The Cracks in China’s Foundation

“The bullish group-think on China is just as vulnerable to massive disappointment as any other extreme example of bubble-nonsense I have seen over the last two decades … the fall to earth will be equally as shocking” -- Albert Edwards, strategist at Societe Generale.

China’s handling of the global recession has set a “gold standard” for sovereign policy responses to the crisis, Nicholas Lardy, a well-known China expert at the Peterson Institute, told the US-China Economic Security Review Commission earlier this year. Lardy told the official body that China’s uniquely aggressive fiscal and monetary stimulus was the reason for his bullish view. Recent economic data out of China seem to confirm Lardy’s view, and last month the World Bank upgraded its 2009 GDP forecast for China to 7.2 percent from 6.5 percent.

We believe it is premature to conclude that China’s economy is out of the woods, based on high-frequency macro data and/or professional growth forecasts because such information assumes all investment, whether government-directed or market-allocated, acts with equal effect on the growth trajectory of an economy.

Investment injected into the economy from government fiscal stimulus and/or via monetary easing (which in China’s case is policy-directed bank loans) is like throwing a wspaper on a fire. It burns brightly very quickly but it is likely to fade just as quickly. Unless there is organic investment behind the wave of directed investment we have seen in China over the past six months, the current growth recovery will fade too. The question is whether China can keep throwing newspaper on the fire until the logs can catch once again.

The logs in China’s case are organic investment. The only way an economy can enjoy a self-reinforcing cycle of organic investment and growth is when investment is profitable. Profitable investment only occurs when the investment is allocated in a bottom-up process by the market. If capital is allocated by a top-down approach as has been the case with China since last November, then it cannot, by definition, be profitable – or fuel sustainable growth.

Even when investment is allocated by the market, there is the possibility of a mis-allocation of capital that proves unprofitable. During a credit bubble, for example, when economic growth is at an unsustainably high level, a country can experience what is highly profitable investment. High profits drive even higher investment and so on. But when the credit bubble bursts, and grow slows, the investment during the bubble also turns out to be unprofitable. That is what we have seen writ large in the US and global economy, and especially in the US real estate and financial sector.

China has avoided the worst of the bursting of the global credit bubble, but it cannot avoid a painful adjustment forever. The good news coming out of China recently is temporary window dressing hiding fundamental distortions in the economy fueled by the same global credit bubble that forced the US and global economy into recession. What China is doing is merely doubling down on a fundamentally flawed credit bubble-accommodating policy approach.

China is effectively following up an epic cycle of mal-investment fueled by a historical global credit bubble with an enormous round of top-down public sector directed investment. That means China is piling another round of mal-investment on top of one that is already there.

While China’s approach may appear to be the gold standard of policy responses to the global recession, time will show it to be fool’s gold. The “China-recovery story” is based on the same sort of wishful thinking that blinds investors to promises of get-rich Ponzi schemes. As long as suckers keep piling into the ponzi scheme, there are big monetary rewards to be made for those who are first in to the scheme. At some point, however, all ponzi schemes run out of suckers. China is keeping a fundamentally unprofitable macro-growth ponzi scheme alive by piling a new round of government directed investment on top of enormous excess capacity built up during the global credit bubble. Bernie Madoff couldn’t have done it any better.

It is a simple equation. Only when investment is profitable can an economy be considered to be in a sustainable growth mode. Investment that isn’t profitable will provide only a temporary boost to growth -- and that is where China is right now.

China is sitting on a mountain of industrial capacity built during an epic global liquidity boom. Until a lot of that extra capacity is rationalized one way or the other, private industry won’t be willing to put any more logs on the fire.

Meantime, the idea that China can somehow transition from an investment-export led economy to a consumption based economy is pure folly; that will only happen if and when the market is allowed to take the economy there through different market-based incentive structures – which includes two key developments that are not likely to happen any time soon: a much stronger currency and deregulation in the services sector.

A stronger currency would kill two birds with one stone: direct export-oriented investment toward domestic markets and increase Chinese consumer purchasing power. Deregulation in the service sector would facilitate productivity growth and earning growth in a job-intensive sector of the economy.

China is supposed to have endless fiscal and monetary resources to keep the “fire” going until the global economy recovers, but we believe such a view is erroneous because it is based on two flawed assumptions. First it assumes a healthy starting point for China’s fiscal position based on superficially “healthy” headline figures like China’s debt to gross domestic product ratioof 20 percent and its small fiscal deficits.

Both figures are enormously misleading because they completely miss directed bank lending and the mountain of contingent liabilities in the form of latent NPLs in the banking system.

Since there is typically a time lag of 12 to 24 months between the effect of monetary easing and increased growth, some analysts argue that China’s massive monetary stimulus beginning in the first quarter of 2009 will continue to filter through the economy and boost growth through the second half and into the first half of 2010. The problem with this view is that China’s “monetary” easing was not facilitated via interest rate cuts, which do take time to filter through the economy and translate into more loans and higher investment. In China’s case, the government directed banks to inject massive loans into the economy without waiting for market dynamics to work out which companies “needed” the loans.

It is hard to predict the timing of a China crash. But we believe the bullish view on China takes an overly optimistic view about the staying power of the stimulus plan; we see stresses returning in Beijing's growth story by the fourth quarter -- as policy makers start to run out of newspaper.

Sam Baker is director of Asia research for Trans National Research Corporation, a US-based political and economic consultancy specializing in global emerging market research.