The Global Recession of 2008 took decades to manifest. The recovery may take just as long.
More than four years ago, I suggested the Chinese economy was headed toward economic slowdown, which would have adverse consequences for the rest of the world. Today, that prognostication seems frighteningly real.
From 2001 to 2010, consumption as a share of GDP in China fell to 36 percent from 46 percent, while the near reverse occurred for investment, rising to 47 percent from 36 percent.
This high level of investment, which was financed with large quantities of debt, could not be supported by the current levels of income. In essence, the Chinese built homes, offices and manufacturing plants that they neither needed nor had the ability to support financially.
Since 2007, China embarked on a debt-driven plan to increase domestic investment, income and economic growth, expanding total debt from $7 trillion to $28 trillion.
As a share of GDP, its debt more than doubled from 130 percent in 2009 to 282 percent by mid-2014, making it larger than that of the United States or Germany.
Roughly half of the loans are associated directly or indirectly with China’s real estate market; unregulated shadow banking now accounts for approximately half of all new lending; and the debt of many local governments is likely unmanageable, according to a McKinsey & Co. study.
China maintains a large presence on the world’s economic stage. By 2011, it contributed 40 percent of the world’s economic growth. In 2014, China was the third-largest importer, closely behind the United States and the European Union, with $1.96 trillion of imports, and the largest exporter with $2.34 trillion in sales. Currently, it accounts for 16 percent of world economic activity, the equivalent of the U.S. in purchasing power parity terms.
China purchases about half the world’s aluminum, nickel and steel, and nearly a third of its cotton and rice, as well as iron ore, copper and coal, which created a boon in commodity prices.
It also expanded its foreign direct investment program, growing ten-fold from 2005 to 2013, and was the largest investor in five of the 10 riskiest countries.
Given China’s premier global economic standing, its difficulties are metastasizing worldwide. It has begun reducing capital investment, causing commodity prices to fall and hurting many of its trading partners, including South Korea, Japan, the U.S., Taiwan, Germany, Australia, and Brazil.
China now contributes 30 percent to world GDP growth, down from 40 percent four years ago.
Structural demographic trends portend poorly for China, since its working-age population is beginning to contract. Lower employment, income and economic growth may precipitate asset sales to service outstanding debt — leading to real estate price declines, lower loan collateral, and less lending.
Further complicating matters, in 2007, Li Keqiang, now China’s premier, told the U.S. ambassador that the Chinese GDP figures are “man-made” and therefore unreliable, according to a memo released by WikiLeaks.
Since then, macroeconomic research firms have attempted to measure these data more independently. The official Chinese estimate of economic growth stands at 7 percent. This is in stark contrast to that suggested by Capital Economics at 4.1 percent, Conference Board/Hitotsubashi at 3.8 percent and Lombard Street at 3.7 percent.
In a bit of monetary and financial schizophrenia, China has recently vacillated between a market and state-driven economy to manage its economic affairs.
In an attempt to have the renminbi included in the International Monetary Fund’s Special Drawing Rights, China sought a more flexible exchange rate, only to see it plunge in value. This led it to strengthen the currency with daily purchases totaling tens of billions of dollars.
Investors suspect the yuan will weaken an additional 4 percent to 6.75 percent relative to the dollar. This anticipated decline is in addition to the 4.4 percent drop since August 11.
Daily trading in yuan options skyrocketed to $12 billion following the currency intervention by the People’s Bank of China from an average of $4.2 billion. The cost to insure $100 million against a weaker yuan ballooned from $30,500 to $1.7 million during this time, suggesting further currency erosion.
In a reversal, after discouraging the use of borrowed funds to purchase stocks, the Chinese government sanctioned this activity by providing funds to state lenders. In addition, it limited IPOs to reduce competition with existing equities; permitted a pension fund to purchase stock; limited stock sales by large shareholders; forced company stock buyback programs; lowered interest rates and deposit reserve requirements; and spent more than $200 billion buying Chinese stocks since early July, with the likelihood that this rate of spending would need to be indefinite.
The Chinese concluded this stock-propping program was unsustainable and decided to discontinue its operation. The gains of 60 percent since December 2014 have evaporated completely.
In March 2007, nine months before the beginning of the Great Recession, the U.S. experienced a government security yield curve inversion, when short-term interest rates were higher than long term rates: the three-month Treasury bill at 5.1 percent and two-year Treasury note at 4.6 percent.
Typically, longer-term investments are more risky and warrant greater returns on investment. However, yield inversion signifies greater short-term risk associated with an anticipated economic downturn.
Since 1970, yield inversions predicted an economic contraction six of seven times. By March 2008, the yield inversion was reversed, and short-term rates were lower than long-term: 1.11 percent for the three-month Treasury bill and 1.33 percent for the two-year Treasury note.
In the case of China, the yield inversion has lasted more than four years. On August 25, the two-year Chinese government bond stood at 3.50 percent and the 10-year bond at 3.48 percent: a minor inversion still exists.
This long duration signals the economic slowdown may continue for many years and possibly approach zero growth with negative global implications.
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