Gary Shilling Op-Ed on China Hard Landing [Parts 1-2-3 of 5]

Gary Shilling, author of The Age of Deleveraging, just published the first 3 pieces of a 5 part op-ed on Bloomberg about he believes China will experience a hard landing. I'll make another post for the part 4 and 5.

Unfortunately, the op-ed is disappointing as it sounds a bit amateurish and shows a lack of knowledge of both China and Singapore in several cultural and economic areas, but there are still some very valid points and it gives a good summary of the issues China is facing.

One of the most important sentence is: even Chinese manufacturers are moving production to Vietnam and Pakistan, where pay levels are a third of China’s.

June 27 (Bloomberg) -- Few countries are more important to the global economy than China. But its reputation as an unstoppable giant -- as a country with an unending supply of cheap labor and limitless capacity for growth -- masks some serious and worsening economic problems.

China’s labor force is aging. Its consumers save too much and spend too little. Its political and economic policy tools remain crude. Its state bureaucracy seems likely to curb spending just as exports weaken, and thus risks deflation. As U.S. consumers retrench, and as the global commodity bubble begins to dissipate, these fundamental weaknesses will combine in a way that’s unlikely to end well for China -- or for the rest of the world.

To start, China is much more vulnerable to an international slowdown than is generally understood. In late 2007, my firm’s research found that too few people in China had the discretionary spending capability to support its economy domestically. Our analysis showed that it took a per-capita gross domestic product of about $5,000 to have meaningful discretionary spending power in China.

About 110 million Chinese had that much or more, but they constituted only 8 percent of the population and accounted for just 35 percent of GDP in 2009, while exports accounted for 27 percent. Even China’s middle and upper classes had only 6 percent of Americans’ purchasing power.

With such limited domestic spending, why do so many analysts predict that China can continue its robust growth?

In part because they believe in the misguided concept of global decoupling -- the idea that even if the U.S. economy suffers a setback, the rest of the world, especially developing countries such as China and India, will continue to flourish.[...]

This concept is flawed for a simple reason: Almost all developing countries depend on exports for growth, a point underscored by their persistent trade surpluses and the huge size of Asian exports relative to GDP. Further, the majority of exports by Asian countries go directly or indirectly to the U.S. We saw the effects of this starting in 2008: As U.S. consumers retrenched and global recession reigned, China and most other developing Asian countries suffered keenly.

Overconfidence in China’s ability to keep its economy booming is also partly psychological. It reminds me of the admiration and envy (even fear) that many felt toward Japan during its bubble days in the 1980s. As Japanese companies bought California’s Pebble Beach, Iowa farmland and Rockefeller Center in New York, what was safe from their zillions? Then the Japanese stock and real-estate bubbles collapsed, and Japan entered the deflationary depression in which it’s still mired.

What’s more, China’s recent successes have been so pronounced that they’ve led many to conclude that its economy is a juggernaut. And, indeed, the Chinese have much to be proud of: Last year, China passed Japan to become the world’s second largest economy, a huge achievement considering China started in the late 1970s with a tiny pre-industrialized economy.
[...]
They were enjoying a well-oiled growth machine. Growing exports, especially to American consumers, stimulated the capital spending needed to produce yet more exports and jobs for the millions of Chinese streaming from farms to cities. Wages remained low, due to ample labor supplies, and held down consumer spending. So did the high Chinese consumer saving rate. Because Chinese could not invest offshore, much of that saving went into state banks at low interest rates. The money was then lent to the many inefficient government-owned enterprises at subsidized rates.
[...]

Part 2

China has become an economic giant because it has so many people who are producing moderate amounts. In most ways, however, China remains an underdeveloped country with political and economic policy tools that are crude by Western standards. Those tools can spur impressive growth --but they also mask some deep structural weaknesses in China’s economy.

It’s relatively easy for developing countries to grow by emulating the technology of advanced nations or, in China’s case, by forcing them to share it as the price of doing business or by simply stealing it.

And a tightly controlled economy can get results quickly. That’s what happened with China’s $586 billion stimulus program introduced in 2009. Growth in gross domestic product leaped from a 6 percent rate in early 2009 back to double digits. Most of the money was channeled through government-controlled banks, whose lending increased by $1.4 trillion, or 32 percent, over the course of 2009 after being flat since early 2006. The money supply increased by 29 percent.

Those loans financed public and industrial infrastructure and real estate. Property prices in January 2010 were up 9.5 percent from a year earlier, according to government numbers, and much more by private realistic estimates. Employment gained along with economic activity, and in the third quarter of 2009, there were 94 job openings for every 100 applicants, up from 85 in depressed 2008, and close to the pre-crisis average of 97.

Here’s what we should remember: This kind of growth is unsustainable, and it won’t be able to cover up China’s underlying vulnerabilities forever.

China’s reliance on exports and a controlled currency for growth, for instance, will no longer work if U.S. consumers are engaged in a chronic saving spree, as I believe they will be. Chinese export growth, which averaged 21 percent per year in the last decade, is bound to suffer.

The country’s seemingly inexhaustible pool of cheap labor is expected to peak in 2014, in part due to its rigid one-child policy. By some estimates, ample labor has boosted GDP growth by 1.8 percentage points annually since the late 1970s, but the contraction of the working-age population will reduce growth by 0.7 percentage points by 2030.

Wages are already rising, and even Chinese manufacturers are moving production to Vietnam and Pakistan, where pay levels are a third of China’s. Some factory workers have seen wage increases of 20 percent to 30 percent in the last year or so, with those producing goods for foreign companies seeing especially large boosts. At the same time, better conditions in rural areas have reduced the flow of cheap labor into coastal cities.
[...]
So the Chinese must save prodigiously to provide for their welfare and retirement. This has contributed mightily to China’s high rate of saving and low rate of spending, and its consequent reliance on exports. Chinese households save close to 30 percent of income on average, in large part to cover old age and medical costs.
[...]
Finally, China’s state-controlled economic boom may soon lead to crippling inflation. In February 2010, the director of the National Bureau of Statistics said that “asset-price increases pose a challenge for macroeconomic policy.”

The housing boom has pushed up prices to the point that apartments in Beijing are affordable to only the top 20 percent of earners -- they’re selling at about 22 times average income (average U.S. house prices peaked at six times average income). A square meter of property in China costs an estimated 164 times per-capita income, compared with 33 times in high-priced Japan.

The 2009 stimulus package also spurred consumer price inflation to a year-over-year acceleration of 5.5 percent in May. Food prices are very sensitive politically because so many Chinese are at subsistence incomes, and they rose 11.7 percent in May from a year earlier.

Chinese leaders are not amused, and are taking stringent restraining actions.[...]

Part 3

June 29 (Bloomberg) -- China is hoping to cool its white- hot economy without precipitating a recession. Doing so will be extremely difficult: Inflation fears are growing, the government’s ability to respond is quite limited, and China’s economic model, which leaves bureaucrats guessing about the market effects of their directives, is ultimately untenable.
[...]
With these restraints in place, and with supply starting to catch up with demand, housing sales have slowed. But this has not fully curtailed China’s real-estate bubble: Housing starts rose about 40 percent last year. Developers are rushing to build while they try to support faltering prices by delaying completions and creating artificial shortages. Of course, these efforts are difficult to maintain because they tie up capital in uncompleted houses. Houses are now being built at about twice the rate they’re being sold, well above earlier norms.

A report this week by China’s National Audit Office found that a significant chunk of bank loans made to provincial- government financing vehicles were improperly funneled into property investments, contributing to a debt load equal to some 27 percent of GDP. Other huge loans to state-owned enterprises, intended to finance infrastructure, also reportedly went into real estate and may be at risk.
[...]
The government appears increasingly worried about social unrest. In November, it said it was ready to impose price controls to reduce inflation, especially on food and energy, and said it would help the poor with higher welfare payments. The unrest continues and, significantly, has moved from rural areas to the cities.
[...]
Finally, implementing any policy in an economy that is partly government-controlled, partly market-driven is very difficult. In a completely controlled economy, as China’s used to be, government leaders might have made economically inefficient decisions, but their authority wasn’t disputed. In an open economy, as in Singapore, the markets make the decisions, and politicians have little involvement.

But under China’s current arrangement, officials making major decisions have to guess what market reactions will result, then try to mitigate the unintended consequences of their actions.

With a managed floating exchange rate, for example, officials have to estimate how much hot money will enter China in anticipation of a stronger currency, and then determine how to neutralize the undesired effects of this flow. Government policies that encourage exports and trade surpluses have pushed China’s foreign-currency reserves to more than $3 trillion. Until recently, all the foreign-currency earnings of Chinese exporters had to be traded in for yuan, but then the central bank was forced to issue securities to sop up that money to avoid depreciation.

Similarly, the Chinese government sets yearly limits on bank loans in advance, but leaves it up to the banks and demand to determine the monthly lending pattern. So the banks rush to make loans early in the year for fear that the government will reduce the limit in a midcourse correction.