According to the Chinese zodiac, the year of the rabbit is now under way, a time when investors will be hoping to see increased tranquility in share markets, in place of the wild swings of recent years.
But many prominent investors are warning of upcoming instability in the Chinese economy, which holds the potential to roil global markets.
Prominent New York fund manager Jim Chanos, who made a massive fortune by predicting the collapse of Enron and other debt-laden US corporates, continues to warn that the country is in the grip of a major property bubble. As a result, he’s built up short positions on Chinese property and financial stocks.
Meanwhile, Niels Jensen, from London-based Absolute Return Partners, argues that the “actual” Chinese economy is in worse shape than many assume, with economic growth lower, and inflation higher, than official Chinese data suggests.
Scepticism about the accuracy of Chinese figures has been increasing ever since WikiLeaks published leaked US diplomatic cables from 2007 in which Li Keqiang — who is tipped to become China’s next premier — referred to some Chinese economic figures as “man made” and “for reference only”. Instead, he preferred to use figures on bank lending, rail freight volumes and energy consumption to give a more accurate reading of the economy.
Jensen has decided to follow this approach, and has uncovered an interesting pattern. Over the past 15 years, whenever Chinese economic activity weakened — such as during the Asian crisis, and the global credit crisis in 2008-9 — Chinese GDP growth was much faster than the increase in electricity output. On the other hand, whenever Chinese growth was strong (such as 2002-07 and 2010), GDP growth was lower than the power output. “Clearly the GDP numbers are massaged,” he concludes.
But his investigation points to an even more alarming trend — the growth in Chinese power output slowed rapidly over the course of 2010.
Total power consumption (measured year on year) grew at an astounding 22.7% in the first quarter of 2010, but this slowed to a mere 5.5% in the fourth quarter. In fact, the slowdown in the final three months of the year was so drastic that power output was 6.3% below the previous quarter.
So while official Chinese stats show China’s growth rate dropping from 11.9% in the first quarter to 9.8% by the fourth quarter, Chinese electricity output showed a much more pronounced slowdown — from 22.7% to 5.5%.
Now, part of the reason for this drop could be the restrictions on electricity use that Chinese authorities imposed last year. But since these were dropped in November, it cannot be the only explanation.
Jensen similarly highlights problems with official Chinese inflation numbers. Official figures show that inflation eased to 4.6% in December, from November’s 5.1%, but anecdotal evidence suggests the actual inflation rate, particularly in the big cities, is running closer to 20%.
What’s more, the Chinese have also taken the extraordinary step of reducing the weight of food in the consumer price index — at a time when sharp rises in food prices mean that households are likely to be spending even more of their income on food.
It’s clear that Chinese inflationary pressures are gathering strength, but the Chinese authorities are immensely proud of their track record of strong economic growth, and are reluctant to raise interest rates sharply for fear of plunging the economy into recession.
As Jensen points out, the situation is further complicated because China is on the brink of a leadership change. “The transition of power from current President Hu Jintao and Premier Wen Jiabao to the next generation of leaders is fast approaching. Although the National People’s Congress, where the new leaders will be officially instated, is not taking place until March 2012, the new power structure will almost certainly become apparent to the outside world at the next party congress, scheduled for October of this year.
“Given the importance of this changeover and the significance the Chinese assign to not losing face, the leadership will do anything in its power to maintain the economic momentum until after the March 2012 congress. This increases the probability that the Chinese monetary authorities will fall further behind the curve in the months to come and make the landing so much harder when it ultimately happens.”
Meanwhile, the forces of instability will continue to build. Jensen points out the Chinese property market is already dangerously overheated, with residential properties now being sold in Beijing and Shanghai at values that exceed 20 times disposable income (compared to a peak of eight times in Tokyo at the peak of its boom, and the US peak of 6.5 times).
He also notes that China’s level of investments in recent years — with fixed investments accounting for nearly 50% of GDP — is unprecedented. But, he adds, the problem is that “when you create too much capacity, the return on invested capital will ultimately prove disappointing. But China is not a capitalist economy where one needs to worry about petty things like that (or so they seem to think). It is driven as much by its desire to dominate on a global scale, as it is by basic economic considerations”.
Ultimately, however, the Chinese economy will succumb to economic forces, and the pain will reverberate widely outside the country. Commodity producers, such as Australia, will be hit hard.
According to Jensen, “when the Chinese ultimately bite the bullet and force the economy to slow down meaningfully (and I believe it is a question of when, not if), the biggest victim is likely to be commodity prices, and none more so than base metal prices, which in recent years have been highly correlated to the fortunes of China.
“Remember — when an economy, which has grown accustomed to expanding by 10% per year for more than a decade, suddenly experiences ‘only’ 5% growth, it will feel like a recession, and its people will react accordingly.”
This first appeared on Business Spectator.