Behind China’s Numbers is a Malaise No One Wants to Recognise

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While there might be one more day of Brexit headlines, the market is yawning about it. As far as it’s concerned, the Brits are staying put.

The Dow fell around 0.5%, oil dropped a bit, while gold was steady after a decent selloff in Asia yesterday.

As far as I can tell, Britain remaining in the European Union is all priced in. Markets have moved on. Only a shock ‘leave’ vote will see volatility spike again.

So what else is happening?

Well, the Aussie dollar is strong. It hit 75 US cents in FX trade overnight. Are these safe haven flows due to Brexit concerns? Or just unrelenting faith in our debt based economy?

I don’t know. I think it has more to do with the iron ore price, which in turn has to do with Chinese stimulus, than anything else.

Yesterday, the Qingdao iron ore price jumped nearly 3% to US$52.30 per tonne. May data showed that Chinese iron ore imports increased to 86.8 million tonnes for the month, up 3% from the prior month and a big 22% over the past year.

That’s Chinese stimulus spending in action. And, according to Bloomberg, it doesn’t look like letting up anytime soon:

China is stepping up stimulus by stealth in its efforts to ensure hitting the leadership’s growth target this year, with moves that will enhance the role of the state even as policy makers say they want a bigger role for the market.

The fiscal deficit when taking off-budget spending into account will exceed 10 percent of gross domestic product this year more than triple the government’s stated ratio of 3 percent, according to economists at UBS Group AG and JPMorgan Chase & Co.

Wow. So China’s enjoying a big credit boom AND a government deficit of more than 10% of GDP just to hit its growth target of 6.5%. The article goes on…

UBS estimates that the augmented fiscal deficit, which includes quasi-fiscal measures, exceeded 10 percent of GDP in 2015, with the government set to add 1.5 to 2 percentage points on top of that this year. The nation’s total debt-to-GDP ratio will reach 280 percent as a result, according to Wang.

Wow again. I know debt levels in China don’t matter. Apparently the government has an infinite well of money it can draw on to keep the economy going and keep the masses employed. But there will come a tipping point. Only no one knows when it will hit.

This is the biggest risk to face Australia. Make no mistake, China is a Ponzi economy. That is, it needs to create more and more debt to pay the interest expense on existing debt.

While it continues to do this, China maintains a semblance of normality. But as economic growth rates continue to slow (and they will), it makes the servicing of the existing debt pile that much harder.

Critics of this view say that the banks are state-owned, that China can just hide or write off the bad debts without too much drama.

There is an element of truth to this. China’s control over the banking system means you won’t get a banking crisis like we experience from time to time in the West.

But that doesn’t mean there are no consequences.

In China, the consequences of rising bad debts fall on the household sector. Let me explain…

China is a nation of savers. It is the world’s largest creditor nation. But it also has massive debt; so how does that work?

Well, it is government and corporate debt that is the concern in China. They borrow from the household sector. That is, the poor old worker puts his or her yuan in a bank account, and the state directed financial system channels these savings into unproductive debt for the sake of achieving short term economic growth targets.

When this debt goes bad, it’s ultimately household savings, and household wealth, that will take the hit. In other words, the household sector, through its high savings rate, is subsidising the rest of the economy.

You may not think this is a big deal. But it will be.

China is trying to avoid falling into the ‘middle income trap’. This has happened to plenty of other emerging nations; it refers to the inability to grow per capita incomes towards levels achieved by developed nations.

Consider China’s challenges in this context. Its demographics are poor, meaning it’s facing an ageing society. As a result, a smaller working population will have to support a growing non-working population.

Given that a large part of China’s wealth is trapped in unproductive investments, it doesn’t inspire confidence about China’s ‘rising middle class’ and ‘rising consumer society’.

Sure, it all looks good now while increasing debt levels juice headline economic growth numbers, but behind the numbers there is an economic malaise that no one wants to recognise.

That’s especially the case in Australia. When it comes to China, it’s a ‘she’ll be right’ attitude. It will be, of course…until it’s not. And what is the plan then?

Cheers,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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