, compared to what many developed countries took decades and even centuries to obtain. Then why is it that 2016 stared with a Chinese stock market crash and why is there so much panic in the global market over China’s growth? Let us study in detail.

To continue with the China’s growth story, the key factors of its growth were high level of savings and even higher levels of investment which lead to development of infrastructure. But here is the catch. For a long time China has been investing roughly 50% of its GDP in infrastructure (Again, for reference – Japan – 22%, US – 20%, UK – 15%). Hence it is observable that there will be mounting pressure on China’s government to invest so much money and invest it well. In the early years of China’s growth, the infrastructure challenges were well known. They needed more homes, more rail tracks, more roads and needed to equip their urban areas with modern facilities. For a single party regime in China, the decision making procedure is very fast and efficient for “checklist” based agendas. Need to build a house? Get raw material, process it, get land clearance and throw in the workforce. There, job done. China has mastered the art to expedite development on issues that resemble like this. Now, since these “simpler, checklist based” agendas are nearly over, the government has to tackle more complex issues such as healthcare, retail services, start-ups. These complex issues need planning, trail and error and experimentation to come with an optimal solution. And it is hard for an economy to tackle such issues that has tasted the success via “brute force”.  Adding to this, 10% growth every year had driven the market to “overconfidence” in their investment outlook. People would make careless mistakes in the bullish attitude, banking on the 10% growth every year to correct everything. The bullish momentum in the Chinese market cloaked the risks, which should not have been overlooked.

Shifting the timeline to 2008 era, when recession happened. Almost all major economies collapsed, except China. The Chinese government undertook some very special steps to avoid or maybe postpone the recession. They invested more money in the infrastructure than was called for. The Chinese government, the state owned banks and the state owned companies worked in a closed loop to encourage borrowing spirit. The implication of this cycle did show its colour. It boosted investment, kept the economy running at a higher level. All of this came at a cost. A huge cost indeed. The debt rose to a point that it was too high relative to rate of return on those projects. Conservative estimates peg the debt to be anywhere between 200% to 300% of GDP (As usual, for reference, US – 106%, Japan – 60%, India – 23%). This setup could work, if the growth is sustained at 10% (Recall the genesis of this setup was based on this rapid growth). But the growth scenario is not the same.

The Chinese government, in 2015, stated that its economy is growing at 7% per annum. But external observers have a different story to share, for the government has not considered other useful metrics. As per JUUICE Economies Monitor, a quarterly publication that focuses solely on economic performance of Japanese, US, UK, Indian, Chinese and Eurozone economies (Hence the acronym JUUICE), there are 11 economic indicators that suggest a deceleration in the Chinese economy. I would like to highlight few indicators from the report.

  • Official PMI manufacturing: PMI is a measure of factory activity in an economy. A reading above 50 denotes expansion in activity and below 50 denotes contraction. According to data from National Bureau of Statistics of China, Manufacturing PMI – an indicator of Chinese factory activity – stood at 49.6 in November (the lowest PMI reading in more than three years) compared with 49.8 in the preceding month.
  • Fixed Investment: It is an important parameter to consider the Chinese economy growth. According to data from the National Statistics Bureau of China, fixed investment grew 10.2% year-on-year in the first 11 months of 2015 (unchanged from the 10.2% year-on-year increase in the first 10 months of 2015 and considerably slower than the 15.8% year-on-year growth in the same in the first 11 months of 2014). In comparison, year-on-year, fixed investment grew (at a higher rate) by 11.2%, 10.9% and 10.3% in the first seven, eight and nine months of 2015 respectively. Slowdown in growth of fixed investment is reflective of overcapacity in real estate and industrial sectors and is acting as a drag on growth.
  • Producer Price inflation: China is facing deflationary pressure: according to data from the National Statistics Bureau of China, the producer price index fell 5.9% year-on-year in November (unchanged from October) – the 45th consecutive month of year-on-year decline in this gauge of producer inflation. Falling prices are discouraging production and investments and the brunt of the slowdown is falling on the investment and manufacturing sectors. Further, steeply declining PPI underscores persistent weakness in the Chinese economy and may put pressure on the Chinese government to let the Yuan devalue further – which might ease deflationary pressures.

If we observe carefully, these parameters shared by Sher Mehta draw a different image of China’s Economy. One this is clear. The growth is not as bullish as it was thought to be. To monitor the recession, we need to keep in mind 5 main agendas that are critical to Chinese economy, namely, the real estate bubble, the stock market bubble, the excess level of municipal debt, excess capacity amongst Chinese businesses and finally, risk of capital flight. I’d like to highlight some of these issues in brief.

The Chinese real estate was very expensive in many cities. The government overbuilt these facilities. The supply far exceeded the demand and there are no takers for many projects. A huge chunk of cash has frozen up in real estate and has been subjected to price crash. A similar story can be seen in the stock markets. Before we discuss about it, it is worthwhile to note that 80% of Chinese stock market investors are individuals, and are prone to instinctive investment. The Chinese government encouraged many people to buy stocks on margin, the ratio of price to corporate earnings was extremely high, and probably a concoction of above stated parameters caused a sharp dip in the stock market index. This depressed consumer spending, lowered investor confidence and create problems for Chinese banks. Another major factor is the “excess capacity”. There are too many firms producing too many goods than the market can take in. Hence the low demand has taken a jab at their profits. But these companies are being pumped with cheap credit from Chinese state owned banks or the Chinese stated owned companies (powered by political privileges). But all of this will fall like a domino effect. The question is when.

On a conclusive note, we have discussed in brief the genesis of the problem, how it has propagated and how it can be monitored. In the game of Chinese Whispers, there is some adulteration as the message is passed. I see the same in the story of China’s growth. Small, inconsequential errors (relative to the time when they were committed) has  added up to a huge potential problem. Let us see the course of actions under Xi Jinping’s government in 2016. The world is early watching the dragon to rise.

Posted by The Indian Economist