Essentially in agreement with Jim Chanos on diminishing ROIs for capital investment in China, Michael Pettis argues China is misallocating capital on a massive scale.
But I think there are more formal reasons to believe that China is misallocating capital. Common sense suggests that when there is massive investment with
- very little accountability,
- severely distorted prices,
- an incentive structure that concentrates the benefits of investment in specific jurisdictions and over a short time period while spreading the costs throughout the national banking system and over the debt repayment period (which can be decades),
- no or very limited budget constraints,
- factional and regional conflicts, and
- shifts in responsibility as the instigators of the investment are promoted (often because of the positive impact of their own investment initiatives),
It would be a rare system in history that did not tend towards substantial capital misallocation.
Certainly the evidence on SOE investment suggests that this is indeed what happened. A number of studies have suggested that if over the past decade you add up direct subsidies, the impact of monopoly pricing (which is of course simply a tax on households) and the interest rate subsidy, they total anywhere from six to ten times the aggregate profitability of the SOE sector. This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.
SOE means State Owned Enterprise. The communists are predictably wasting lots of capital in SOEs.
A couple of months ago Chanos said China's hard landing has already begun.
NEW YORK (MarketWatch) — China is heading into an economic storm, and the much-feared hard-landing of the world’s second-largest economy has already started, warned celebrated hedge-fund manager and China-bear Jim Chanos of Kynikos Associates on Monday.
On the bright side: Since China doesn't buy a lot from us we aren't as vulnerable to their economy going into the ditch as we would be if they didn't manipulate our currency and engage in such mercantilist trade practices. Also, we'll get some relief on natural resource prices if China's big construction boom and factory building boom takes a big dip. They'll eventually recover and I am still expecting them to eventually demand even more minerals and other natural resources in the long term. But we might get to grow for a while as their economy slows.
Most global investors predict China will face a banking crisis within the next five years, paring their appetite for the nation’s shares and eroding confidence in its leadership, a Bloomberg Global Poll indicated.
But Goldman Sachs remains very bullish about China and expects growth rates over 8% per year the next two years. Who is right?
This time is not different. Mish Shedlock has the details. Mish expects a 50% to 70% price drop. Though the Chinese government might opt for inflation to reduce the total price decline.
Why I care: If the Chinese economy contracts that will lower the price of oil and other natural resources enough to allow Western economies to grow - at least for a while. We live in an increasingly zero sum world where competition for natural resources drives up natural resource prices (especially oil prices) so high that economic growth in Western countries gets cut down. If China's government can't find a way to quickly the Chinese economy away from its lopsided focus on construction then we might get a year or two of growth in the Western countries while China's economy stalls.
With over half the Chinese GDP going to investment, bubble-level real estate prices, and debts rising to unsustainable levels hedge fund manager Jim Chanos sees cracks in China's bubble.
The Chinese Communist Party played a strategy of funneling most economic output back into investment during a time when the country had little capital. They could get away with it because they had great growth potential for exports and because they had so little capital to start with. A new steel plant's output could be used for exports and factories and rail to haul exports to ports. The output of a new concrete plant could be used to make factories and roads and port facilities. No great finesse was needed to cause growth.
Mercantilism combined with state-subsidized capital expenditures worked well for China for a few decades. But China can't sustain this strategy. They've gradually run out of productive ways to use large amounts of capital. As a result their return on capital has gone down and, has Chanos has pointed out previously, China is hit by the law of diminishing returns. At the same time, costs of raw materials inputs have soared as long term extraction costs are trending upward.
Whether China's policy makers can even make the shifts needed is debatable. The interests inside of China dependent on the current status quo (e.g. construction firms, real estate spectators, steel mills) work against the needed shift toward greater internal consumption.
Mish Shedlock says China is headed for a correction. Also see Vitaliy Katsenelson's China – The Mother of All Gray Swans. Katsenelson believes China's measures to avoid recession when the rest of the world contracted in 2008 have severe global consequences.
My questions: How severe a correction will hit China? Also, on the other side of that correction what will be China's new (lower) long term growth rate? Will Peak Oil prevent resumption of growth? Or will China's Communist Party manage to shift transportation to electric power fast enough to avoid stagnation due to Peak Oil? Also, can the Chinese Communist Party maintain sufficient legitimacy during a downturn to prevent regime-threatening mass protests?
For the next year or two put this in a global context. Every major region has serious economic problems and these problems will interact. The US economy is weak and hard hit by high oil prices. Japan's economy is down for 2 quarters and is in a double dip recession. Popular opposition to austerity measures in the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) seem likely to force sovereign debt defaults in the PIIGS. The resulting German bank losses will increase German popular dissatisfaction with the Euro. Will the currency zone survive without defections?
According to the latest IMF official forecasts, China’s economy will surpass that of America in real terms in 2016 — just five years from now.
Put that in your calendar.
I mourn the passing of the country I was born into. So much has been lost and so much more will be lost. We live at the end of an era in more ways than one. As Brett Arends points out, the change has come very rapidly.
Just 10 years ago, the U.S. economy was three times the size of China’s.
Whether this happens so soon depends in part on whether the Chinese can soft-land their enormous real estate bubble. Jim Chanos is skeptical and other observers think China's growth rate can't be sustained. But the US isn't going to grow very either.
In 2009 China surpassed the US as the world's top energy consumer. It did this using coal, which accounts for % of their total energy production. This makes China much less vulnerable to high oil prices.
The IMF is also projecting world economic growth of about 4.5% per year over the next 5 years. As Stuart Staniford explains at that link, that's so not going to happen. That level of economic growth would require world oil production to grow at 3% per year. Yet oil production is about where it was in 2005 and International Energy Agency chief economist Fatih Birol says the age of cheap oil is over. Only recession can lower energy prices. The economies of the world are becoming increasingly constrained by resource limitations. US economic growth has slowed to only 1.8% due to high energy and commodity prices. This is the new resource-limited normal.
So what's the net effect of resource limits on the relative standing of the US and China? The Chinese have one thing going for them: Oil makes up a much smaller percentage of their total energy usage than is the case with the US. So the Chinese economy is less dependent on oil. China's heavy reliance on coal makes Peak Oil much less a problem for China than it is for America.
Coal makes up 71 percent of China's total primary energy consumption, and China is both the largest consumer and producer of coal in the world.
China's 18+ million per year car production (and growing) is making the Chinese more vulnerable to oil price shocks. But China's economy is still not structured around oil unlike America. For this and other reasons I expect China to continue to catch up and eventually surpass the US as an economic power.