Engaging with China as a Global Economic Superpower

Last Wednesday, the World Bank declared China would overtake the U.S. as the world’s biggest economy on a PPP basis by the end of this year. The practice of utilizing PPP in comparing economic output across countries has become less useful as global trade and cross-border asset flows continues to grow as a percentage of the global economy. Yes, your US$ still gets you further in China than in the U.S. on average; and the median Chinese urban household still earns less than 20% of the median U.S. (both urban & non-urban) household. But this ignores the fact China is the world’s biggest importer of commodities such as copper, iron ore and precious metals–all of which are settled at world market prices which PPP has no bearing upon. Chinese economic output measured at PPP also ignores the fact that real estate prices in Tier-1 cities such as Beijing and Shanghai are now on par with those in New York and Los Angeles. Seen in this light, a Yuan actually goes further in a major U.S. city such as Houston or Dallas than in Shanghai or Beijing. Since Americans are generally much more mobile than the Chinese (which in theory allows a U.S. family to resettle to lower cost-of-living areas), a comparison between U.S. and Chinese economic output using PPP is highly misleading.

That is not to say it isn’t a worthwhile exercise. At the very least, the World Bank study has again put the Chinese economy, leadership, and corporations in the spotlight as the “Central Kingdom” re-asserts herself, first in the global economy, and second, in global geopolitics. Work done by the late British economist Angus Maddison suggests China’s share of global GDP was over 30% as recent as 1820. At their respective peaks, total economic output of China and India together made up approximately half of global GDP during most of the last two thousand years, with the exception of the last 200 years.


As students of Asian history, the above chart comports with our understanding of the history of the Chinese dynastic system, and its subsequent decline (note that pre-1368 A.D. data–i.e. pre-Ming Dynasty–is almost non-existent, e.g. the invasion of the Mongols and its impact on China during the early 1200s does not register in the above chart). The relative decline of China’s influence as the Ming Dynasty retreated from global trade–along with a costly war with Hideyoshi-led Japan–could be seen in the above chart. The decline in Chinese relative influence accelerated in the early 1600s as the Ming Dynasty weakened, with the dynasty eventually falling due to corruption, inept management, bad harvests, and the Manchu invasion during the early to mid-1600s.

Under the Manchu-led Qing Dynasty, however, the Middle Kingdom regained her former glory. The Qianlong Emperor (who ruled for 60 years and interestingly, would die in 1799–the same year that President George Washington died) ruled an empire unprecedented in size–encompassing both Mongolia and Tibet. By 1790, the population of the Qing Empire soared to over 300 million, or just under the U.S. population today. Chinese relative economic output would peak soon afterwards at nearly 35% of global GDP.

According to Professor Maddison and Professor Dwight Perkins of the Harvard Kennedy School, what was most impressive about China during most of her history was not its sheer population growth; nor the size of her empire. What was most impressive about the Chinese economy was her successful response to population growth–i.e. her ability to sustain per capita consumption over time even as population grew. The Chinese drove productivity growth in agriculture through increased use of fertilizers, irrigation, development of crop varieties, as well as published and distributed agricultural handbooks to spread “best practices” in farming. New crops from the Americas–which could be grown on inferior lands–were also introduced.

In other words, China has a rich history of innovation, adaptation, and engaging herself with the rest of the world. By the early 19th century, however, China’s 2,000 year-old dynastic system was no longer a suitable governing system for a fast-changing, industrializing world. As innovation and change swept the world, the Chinese ruling class hung on to outdated concepts and actively discouraged reforms–including the emphasis of science/math over the “classics” in the Imperial Examination. The rigidity of China’s ruling class and system during the 19th century made her vulnerable to foreign influence and invasion. The subsequent experimentation with Communist ideology in the early 20th century would prove disastrous. All in all, it took over 150 years for China to recover and to be recognized as a global economic power once again.

The latest World Bank study is thus timely, as both China and the rest of the world need to begin addressing the consequences of China rising to become the world’s #1 economy. Consensus suggests China will surpass the U.S. in nominal GDP by 2019 (as recent as 2003, Goldman Sachs believed China won’t surpass the U.S. until 2041). e.g. Chinese battery maker BYD experienced significant growing pains due to the company’s inexperience when it opened its North American HQ in Los Angeles. As Chinese influence continues to grow around the world, there will be inevitable clashes over business practices, cultural  misunderstandings, and increased competition (including those for real estate and college applications). As an investment bank who actively engage in U.S.-Chinese cross-border transactions, CB Capital has had first-hand experience in working with Chinese companies and cultures. We are also engaging with other U.S.-Chinese cross-border groups to cultivate closer relationships between local U.S. and Chinese/Hong Kong companies.

Sure, China is experiencing growth challenges, but this is to be expected. In particular, we are watching three issues very closely. As we have discussed, the Chinese “demographic dividend” is over. We expect Chinese real GDP growth to be in the range of 5%-8% over the next several years. China’s population growth has sunk to just 0.47%, ranking 159th in the world. By 2020, the Chinese demographic pyramid will be more inverted than that of the U.S. Another challenge is China’s unprecedented credit growth over the last five years, which was fueled by the country’s well-intended but poorly-executed US$586 billion fiscal stimulus package in 2008-09. A final challenge–which comes with the territory of being potentially the world’s #1 economy–is China’s dependence on foreign energy imports. China as we speak is making slow but steady progress on shale gas, but the country’s oil consumption growth remains unabated. In fact, the Energy Information Administration (EIA) expects Chinese oil imports to surpass those of the U.S. sometime this year. Energy security will thus become an increasing concern for China over the next several years.

Chart 2: China to Become World’s #1 Crude Oil Importer in 2014


An Imminent Correction in Risk Assets

In our 2014 U.S. stock market outlook (published on December 22, 2013), we asserted that U.S. stocks will only return in the single-digits in 2014, due to: 1) a tightening Fed, 2) the reluctance of the ECB to adopt quantitative easing policies, 3) higher-than-average valuations, as well as 4) increasingly high levels of investor speculation (e.g. record high levels in margin debt outstanding). We stand by our 2014 S&P 500 year-end target level of 1,900 to 2,000.

Conversations with our clients suggest one overarching investment concern/theme. Investors are concerned with the unprecedented global monetary experiments, while most of Asia is concerned about runaway Chinese credit growth and the country’s shadow banking system. The shift from a unipolar investment environment (one dominated by U.S. policy and institutions) into a multipolar one–beginning with the fall of the Berlin Wall in 1989 and accelerating with China’s entry into the WTO in 2001–means an understanding of global macro is essential to understanding the main drivers of future asset prices (hint: it is not classical indicators such as P/B, P/E ratios, etc.). Going forward, monitoring the actions of the People’s Bank of China and Chinese credit growth will be just as important as monitoring the actions of the Federal Reserve.

We believe 2014 represents a transition year as the Federal Reserve definitively halts its QE policies/asset purchases and as Chinese policymakers adopt financial reforms (e.g. allowing companies to go bankrupt to prevent future moral hazard problems) in an attempt to alleviate investors’ long-term concerns. In many ways, these recent moves–including Fed Chair Janet Yellen’s surprisingly hawkish comments at the March 18-19 FOMC meeting–are reminiscent to the events of 1994, when the Greenspan-led Fed unexpectedly began hiking the Fed Funds rate in February 1994. The Fed Funds rate rose from 3.0% to 5.5% by the end of the year, while the two-year Treasury yield surged from 4.0% to more than 7.5%. The S&P 500 experienced significant volatility and finished down the year by 1.5%.

We do not believe the Fed will hike the Fed Funds rate anytime soon; however, we anticipate the Fed to halt its QE/asset purchase policies by the end of this year; and to begin hiking rates in the 1st half of 2015. That is, global liquidity will get tighter as the year progresses–further compounded by overbearing U.S. financial regulations, a hike in the Japanese sales tax this week from 5% to 8%, and the ECB’s reluctance to adopt a similar QE policy. The action in the S&P 500 in the 1st quarter of this year has so far proved out our thesis. The S&P 500 ended 2013 at 1,848.36 and as of last Friday, sits at just 1,857.62 for a meager 0.5% gain. We reiterate our year-end target of 1,900 to 2,000. In the meantime, we believe the S&P 500 is heading into a significant correction, i.e. 10-15% correction over the next 3-6 months–for the following 3 reasons.

1) Hot Money Action is Getting More Risk-Averse

Since the global financial crisis ended in early 2009, EM fund flows from DM countries have been highly positive. Fund flows to EM countries turned negative during the summer of 2013. Many EM countries never implemented much-needed reforms during the last boom (Russia leadership just proved it is still stuck in the 19th century), nor made much-needed infrastructure and educational investments (with the major exception of China). Investors have forgotten that EM growth (actual and potential) rates no longer justify such investment fund flows–and have continued to dial back risk-taking in general. Most recently–the stock prices of two of the hottest industries, i.e. Big Data and Biotech–have taken a significant hit in recent trading. We believe momentum investors are now leaving the stock market; and that there is a good chance this will turn into a market rout (i.e. S&P decline of 10-15%) over the next 3-6 months.

2) The Federal Reserve’s Monetary Policy Tightening

Once the Federal Reserve wrapped up its “QE2” policy of purchasing $600 billion in Treasuries at the end of June 2011, the S&P 500 subsequently corrected by 14% over the next three months. The S&P 500 had already declined by 3% during May/June 2011, as the Fed did not provide a clear indication of further easing (i.e. QE3) until later in 2012. Prior to the end of QE2, the Fed purchased an average of $17.5 billion of Treasuries on a weekly basis. At the peak of QE3 (i.e. before the recent tapering), the Fed was purchasing an average of $20.0 billion of Treasuries and agency-backed mortgage securities on a weekly basis. The current tapering process is already having an effect on global liquidity, as foreign reserves held by global central banks have been declining over the last couple of months. Based on the current tapering schedule, the Fed will halt its QE policies at the October 28-29, 2014 FOMC meeting. The Fed’s balance sheet of $4 trillion of securities will take a decade to unwind (if ever). Unless the ECB chooses to adopt similar QE policies, we believe global central bank tightening (EM central banks are projected to tighten further over the next six months) will act as a significant headwind to equities and other risk assets for the rest of 2014.

Feds Balance Sheet

 3) A Record High in U.S. Margin Debt Outstanding

Our studies and real-time experience indicate significant correlation between U.S. margin debt outstanding and other leverage indicators, as well as major peaks and troughs in the U.S. stock market. We first discussed this indicator in our January 29, 2014 commentary (“Record Rise in Margin Debt Outstanding = Single-Digit U.S. Stock Returns in 2014“). We asserted that the record rise in margin debt outstanding (a 12-month rise not seen since July 2007–during the last major peak in stock prices) is indicative of significant speculation in U.S. equities. Since our January 29 commentary, U.S. margin debt outstanding has risen another $23.6 billion to a record high $502 billion. Meanwhile, the 6-month rise in margin debt outstanding hit $88 billion–again, a high not seen since July 2007 (when it hit $105 billion). More important, it is clear to us–based on the action in Big Data and biotech stocks over the last couple of weeks–that the willingness to speculate is declining. All of these indicators suggest to us that the S&P 500 will experience a major 10-15% correction over the next 3-6 months. We also assert that Emerging Market stocks will experience a significant decline, along with gold prices. We expect gold prices to bottom at the $1,000 to $1,200 an ounce level over the next 3-6 months. We will look for a buying opportunity in both gold and North American gold-mining stocks sometime in the next two quarters.

China’s Credit Concerns To Constrain Structural Growth

In our June 13, 2013 Global Macro Newsletter (please email us for a copy) and July 31, 2013 commentary (“Our Revised 12-Month Outlook for Major Asset Classes“), we asserted that China will experience a lower structural real growth rate of 5% to 8% over the next five years. The era of consistently double-digit growth rates is over. This is not surprising, for many obvious reasons:

  • Recent growth in China has been highly dependent on an unprecedented burst of credit growth beginning in 2007. Simply put: The “efficiency ratio” of each RMB of credit growth–i.e. the amount of credit to drive a unit of GDP growth–is near a record low. According to official records, an increasing amount of credit is being spent on existing assets as opposed to new capital formation, while less credit-intensive areas of growth, such as exports, have slowed. At the same time, Chinese policymakers are curtailing both formal and shadow banking financing, which does not bode well for credit–nor GDP growth–for at least the next couple of years;
  • Chinese population growth has sunk to a new low of 0.47%, ranking 156th in the world. More important, China’s “demographic dividend” ended a couple of years ago. The Chinese labor force is now growing at a slower rate than that of her retirees. By 2020, China’s dependency ratio (the retiree-to-labor-force ratio) will rise above that of the United States. Overall productivity growth will shrink, and the risk of the Chinese populace “getting old before getting rich” is very real;
  • China’s GDP last year was US$8.2 trillion–just over 50% the size of the U.S. economy. The World Bank projects China to hit her growth target of 7.5% this year, i.e. economic activity in China will hit a whopping $8.8 trillion at the end of this year. The sheer size of the Chinese economy–accompanied by economic maturity along the coast–means China is starting to hit a wall (excuse the pun) in terms of export and capex growth. In fact, Chinese policymakers are now much more concerned about reducing environmental pollution and income inequality than meeting their GDP growth targets;
  • The Energy Information Administration (EIA) projects China to surpass the U.S. as the world’s biggest crude oil importer by October of this year. Chinese oil imports–currently at 6 million barrels/day–is expected to hit 7 million barrels/day by summer 2014. Meanwhile, U.S. oil imports–at 7 million barrels a day–is expected to decline to just 5 million barrels/day by the end of 2014, due to increased domestic oil production, as well as declining gasoline demand. China’s increasing dependency on foreign oil will adversely affect its trade balance (thus lowering GDP growth–an increase of 1 million barrels/day in imports, at $100 a barrel, will reduce China’s GDP by 0.5%), as well as increase the country’s vulnerability to spikes in oil prices.

China oil imports

In a nutshell, we believe China’s economic growth will slow down dramatically over the next several years relative to recent growth. These issues are structural and logical in nature–they are not speculation on our part. Perhaps of more concern is the potential for a systemic crisis in China in 2014/15, which we mentioned in our March 2013 global macro newsletter. Let’s review some charts, starting with a comparison of Total debt-to-GDP ratio across different countries (courtesy Goldman Sachs):

China leverageChina’s total debt load as a percentage of GDP (which includes shadow bank financing, but could be understated due to the relative unreliability of official records) is now the seventh largest in the world, and is the highest among Emerging Market countries. The vast majority of the debt load is borne by her corporate sector. Cyclical industries, such as steel, aluminum, and shipbuilding are especially vulnerable, as these industries are also dealing with overcapacity and slow-down concerns (one would be crazy to purchase securities in these industries right now).

Of course, on a stand-alone basis, the above chart doesn’t say much. Firstly, China–just like most countries in the top 6–can print her own currency. Secondly, and perhaps more important, most of Chinese debt (just like that of Japan) is owned by her citizens. We know this since the Chinese capital account is technically closed. Unlike India, China isn’t at much risk of foreign capital flight. Finally, the country’s US$3.4 trillion in foreign reserves does provide a cushion (or least the perception of a cushion) in the event of a run or capital flight.

History has shown, however, that a more accurate leading indicator for a systemic meltdown is the amount of credit growth leading up to the crisis. For example, Thailand’s total debt-to-GDP ratio increased by 66 percentage points, while Malaysia’s grew by 40 percentage points in the five years leading up to the Asian Crisis. Similarly, the U.S. total debt-to-GDP ratio increased by 46 percentage points during 2002-07. As shown below, China’s credit growth over the last five years (at 56 percentage points) is in that range (interestingly, Brazil’s credit accumulation in the same time frame is also a concern–which is one reason why we are not bullish on the country).

China credit growthCharlene Chu, who oversees credit ratings for Chinese banks at Fitch, observed that over the last five years, Chinese bank assets increased by about $14 trillion, which is equivalent to the size of the entire U.S. commercial banking sector! China’s US$586 billion 2008-09 fiscal stimulus, while well-intended, also added significantly to indebtedness without the commensurate benefits. Logically, studying the rate of credit growth–as opposed to the stock of credit–makes more sense. For example, underwriting standards tend to be more lax in a period of high credit growth, and transparency usually takes a backseat. Also, due to its sheer size and the rapidity of its deployment, much of the 2008-09 fiscal stimulus was misallocated, and the growth of its shadow banking sector has (rightly) become a concern.

Chinese policy makers are beginning to take a pro-active stance in reducing credit growth. But they are stuck in a no-win situation. If they succeed, Chinese economic growth will immediately slow down next year, and is likely to remain relatively low (5% to 8%) for the next several years. By 2020, China’s economic growth should slow down permanently–likely to the 3% to 6% level. Should Chinese policy makers fail to rein in credit growth, the possibility of an economic meltdown becomes more real with each passing year. An ongoing debate within CB Capital suggests it is only a matter of time (especially so in Japan)–likely by late 2014 or early 2015. A Chinese credit event could be triggered by a number of events, such as: 1) global monetary tightening, 2) another global recession, which will immediately hit Chinese exports, or 3) a Chinese property price collapse. Chinese policy makers are now engaged in an unprecedented balancing act.