What If China Stops Growing?

There is something that we need to remember about China: it's a powder keg. And as such, it is perfectly safe provided there is no spark. The communist government of China undoubtedly realise the nature of the society over which they govern. When China opened with the reforms of Deng Xiao Ping, the government firmly turned its back on the world that was built by Mao Zedong, removing the imperial system that gave communism the legitimacy of the mandate of heaven. Mao was an emperor in new clothes, but rejection of the new imperial system represented by Maoist 'communism' left a gaping hole in Chinese society. It was a hole filled with the pursuit of economic growth. Never mind ideology, just enjoy a growing economy, and all the benefits that it will bring.

Deep And Shallow Legitimacy
It is both a shallow and deep form of legitimacy. It is deep, because who would want to return to the poverty of the empire of Mao. It is shallow because it rests the stability and legitimacy of the ruling party only on growth in the economy. It gets worse; the Chinese government has raised expectations of endless growth to the point where it is a minimum expectation. This is combined with nationalism and resentment. Read a Chinese school history textbook in the original Chinese, and you can see how a metaphorical chip on the shoulder has developed. China is growing to become a major superpower, and with a desire to overturn the shame of recent history. What happens if China stops growing?

We may now be at that turning point. I emphasise may. There are worrying signs that are developing, and the prospect of a hard landing needs to be considered. A review of current news about China tells the story. Yukon Huang, writing in the FT 'gets it'. The dispute over the Senkaku/Diaoyu islands are tinged with economics, and the economics are tinged with politics. However, the politics versus the economics may become ascendent; if the economy nose-dives, the risk is that nationalism will be seen as a route to re-establish the legitimacy of the government. There is a lot at stake when considering the Chinese economy, including the stability of Asia Pacific, and the intertwined question of the stability of China itself. In short, the stakes are high if China should have a serious hard landing. Perhaps not as high as this discussion might suggest, but certainly high.

From this context, I will review the questions surrounding the Chinese economy. We could look at the lows being plumbed by the Chinese stock market, but this particular casino is not to be trusted as an indicator of the real state of the Chinese economy. If the stock markets of the West have ceased to reflect economic fundamentals, the Chinese stock market has never really been anything but a stereotype of the Chinese love for high stakes gambling. Official outlets, such as the China Daily trumpet positive news, but are not trustworthy, being driven by political considerations.

Get The News You Want

Read market moving news with a personalized feed of stocks you care about.

Get The App

However, even official sources are reporting some worries about the Chinese economy.

Since the latest data reignited concerns about excessive production capacity in some raw materials industries in China, experts have urged those industries to step up restructuring and add more value to their products.

Raw Materials
Data released this week by the National Development and Reform Commission -- the country's top economic planner -- showed that many raw materials industries have seen slowing growth and falling profits from a year earlier.

Total cement production in the first eight months grew by 5.9%, 12.5 percentage points slower than the same period last year, while the growth rate of crude steel output slowed 8.3 percentage points to 2.3% during the same period, according to the NDRC.

Profits of the country's building materials industry dropped 9.6% in the first seven months this year, with cement producers' profits plunging 53.1%.

Steel
The steel industry saw profits tumble 48.3% year-on-year, the NDRC said. Zhu Hongren, chief engineer of the Ministry of Industry and Information Technology, said Tuesday in an exclusive interview with Xinhua that many materials industries in China are currently confronting serious problems, including overcapacity, dropping sales and sliding profits.

The problem is simple. China has state-owned enterprises that have favoured status, and the Chinese government has been pouring capital at cheap rates into these industries. When the process started, the only direction could be positive; industry had been flattened by the destructive policies of Mao. As time moved forwards, the state juggernaut could hardly put a foot wrong, but in recent years - they have overtaken themselves; they are overinvesting in capacity for which there is no real market. A bust is on the way, albeit a bust that is backstopped by the government, and/or state banks that are likewise backstopped by the government. I have been discussing the malinvestment in real estate since 2008 (see post “Beijing hints at bond attack on Japan,” is a telling look at China’s economic policy, and it’s one that carries some important implications for the United States.

The gist of the story is that China has indirectly, with official deniability built in (a common Chinese tactic), threatened to attack the Japanese economy through the bond market by using quasi-official sources. It is an exemplar of the growing over-confidence of China, and an over-confidence that is self-defeating for their own economic position. Quite frankly, it is scary. China is throwing its weight around, and it is being noticed. They are overplaying what is a a powerful hand, but not as powerful as some in China might imagine. Whilst there are many politicians still courting China, there are going to be many who seek the opposite path. China's overplaying of its hand is going to strengthen the latter, and that could be very bad news for the Chinese economy.

And That's Just The Beginning
There is plenty more that could be said about the situation in China, and China's economy in relation to the world economy, such at their proclivity for industrial (state sponsored?) espionage. There is much more that could be said about the state of Chinese investment (or malinvestment). There is much more that could be said to emphasise the questions of the sustainability of the Chinese economic miracle. However, this is an overview, and I have limited the review to a very broad overview.

Invest At Your Own Risk
Although I have lived and conducted business in China, and read extensively on Chinese history, both recent and modern, and speak (and used to be able to read) Chinese, I do not profess to be all-knowing about the Chinese situation. Having lived in China, I view China with affection and fear. I would like to see a bright future for China, but the politics in China threatens the miracle of the last few decades. The politics cause the fear, and the endeavour and determination of the Chinese people to create a better life creates the affection and also an admiration. Regardless of my personal views, warning signals are starting to flash, and I would not, if it were my money, risk my money by investing in China. I am somewhat conservative, but not risk averse.

Chinese workers are restive. While a few reports do not make a trend, it is necessary to remember that Chinese workers have been raising their expectations, and that the expectations may be dashed in the even of a downturn.The growing wealth and expectations might not match up in the event of a serious downturn. We should also remember that nearly 50% of Chinese exports originate with foreign multinationals. China still needs those companies and they may be thinking of alternatives to China.

On balance, I think that China may be entering a period when there is a real risk that the powder keg may be lit. It is both a worrying and scary conclusion. As China goes through another opaque process of power transfer, I can only hope that the new regime recognises that the current paths of policy are taking China towards a world of high risk.

Written By: Mark Avis