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Why China's a Bad Historical Bet

China needs to rebalance. That means much slower growth...

OH WHAT a surprise! China's GDP growth for the third quarter came in bang on the consensus estimate of 7.4%, the slowest rate of growth in years, writes Greg Canavan for the Daily Reckoning Australia.

But the market liked it because on a quarter-on-quarter basis growth was 2.2%, up from 2% in the prior quarter. So on an annualized basis, the Chinese economy grew at a fast 8.8%.

Or did it?

The published numbers are a farce. They tell you what the Chinese Communist party wants you to know — that they are in control and everything is going according to plan.

For example, here's the introduction to China's GDP release from the National Bureau of Statistics of China:

'In the first three quarters of 2012, faced with the complicated and volatile economic environment at home and abroad, the CPC Central Committee and the State Council committed to the general tone of progressing steadily, correctly handled the relationships among steady and comparatively rapid economic development, the adjustment of economic structures and the management of expectation on inflation, paid more attention to maintaining steady growth, carried out the proactive fiscal policy and prudent monetary policy, and made great efforts in policy presetting and fine tuning. As a result, the overall national economy realized steady development with some positive changes: the economic development stabilized; structural adjustment speeded up and people's livelihood continued to be improved.'

So there you have it, The Party has it all under control...nothing to see here, go about your business.

And the bluster seems to have worked. Based on yesterday's data release, everyone now seems to think that China's growth rate has 'bottomed' and it's back to business as usual from here. John Garnaut's article in The Age nicely encapsulates this cozy little world view.

Garnaut's reporting from China is normally good, but here he just reports the 'facts' as dished out by China's central planners. To really get a grip on what's happening in China you have to look behind the facts. So as a counter to the mainstream view, which is one that the media will no doubt run with for the next few days, have a read of this. It's analysis from one of our favorite China watchers, operating out of Hong Kong.

The gist of the analysis is that the numbers really don't make sense. That there are other important indicators that suggest China's GDP growth should (or could) be much lower. For example electricity consumption growth is nearing 0% year-on-year.

China's supposedly better-than-expected data is not what it seems. And especially for Australia, it means the 'pain' has only just started.

Allow us to explain.

The whole point of this 'engineered' Chinese slowdown is to rebalance the Chinese economy. That is, rebalance away from property and 'fixed-asset' related investment, and more towards domestic growth. The third quarter China's GDP data suggests that is not happening at all. In other words, the rebalancing has not even started.

For the three months to September, fixed asset investment grew at an annualized rate of 17.6%. That's slower than annualized growth for the first three quarters of the year of 20.5% but it's still very robust and much faster than overall growth. This means that fixed asset investment as a percentage of GDP is still growing — exactly the opposite outcome of what China says it's trying to achieve.

Or take real estate investment. In the first three quarters of the year, real estate investment grew at an annual rate of 15.4%. That's a big slowdown from the same period last year (when annualized growth hit 32%) but it's still in excess of overall GDP growth, which means property investment as a percentage of China's GDP still remains stubbornly high.

In other words, China's rebalancing has not even started. The process of rebalancing is underway, in that growth rates for real estate and fixed asset investment are coming down, but they need to slow much more for actual rebalancing to occur.

China can spur growth again easily if it wants...but it will be unstable growth. It will cause even greater transition problems down the track.

This is the issue that most people don't understand about China. That is, rebalancing the economy requires much, much slower growth in the commodities intensive sectors of fixed assets (roads, railways, empty cities, etc) and real estate, and much faster growth in domestic consumption.

Given that much of China's household wealth has actually financed the investment boom, turning off the funding tap (to encourage spending instead of saving) would prove disastrous.

Xiao Gang, Chairman of the Bank of China, recently wrote an op-ed piece for China Daily that focused on this financing of the investment boom. Much of it occurs through China's 'shadow banking system', which consists of 'Wealth Management Products'. They are off-balance sheet vehicles sold by the banks to households and could be as large as nearly US$2 trillion. Gang writes:

'Chinese banks work closely with trust companies or other entities by packaging trust loans into WMPs, offering investors a higher yield than conventional bank deposits can. These products are mainly sold by commercial banks either at their branches or online. Many of the funds that were obtained through these channels went into real estate development, infrastructure projects, the manufacturing sector and local government financing vehicles. Banks are playing the role of "middlemen" between the recipients and investors.

'There are more than 20,000 WMPs in circulation, a dramatic increase from only a few hundred just five years ago. Given that the number is so big and hard to manage, China's shadow banking sector has become a potential source of systemic financial risk over the next few years. Particularly worrisome is the quality and transparency of WMPs. Many assets underlying the products are dependent on some empty real estate property or long-term infrastructure, and are sometimes even linked to high-risk projects, which may find it impossible to generate sufficient cash flow to meet repayment obligations.

'Moreover, many WMPs are not even linked to any specific asset, rather, just to a pool of assets, whose cash inflows may often not match the timing of scheduled WMP repayments.

'China's shadow banking is contributing to a growing liquidity risk in the financial markets. Most WMPs carry tenures of less than a year, with many being as short as weeks or even days. Thus in some cases short-term financing has been invested in long-term projects, and in such situations there is a possibility of a liquidity crisis being triggered if the markets were to be abruptly squeezed.

'In fact, when faced with a liquidity problem, a simple way to avoid the problem could be through using new issuance of WMPs to repay maturing products. To some extent, this is fundamentally a Ponzi scheme. Under certain conditions, the music may stop when investors lose confidence and reduce their buying or withdraw from WMPs. The rollover of a large share of WMPs could weigh heavily on formal banks' reputations, because many investors firmly believe that banks won't close down and they can always get their money back.'

They're some pretty strong words from a bank Chairman currently enjoying the benefits of the Ponzi. It just goes to show the deep-seated natures of the problems unleashed by a credit boom.

The thing to keep in mind when looking at headlines about China's so-called 'revival' is that this is a long term problem. More importantly for commodity exporters like Australia, China's economic adjustment has not even started in earnest.

As is the nature of these long term trends, there will always be a short term counter-trend or argument to deal with along the way. But don't be misled. Keep your eye on the big (underlying) picture, because worries about China's growth trajectory will surface again...maybe later this year...maybe in early 2013.

The bottom line here is that if you're betting on China, you're betting against history. No nation in history has ever had such unbalanced economic growth (that is, investment accounting for around 50% of GDP). In the instances that came close (the notable examples are Japan in the late 1980s and the US in the late 1920s) the aftermath was not too pretty...

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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