China Replays Pre-2008

GDP threat of social unrest spurs SPVs...

CHINA's economic data is always worth taking with a pinch of salt, writes John Stepek – editor of MoneyWeek and author of the newly published Sceptical Investor (Harriman House) – in his free Money Morning email.

The figures are always going to say what the men in charge want them to say. If that means they need to be fiddled, so be it.

So it's interesting that – despite this widely-acknowledged unreliability – China has just come out and cut its growth target to the lowest since 1990.

Chinese premier Li Keqiang addressed the National People's Congress this week. Among other things, he noted that China's growth target this year will be 6-6.5%, down from a target of 6.5% last year.

Given that Chinese GDP figures can effectively be whatever the party wants, you have to understand this as a political message.

China is acknowledging that things are a bit tough. It's blaming that mainly on the US-China trade war (more on that in a moment). And Li promised an array of sweeteners in the Budget-style speech – from tax cuts for various business sectors, to boosting elements of the welfare state.

It doesn't help that this year is the 30th anniversary of the Tiananmen Square protests. A lot in China has changed since then. It has disrupted the global trading system in a big way. It has become the world's second-biggest economy, and arguably eclipsed Russia as the main rival to the US.

Yet China still faces a fundamental problem: its social contract has not changed. Here's the deal: the Communist party gets to stay in charge, be authoritarian, and (quietly) enjoy the spoils of power; the citizens behave themselves. Social media eradicates all mention of things like Tiananmen Square.

In exchange, citizens are allowed to enjoy a slowly improving standard of living and a certain level of economic freedom. That's the trade off.

Problem is, slowing economic growth or recession are not conducive to social harmony. If people don't have jobs, they cause trouble. If people feel that life tomorrow is not likely to be any better than it is today, then they cause trouble.

"Trouble" in a democracy results in politicians losing their seats. "Trouble" in a dictatorship results in politicians losing their heads. (This is mature democracy's fundamental – and in my view, much under-rated – benefit.)

This is why China is blaming the US trade war for the slowdown. It's also always better to blame these things on external forces, particularly hostile foreign governments. That way you can offset internal dissent with an appeal to nationalism.

The trade war is indeed a problem for China. But a bigger issue is probably the fact that China decided to try to clean up its debt-ridden financial system. And it now looks as though that mop-up attempt is at an end.

China has not announced any new 2008-style, big-spending stimulus package. But clearly the focus has switched to propping up the economy rather than cleaning out the piles of bad debt festering in every other corner.

"Beijing has found a new way to finance its spending, off the books and under the radar for outside observers," says Shuli Ren on Bloomberg, who notes that China is in fact boosting spending by a lot more than might seem obvious from the headline figures. It's new secret weapon debt vehicle is "special purpose bonds".

You may or may not remember "special purpose vehicles" (SPVs) from the 2008 financial crisis. SPVs were set up by banks as a way to issue more mortgage-backed debt.

The SPV did not appear on the bank's balance sheet. So it meant that the bank could continue to issue more and more mortgage debt without needing to hold more capital. The problem was that while, technically, the SPV was at arm's length from the bank, in reality, it was on the hook when the loans went bad.

So now Beijing is using something similar to sweep debt away from local government balance sheets. In this case, the justification is simple. This debt is attached to specific projects. Those projects are effectively self-funding – they generate enough cash to pay the debt and the interest. "Therefore the credit profile of these bonds is independent of a local government's fiscal situation."

It's the same old scam, in other words. You find an intellectual fig leaf to cover for the fact that your debt-glutted economy needs more debt just to keep ticking over, and then you make sure the credit keeps pumping out there.

Apparently, by the end of last year, $1.1trn-worth of these bonds had been issued, and this year, plans are to issue even more. Most of that money will be spent on infrastructure.

As a result of all this borrowing and spending, HSBC estimates that China is running a deficit (the amount the government overspends relative to the taxes it takes in) of 8% of GDP. That's hefty (for perspective, the European Union doesn't like deficits to go above 3%, and the UK's is currently below 2%).

The question, of course, is: what does all of this mean for your money?

It's perhaps small wonder that Chinese stocks have taken off this year. They were widely disliked and cheap, which makes them the natural epicentre of any burst of "risk-on" feeling. Also – and importantly – Chinese stocks have just been given a bigger weighting by powerful index provider MSCI, which means more passive funds have to buy them.

Will it continue? A trade deal would help. But what's probably more important is that global central banks follow through on their recent shift from tighter monetary policy. In particular, those looking for a lasting recovery in markets should be looking for a weaker Dollar.

In the meantime, if you're keen to play China's rally, I'd be more inclined to invest in general emerging markets. China is still too much of a black box for my liking when it comes to corporate governance and the reliability of balance sheet data.