A lot of smart investors worry that China is a gigantic bubble in search of a pin. It is not hard to see why when one looks at the unparalleled economic expansion that has taken place over the past several decades. The combination of a populous nation and high sustained productivity growth rates has pushed China’s economy back up the world rankings such that only the US is higher in terms of overall economic weight.
For China to have such a high ranking in the world is not unusual, it held this position for many centuries – see chart below. What is unusual is the unprecedented speed of its ascent – no nation ever has witnessed an economic expansion of this magnitude in such a relatively short period of time. Over the past 500 years, the only comparable episode is the rise of the US during the 19th century. Its world GDP weight rose from around 3 percentage points to just under 20 percentage points, a transformation fostered by a massive population expansion – it rose from roughly 5 million in 1800 to more than 76 million!
Exhibit 1: World GDP Shares (Percentage of Total)
It is not just the unparalleled nature of China’s economic expansion that is causing bubble concerns. The economic “miracle” has been fuelled by a surge in debt. According to the latest BIS annual report, economy-wide indebtedness (public plus private) in China has risen to almost $28trn to more than 260% of nominal GDP, a near doubling in the 10 years since the start of the Great Recession. Of this total corporate debt accounts for between 120-160 percentage points (the lower figure excludes borrowing from financing vehicles owned by local governments). Relative to the norms of advanced economies this is elevated, but when compared with economies with comparable GDP per capita ratios it is extremely high.
History is replete with examples of major credit booms followed by busts – see exhibit below. Gentle deflations appear to be rarer than hen’s teeth although Japan came closest at the cost of a lost decade or two. In large part, this is because the positive feedback loop between rising debt and stronger aggregate demand in a leveraging cycle quickly turns from virtuous to vicious. Hence, such concerns are understandable.
Exhibit 2: Total private Nonfinancial Credit (Percentage of nominal GDP)
Moreover, it is not just investors who are worried about these debt dynamics and the implications for China’s macroeconomic future. Global policymakers are also sounding increasingly alarmed with the BIS, the IMF and most recently the RBA (given the importance China’s economic renaissance has had on the Australian economy they are understandably sensitive to such risks) have all warned about the potential for major economic disruption.
China’s leading policymakers, too, appear to understand and acknowledge this fact. Speaking on the sidelines of the recently concluded 19th Party Congress, PBoC Governor Zhou went as far as to reference a possible “Minksy Moment” for the Chinese economy – unusual candour from a leading Chinese policymaker – no doubt the fact he is expected to retire in the coming months has emboldened him to make such comments publicly. (As can be seen in the exhibit below the crowd is not displaying much worry about either financial instability or debt default in China – suggesting a modicum of blindness towards Zhou’s concerns.)
Exhibit 3: Crowd-Sourced Topic Sentiment – China
As the old adage goes, the first step in solving a problem is identifying there is one, but this does not make the transition to a more sustainable growth model (the “soft-landing” scenario), one which must be increasingly reliant on domestic consumption, an easy outcome to achieve.
The alternative “hard-landing” is a scenario most worry about, but this is hardly new. A simple google search lasting all of 0.37 seconds of the phrase “China hard-landing” returns 1.6 million results, while a google search for “China bubble” brings up over 90 million articles (in 0.73 seconds by the way!). Both results contain links to articles stretching back for years.
Yet, despite the glaring imbalances in the Chinese economy, reflecting external and intertemporal disequilibria, the widely anticipated bubble burst has not occurred (beyond, of course, the correction seen in listed Chinese equities in 2015 – see below).
The main reason why the Chinese bears have been so wrong in their timing (if not the direction) is failure to appreciate that just because an economic situation appears unsustainable doesn’t mean that a correction is imminent. Just as asset price bubbles can become more bubbly, so too can economies. This is especially so for China’s economy which, unlike the democratic market-based economies most analysts are familiar with, is rigidly controlled from the centre.
There is no clearer example of this different policymaking approach than comparing the responses to the Great Recession. While US policymakers were pleading with House to pass the TARP legislation (it failed in its first attempt causing US stock markets to plummet), China’s policymakers implemented dramatic Keynesian economic stimulus swiftly and effectively. In China if infrastructure investment needs to rise to plug a possible aggregate demand slump, it gets done, if more monetary stimulus is required, it gets done (something President Trump must surely envy).
Like most economists, one agrees that a market-based system, as opposed to a centrally-planned system, is the first-best method to achieve economically optimal long-run outcomes. Hence, one is favourably disposed to the bearish perspective. Nevertheless, over a shorter-term horizon, centralised power does help to inoculate the economy from imminent downside risks, and this is something that cannot be ignored.
Following the conclusion of the recently held 19th Party Congress, the prevailing consensus is that President Xi Jinping has consolidated his position as leader. The new seven-member Politburo Standing Committee contained no obvious successor to Xi, which was taken as a sign that he intends to remain in power beyond 2022 (an unofficial deadline). Although Xi, in his three-and-a-half hour speech (one of longest ever) included statements that his government would seek to minimise systemic financial risks, there is little indication of further market-liberalising reforms. Instead, Xi announced plans for “promoting [the] strengthening, improvement and expansion of state capital”, comments that suggest the visible hand of government is not about to be scaled down.
It is this tug-of-war between economic gravity and interventionist governance that makes analysing (and predicting) the situation in China much more complex. The siren song of the bearish scenario has seen investors becoming overly pessimistic in their macroeconomic expectations, negativity that gets subsequently unwound. One can illustrate this very clearly when considering the evolution of crowd-sentient in China over the past few years.
As the exhibit below shows, in the wake of the aforementioned bursting of the Chinese equity bubble, the crowd become extremely pessimistic about Chinese growth, with sentiment hitting negative values not seen since the depths of the Great Recession. However, the substantial monetary and fiscal stimulus injected by the Chinese government gave the economy a much-needed shot-in-the-arm, forcing the crowd to reverse its view, the emotional fuel for the rebound. With Q3 GDP having once more come in above the government’s official 6.5% goal what one now sees, in contrast to the situation in early 2015, is crowd positivity towards Chinese economic growth has risen markedly (on social media it stands at post-Great Recession highs).
Exhibit 4: Crowd-Sourced Economic Growth Sentiment By Media Type – China
Looking at sentiment towards China more broadly, the crowd’s positivity is even clearer. Country-level sentiment is has surged. However, when one looks at the other primary sentiment indicators – optimism, stress and subjectivity – what is also apparent is that the recent rise in confidence has been matched by rising subjectivity. This indicates that the positivity is more reflective of emotions than facts. Combined with China’s Stress sentiment indicator having ticked up, the current constellation of sentiments suggests that the pendulum of public perceptions may have swung a little too far into the positive camp.
Exhibit 5: Crowd-Sourced Country Sentiment Indicators – China
In addition, when one looks at crowd sentiment towards Chinese equities one sees that while it has closely tracked the crowd’s perceptions of economic growth just lately a modest loss of positive momentum has occurred. As regular readers will appreciate when sentiment changes direction following an extreme this is something one pays a great deal of attention to for the reasons one outlined in previous articles.
Exhibit 6: Crowd-Sourced Country & Equity Sentiment – China
This surge in emotion-driven positivity suggests a certain ripeness for crowd fail to us and that the Chinese bears who have been in hibernation in recent quarters may be poised for a near-term comeback.
Given the well-known imbalances in the Chinese economy and the slew of warnings about high and rising debt levels, many investors will be tempted to anticipate this as being the start of the “Big One”. However, with President Xi having consolidated his position as leader, and given his commitment to deliver “socialism with Chinese characteristics”, one would be surprised in the extreme if any economic/financial downdraft is not met with offsetting government intervention.
In short, President Xi is not about to do a King Canute and demonstrate his policymaking fallibility should the economic tide reverse – quite the opposite. This is something the bears should continue to bear in mind no matter how dire the debt statistics appear.
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