China's challenge

China’s much anticipated transition away from an economy based on fixed asset investment is crucial to China’s future. At 44% of GDP, China’s investment in fixed assets is far too high.

How is China doing in the quest to transform its economy?

In a recent Credit Suisse report China’s 2016 surprise rebound in growth is highlighted. Credit Suisse makes it clear that there has been no progress in the rebalancing attempt. The current economic growth surge is a step backward as it comes from a government-backed push in fixed asset investment.

There are examples of comparable growth trajectories from recent history in Korea, Hong Kong, Singapore and Taiwan. These countries grew rapidly investing in fixed assets until the late 1980s and early 1990s before hitting a wall. The large share of income going into fixed assets meant that return on those assets faltered while debt soared, leading directly to the Asian Crisis on 1997-98. China could be heading down that same path.

In China, infrastructure investment has held up better than real estate or corporate investment – Credit Suisse believes it will have to weaken

Source: Thomson Reuters, Credit Suisse research

Obviously in the long run there is no chance that China can grow its per capita income to North American and European levels (about 7 times higher) without weaning itself off investing more and more into capital asset projects.

But much of China’s recent success in economic growth and maintaining full employment has been accomplished through a blistering pace of construction activity in housing and office towers as well as industrial projects such as steel plants. There are some very smart investors that believe a crash is inevitable in China’s property sector. As highlighted in a recent interview with Financial Time’s “Alphachatterbox”, Jim Chanos, legendary short seller, states that China is building office and residential space at an unsustainable pace with 5.6 billion square metres under construction, which is equivalent to a five by five foot cubicle for every man, woman and child in China.  Chanos believes that policy makers are afraid to stop spending so they “can’t let up on the gas pedal for fear of stalling” and “that sounds just like an absolute prescription for disaster.”

Of course the related debt bubble is an even bigger worry than all that excess space.  China’s private sector added debt at a record setting pace over the last seven years.  In spite of adding all that debt the economy’s rate of growth continues to slow.  There is less and less “bang for the borrowed buck”.

Left panel: the seven-year change in private sector debt to GDP in China has been comparable to previous changes in Thailand and Spain prior to their crises

Right panel: Total debt to GDP is now 36 percentage points above trend

Source: Thomson Reuters, Credit Suisse research

The less-well-known issue is education. China’s education system is based on a mandatory 9 year primary education. After that, at about age 15, the state doesn’t pay for more schooling so many students especially in rural areas stop before they enter the 10th grade. According to UNESCO, China spends less than 2% of GDP on education, although other websites cite a slightly higher number. In Canada governments spend 5.3% of GDP, much higher than China.

In China’s transition to a more knowledge-based “software” economy, education is crucial. In order to escape the “middle income” trap that many countries fall into, economies need a growing supply of highly trained technical workers and advanced education opportunities.

A slowdown in fixed asset investment in China would have implications throughout the world. Iron ore, coal, nickel and Vancouver real estate are just a few asset classes worth mentioning. There might be no single situation more important to forecasting the medium-term economic and market outlook for the world than China.

In the short run expect those Chinese policy makers to continue to ratchet up spending to even more unsustainable levels. They have no choice but to “keep the pedal to the metal.”  In the long run, expect market volatility and political unrest since the transition won’t be easy.


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Hilliard, The MacBeth Group team and their clients may trade in securities mentioned in this blog.


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