Concerns that the Chinese economy might ‘crash land’ in 2012 ranked high on the list of potential negative tail events that troubled investors in risk assets as they returned to their desks for the New Year. These fears were eased if not removed altogether, once the Middle Kingdom’s National Bureau of Statistics revealed that the economy expanded 8.9 per cent year-on-year during the fourth quarter, comfortably above expectations and far removed from levels of growth that could be considered consistent with a hard economic landing in the immediate future.
However, the positive sentiment generated by the headline numbers would appear to be decidedly naïve given that the annualised growth rate quarter-on-quarter dropped to 8.2 per cent from 9.5 per cent in the third quarter – a troubling rate of deceleration – while, the ongoing correction in the property market still has the potential to provoke further downside momentum. The fact of the matter is that the debt-financed, investment-led growth of recent years has significantly increased the potential for greater economic turbulence in the months and years ahead than most analysts currently envisage.
It is important to note that China’s fundamental strategy since reforms were first introduced in the late-1970s has been large-scale investment in physical capital, facilitated by high gross domestic savings rates and through state control of banks. China emulated the precedent set by its high-achieving Asian neighbours during their corresponding periods of development and, through most of the subsequent three decades its investment rate has not been out-of-line with the capital spending booms of previous great economic transformations.
Gross fixed capital formation (GFCF), a broad measure of investment, averaged 34.5 per cent of GDP during the latter half of the 1970s, 35.4 per cent during the 1980s and 38.5 per cent during the 1990s. This compares to an average investment rate of 33 per cent of GDP for Japan between 1961 and 1973, almost 40 per cent for Singapore during the 1980s and, 31.5 per cent for South Korea from 1983 to 1991.
However, the close parallels between China’s economic renaissance and previous great transformation periods comes to an end during the most recent decade, as the Middle Kingdom’s capital spending boom continues to grow in magnitude and duration. GFCF jumped from 32 per cent of GDP in 1997 to near 50 per cent in the most recent calendar year and, has been above 40 per cent for nine straight years.
In contrast, of its high-achieving neighbours, only Singapore managed to register a peak investment rate during its corresponding period of growth anything close to the level currently reported in China and, even then the GFCF to GDP ratio was sustained above 40 per cent for a brief period. Indeed, the investment rate dropped sharply from an average of 46 per cent of GDP between 1981 and 1985 to 33 per cent in the subsequent five-year period.
Neither Japan nor South Korea registered investment rates above 40 per cent during their respective periods of high growth – the former peaked at 36 per cent of GDP in 1973 and the latter at 39 per cent in 1991 – while, rates above 30 per cent did not persist for long in either case.
It is abundantly clear therefore, that China’s capital spending boom is unprecedented in modern economic history but, a relatively high investment ratio of itself does not necessarily imply that it is excessive and predetermined to end in a bust. That depends on how efficiently resources are allocated and, in this regard, the omens are not good.
The incremental capital/output ratio (ICOR), the quantity of new capital required to generate an additional unit of growth, is commonly used to measure investment efficiency, where a reading of three is considered normal and a ratio above four is considered inefficient.
The trend in China’s ICOR is far from reassuring given that it was above four during most of the past decade and jumped to a reading of six in 2011 following the most recent surge in capital spending. Of note is the fact that the efficiency of capital investment is at the worst level since the Middle Kingdom’s last hard economic landing in 1989/90.
The marked deterioration in the marginal return on investment is troubling since it has been fuelled by a credit boom that has seen total domestic credit – private and government – jump from 121 per cent of GDP during the fourth quarter of 2008 to an estimated 180 per cent by the end of 2011 – a level that is notably high compared to countries at a comparable income level.
The almost sixty percentage point jump in credit relative to GDP – with much of the increase emanating from the large unregulated banking sector – would appear to be symptomatic of the increasingly speculative nature of the investment boom and a financial crisis could well ensue should the boom turn to bust.
Official data for economic activity during last year’s final quarter has convinced many investors that a hard landing is not in store for the Chinese economy. Close examination of the facts however, suggest that such a call is far too early to make – the probability of significant economic turbulence is far from non-trivial.
Previously posted on www.charliefell.com
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