March 26, 2012
Could the China that Enda Kenny is visiting this week enter a recession in the next year or two? Yes, a recession, not a gradual slowdown, but a recession. This might seem a preposterous suggestion, given what we know has happened in the past ten years. But that is precisely the point. The recent past has been stellar, but all growth spurts come to an end, particularly those driven by huge credit growth.
For China, such an end will only be the end of the beginning, because the long-term process whereby economic vigour is moving relentlessly from west to east seems unstoppable. In the absence of war or protectionism, the march of the east will continue, but it won’t continue in a straight line. The economy rarely works like that.
As we in Ireland reassess the legacy of the Ahern years, we all know about the chimera of credit-fuelled growth. We would be wise to apply the same basic rules to China.
I have visited China four times for work in the past five years, and the place has changed almost beyond recognition on each of those occasions. Buildings and train lines have sprung up where they didn’t exist a few months previously; huge bridges were constructed apparently overnight; entire cities seemed to appear where there were none before. Shenzhen in the south is one such example. Twenty years ago, it was a fishing port. Today it is bigger than New York.
One visit to the Pearl River Delta (for book research) – in search of the factory where Irish soccer shirts are made – was one of the most bizarre I’ve ever experienced. One year, the street where the shirts were made was there. I met the owner and the workers. We took photos with them and shot a scene for a documentary there. The next year it was gone. So, too, were the dormitories that housed all the workers, the internet cafes and all the tiny shops making all sorts of tools and parts of machines. The place was a huge building site.
China’s extraordinary growth over the last decade has been built on exporting cheap goods to the developed economies, where punters have been flush with credit-fuelled wealth. But as we know here in Ireland, that wealth has now largely disappeared because it never really existed.
From 2000 on, the global deal was pretty straightforward. China exported stuff to us in the west. With the proceeds, the Chinese bought US government bonds, allowing the US to keep borrowing. The more the US borrowed, the more the price of houses in the US rose, making the average American feel richer. They borrowed yet more against this wealth and bought yet more goods from China. We were at the same carry-on.
Now it has all collapsed around us. We have moved from the great age of leverage to the great age of deleveraging. This means we don’t have the cash to buy the Chinese stuff in such quantities. This big move was becoming apparent in 2008 and 2009, so the Chinese switched to lending at home, rather than lending to the Americans. Domestic credit in China exploded, driving up the price of everything, especially property.
The Chinese government flooded the economy with cheap loans to boost demand, because the last things an authoritarian government wants are unemployment and restless people who might start asking questions about who rules the place and why.
According to the wonderful American analyst Bill Bonner, the key to understanding what is happening in China now is the fact that these local cheap loans are going bad as the economy contracts. We know from our experience here that, when loans go bad, they go bad quickly and relentlessly.
The slowdown is being felt in manufacturing because we are not buying their stuff in such huge numbers. HSBC’s Chinese manufacturing purchasing managers’ index for March is down to 48.1 in March, from 49.6 in February. A reading below 50 shows a manufacturing sector in decline, so we are moving towards contraction. Japanese exports to China were also down 14 per cent in February.
This is all feeding into a rise in bad loans and write-offs. In the view of many investors, things are worse than we think. Even the Chinese government admitted that half of all new loans to local governments in China were going to go bad.
Now, here are some figures that should set alarm bells ringing. Total credit this year is likely to be between 30 per cent and 40 per cent of GDP. If half of these go bad, that is 15 per cent to 20 per cent of GDP. Imagine that the recovery rate on bad loans is 50 per cent. That means that the Chinese economy – after write-offs – may not be growing at all.
According to the hedge fund manager Jim Chanos (the man who was the first to spot that Enron was a pile of junk), China may be heading for a hard landing. He argues that the write-downs on bad debt means that China’s “9 per cent growth may actually be zero”.
Counteracting this negative cyclical view is the sense that even a short recession won’t stop the march of China.
Any indicator you take reveals an extraordinary global behemoth like the US economy from the 1890s onwards.
My own favourites are the figures on internet usage. According to Internet World Stats, the number of internet users in China has more than tripled since 2006, soaring to 485 million in mid-2011. Moreover, China’s rush to connectivity is far from over. As of mid-2011, only 36 per cent of its 1.3 billion people were connected. This is far short of the nearly 80 per cent penetration rates seen in South Korea, Japan and the United States. (For more on this see: http://www.kpcb.com/insights/internet-trends-2011.)
Irrespective of the likely sharp contraction in growth, Irish companies should be looking to China because it’s simply too big to ignore. This can take many forms, and sometimes we don’t realise that we have some things here that Chinese business people need and want. For example, law firm A&L Goodbody is this week launching an internship in Beijing for Chinese lawyers from the biggest and best-connected Chinese law firms.
The golden rule of business is that you do business with people you know. Therefore, creating a Chinese network means that there is someone you know at the end of a phone when you want to trade. Consequently, the initiative from the likes of Goodbody is highly likely to bear fruit in the years ahead, and it’s good to see private companies doing this for themselves rather than waiting for the state to take the lead.
Even if China comes to a shuddering halt after 20 years of extraordinary growth this year, which is the year of the Dragon, it will rev up again and, as always, fortune will favour the brave.