China: what happens when the party is over?

This is a finance related blog, but of course economics and politics have an indirect impact on returns for investors.  China is a pretty big story this year, as ever.  There are big reasons, however, to believe that the party is coming to an end in China, in more ways than one.

It is not my place to make specific predictions about when the Chinese Communist Party (CCP) will collapse in China, and indeed Gordan Chang, amongst others, has made gloomy predictions in the past, which have been proven wrong.

The fact does remain that the CCP has not changed human nature,and the global economic crisis in 2007-2008, far from ushering in a new Chinese era, will probably set in motion a set of circumstances that leads to its collapse.

When China started opening up from 1978 there was an unofficial contract between the party and the people.  Higher living standards would maintain social order.  Few even within the ranks of the CCP believe that China could maintain social order in the face of a domestic recession.

This shows how weak the party is, and illustrates the misconception many people have about what the word stability means.  If the stock markets decreases 10% in a day and rises by 15% the next day, that means the market is experiencing volatility, not instability.  When the USSR collapse in 1989 few saw it coming, precisely because they could not distinguish between the two words.

In any case, after the financial crisis, China faced a problem.  They could not depend on Western countries to export to forever, and with a small middle class that likes to save money, they also could not depend on Keynesian demand-side stimulus policies that depend on consumer spending. Only government led infrastructure spending could do the job,  and in a non-democratic system, this was a quick and easy way to stimulate growth.  The rest of the world, including the US led by Hank Poulsen, supported the CCPs plans, and even pressurised them to do it during the depths of the crisis.

And the plan worked, with impressive 2010 GDP growth.  Roosevelt used similar schemes in the Great Depression with good effects, but this Chinese stimulus, which was the biggest out of any country as a proportion of GDP, was had many nasty side effects.

The first thing to understand is that this money is borrowed money.  The increase in leveraged in the financial system was huge, and real estate and general inflation spiked.  In the first year after the crisis, Chinese banks lent more than one and a half trillion dollars.  Bare in mind, that this is what the official figures suggest, and that many estimates are much higher.

It is true that the CCP has tried to tone down this lending binge, but local governments, through shadow banking institutions, found new ways to lend.  So off balance sheet debts have continued to climb.  This has made it harder for the central government to control the situation and put the genie back into the bottle, and many of the debts are now hidden.  Nobody really knows how much debt exists in China.

The combination of cheap credit, a bigger middle and upper class and urbanisation has created a massive bubble in the process, and therefore risked social stability in a country where having a home of your own is seen as a prerequisite for marriage in most cases. This increased inequality, in turn, has led to further problems for the CCP.

The politics matters here.  The CCP, believing that they saved China from 100 years of humiliation at the hands of foreigners such as the Japanese and British, believe they need to show the world that their model works.  So the profitability of these projects matters less to them than in other parts of the world. Ghost cities are already here and 15% of Chinese homes are empty this evening.

Some people may ask one question.  In a totalitarian society like China, why can’t the central government just turn the tap they started off?  The problem isn’t only the aforementioned shadow banking problem, but also the special interests within the party and the society that want to keep the party going.

Despite the so-called anti-corruption campaign which is more like a political purge, local officials are still getting big bank-handers from developers and other financial and real-estate firms.

The credit boom has led to the Chinese banking sector going from 10 trillion dollars to 25-30 , which means that China, in the space of a decade, has added more value to its banking sector, which took more than 100 years to build. This kind of tsunami of debt cannot end well, and never has historically. There is no sign that deep cultural norms surrounding saving money are changing. So the unbalanced growth continues.

Optimists on China think they can grow out of the problem with a healthy middle class spending more. But credit is already twice the economy, and growing more than twice as fast as consumption. As more Chinese people lock in profits from selling their houses, the valuations will continue to go down, which means that the so called substitute pensions of housing will lose value, and hence further increasing social unrest. One only has to look at how many new schemes the CCP are announcing, to observe how desperate they are for housing to start to turn the corner.

Approximately 50% of wealthy Chinese people want to emigrate in the next 5 years, and many who don’t want to at least own a foreign passport. Government backed schemes in Australia, Canada and the UK are trying to attract wealthy Chinese with citizenship schemes. The fact that so many highly placed individuals who have links to government want to move, tells you something.

The bottom line is that too many people were on one side of the boat when it came to China and other developing countries. The next question is, what should individual investors do? In the short term they might want exposure to the Shanghai market, which has already gone up dramatically, as investors sell their overvalued homes and put it into equities. In the long-term they should avoid China until the crash, and China related products, such as commodities that depended on Chinese growth. Nobody wants to be the last person to leave the party, after all.

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