The following is a summary of research by Pivot Capital (h/t Naked capitalism)
China’s capital spending boom will not be sustained at current rates and the chances of a hard landing are increasing. The coming slowdown in China has the potential to be a watershed event for world markets similar to the sub-prime crisis.
China’s current expansion cycle is surpassing historical precedents in its duration and intensity. Growth is being powered by investment, principally from the government (measured by gross fixed capital formation), which accounted for almost 90 per cent Chinese growth in the first half of 2009. This has led to overcapacity. But what is more worrying is the rapidly decreasing efficiency of China’s investments. These falling marginal returns on investment are symptomatic of the increasingly speculative nature of China’s capital spending boom. Policy actions are not sustainable into 2010.
Meanwhile, domestic credit is expanding rapidly – up 50 per cent more than GDP since the start of the decade – while its effectiveness in generating growth is falling. In the period from 2000 to 2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favourably with the peak $4 of credit for $1 of GDP in USA in 2008. However in H1 2009 in China this ratio was already at around $7 to $1.
China is thought able to continue current levels of investment because of its low explicit debt (23 per cent of GDP) and large reserves (at about $2,000bn). But we calculate the debt ratio at nearer 62 per cent, which is comparable to Western economies. So China’s reserves, while large, cannot continue to bankroll government spending. To conclude, credit growth in China has reached critical levels and its effectiveness at boosting growth is falling.
A slowdown is highly likely in 2010, but the main issue facing investors is when markets will start to price in that slowdown. The biggest uncertainty relates to deflation versus inflation. In principle, a Chinese slowdown should initially be deflationary, especially given the overcapacity currently building up in various Chinese industries. This should be negative for credit in general and also for most equities. However, depending on how aggressive the policy response will be in China and elsewhere, investors may very well start focussing on the inflationary risks again.
