VINACHEM

China has been primarily responsiblefor driving global growth since the Crisis began in 2008. Auto sales, for example, would have seen negativegrowth world-wide without China. And auto manufacturing is the world’slargest manufacturing industry. The chemical industry has been in asimilar position. Whilst China is also now responsible for nearly 50% of global metal demand.

China’s growth has thus given atremendous boost to the emerging economies, whose raw materials have fed itsseemingly unlimited appetite for infrastructure investment. In turn, thishas boosted corporate earnings everywhere. Currently, for example, around 50% of earnings for the S&P 500 companies comefrom operations outside the US.

Yet most of us have a very hazy ideaabout China’s economy and its population. This week therefore, followingthe enormous interest created by its recent Research Note, the blog would like to presentsome key facts about its economy, and remove some myths about the wealthof its urban and rural populations.

It begins today by looking at theeconomy. Contrary to popular opinion, this is now widely seen withinChina’s leadership as having suffered a “lost decade” between 2002 – 2012 (yellowshading):

• The key is the green line, showing how it has become dangerously dependent on infrastructure investment
• Infrastructure spend is now nearly half of GDP – an unbelievable amount for an emerging economy
• The red line shows the impact on urban household spending, which should be the motor of the economy
• It has instead actually fallen to just 28% over the decade
• The purple line shows rural household spending, which should also be seeing reasonable growth
• It has fallen to just 8% of GDP, although nearly half China’s population still live in rural areas

This is why we are now starting tosee radically new economic policies from President Xi and Premier Li. They really have little choice. As state-owned China Daily wrote lastweek:

“People always say China’s economicgrowth model is export- and investment-driven. But if you look at the data forthe past two or three years, it is becoming solely investment-driven. Exports in 2012 made a negative contribution to GDP growth, and if you deduct speculativefunds disguised as trade payments, you’ll find that exports were a drag ongrowth again in 2013. As the economy increasingly relies almost solely oninvestment, any slowdown in investment could curtail growth.”

The black line in the chart showsnet exports, and confirms the point they are making. China is no longer the “manufacturing capital of theworld”. Its exports peaked at 9% of GDP in 2007, and have sincefallen sharply. And no economy in the modern world has ever basedits growth on infrastructure investment, for good reason.

What is the point of thisinvestment, if the population cannot afford to use it? And how canthis investment ever be repaid if the population cannot afford to use it?

The “answer” for the past 5 yearshas been to try and bridge the gap via a massive credit bubble worth $10tn (more thantotal GDP). This covered up the problems caused bydeclining household spend by instead creating a ‘wealtheffect’. The US Federal Reserve did the same in 2002 – 2007period, and created the sub-prime bubble instead.

The result of the policy was thatChina’s banks added $14.6tn of lending over the period, equivalent tothe entire size of US bank loans. And the US banks’ loans were builtup over a century, not 5 years. The sheer volume of this lending suggestscredit checks must have been virtually non-existent. Equally important isthat the effectiveness of the lending in stimulating GDP growth has been falling sharply:

• In 2007, each dollar of credit added 83 cents to GDP
• By 2012, each dollar was only adding 29 cents; last year, a dollar added only 17 cents
• Estimates suggest the figure this year may be as low as 10 cents
• At this level, lending will have almost no impact on the wider economy

The only sensible solution is to cutback sharply on investment, whilst starting to boost consumption and householdspending. The former has to happen immediately, due to the risk createdby the size of the credit bubble. But the latter can only take placeslowly. Total household spend is, after all, only a third ofGDP today. As China's Academy of Social Sciences has warned,clearly reflecting the views of the new leadership:

“To have more sustained andquality growth, we’ve got to let the growth rate go down.”

It also explains why Premier Liwarned in his first press conference that the changes underway would “feel like cutting one's own wrist “. Hewas referring to a Chinese legend, in which a warrior who had been bitten by asnake cut off his hand to save the rest of his body

New Premiers do not normally starttheir term of office in this way. The blog can only recall one otherexample in modern history – Winston Churchill’s first speech to the UKparliament on taking office in July 1940 as the Battle of Britain began: ”I have nothing to offer but blood, toil, tears, and sweat.”

The seriousness of the situation,and the dire warnings being given by the leadership about the necessity forchange, suggest that the current debate over China’s likely level of GDPgrowth is missing the point. As co-author John Richardson commented yesterday, “there is a distinct possibilitythat growth will be much lower than any of the consensus forecasts”. Zerogrowth at some point in the next 2 – 3 years would seem to be a prudent BaseCase.