China: Hugh Hendry warns investors' infatution is misguided

Hugh Hendry wonders whether professional money managers' infatuation with China could prove unrewarding?

Robert Prechter, the eminent American observer of social and economic trends, wryly contends that stock markets usually deceive those people who argue for outcomes based on seemingly logical causation.

Could our professional money managers' infatuation with China prove similarly unrewarding? China's economy is certainly on a tear; economic growth has averaged 9pc a year over the past 10 years, compared with a paltry 1.9pc for the British economy. Last year, despite the credit crunch, China posted a remarkable growth rate of 10.7pc against a British contraction of 3.2pc. This is impressive stuff.

The spell cast by a contemporary cult is undoubtedly hard to resist and some brave souls, willing no doubt to extrapolate present trends forward, are even proclaiming that China will usurp the United States as the world's largest economy. Goldman Sachs' chief global economist, Jim O'Neill, even taunts the naysayers, saying, "You either get it or you don't." Such is his conviction.

However, the composition of China's growth has undergone a potentially treacherous change: in the absence of expanding foreign demand for its exports, it has instead come to rely on a massive surge in domestic bank lending to fuel its growth rate.

Indeed, when measured relative to the size of its economy, the 27pc point jump in bank loans to GDP is unprecedented; at no point in history has a nation ever attempted such an incredible increase in state-directed bank lending.

What a turnaround: from an export juggernaut to a credit addict. Who would have thought it necessary back in 2001, the year everything all started to work out for China?

That was the year the Chinese gained entry into the World Trade Organisation. The ascension to the WTO also coincided with the American Federal Reserve's loose monetary policy response in the aftermath of the NASDAQ crash. Exports surged, especially to the US, and China's current account surplus increased from a modest 2pc of its economy to a monumental 11pc, all by 2007.

This appetite for cheap Chinese exports, which had at one point seemed insatiable, means that we in the West have come to owe our largest Asian trading partner quite a hefty sum of money. China has become the world's biggest creditor, after amassing nearly $2.3 trillion of foreign exchange claims on us. However, the spectre of a creditor nation running persistent trade surpluses has ominous historical portents. It has happened only twice before, with the US economy in the Twenties and with the Japanese economy in the Eighties.

Economics is a cruel master and in both of the previous examples a failure to allow exchange rates to adjust to the new reality created a large speculative pool of credit that, in turn, led to overvalued domestic assets and, eventually, an economic crisis. Never forget that in economics, first can become last.

The China bulls assure us that this time it is different. Yes, the banks are lending money at breakneck speed, but look at what they are doing with it! They suggest a new era reminiscent of Protestant Capitalism. They want us to believe the atheist Chinese are prepared to work harder and defer their gratification for longer.
Undoubtedly, China's state planners have favoured investment over consumption. High-speed rail networks, first-class infrastructure projects and the urban migration of 55 million people every year are common explanations for the ability of the nimble Chinese to overcome the frailties of this global economy. But can too much of a good thing be bad for you? The goal of economic policy, after all, is to maximise households' wellbeing and consumption. Unfortunately, unlike in most countries, China's share of consumption within its economy has fallen relentlessly, reaching 35pc of GDP in 2008. Something isn't right.

The ancient ethical system of Confucius is silent on the subject of modernisation. There is no proverb counselling that "wise men not invest in over-capacity". Perhaps there should be: in China, investment spending has tripled since 2001 and the consequences are staggering. A country that represents just 7pc of global GDP is now responsible for 30pc of global aluminum consumption, 47pc of global steel consumption and 40pc of global copper consumption. The overriding problem is that the Chinese model leads to a deflationary spiral that is perpetual in nature. Domestic consumption never grows fast enough to absorb the supply, prompting the planners to commit to ever-higher levels of investment. Over-capacity inevitably plagues many sectors of the economy and Chinese profitability is already low.

Remember, it is one thing to create economic growth, but it is another thing to truly create wealth. If I commit to building a new commercial property in Shanghai I will undoubtedly contribute to GDP growth. However, if I have no tenants and the city already has a vacancy rate of 20pc, then I am probably destroying wealth.

Adam Smith taught us that real wealth comes not from piles of gold or their modern-day equivalent, the foreign exchange reserves amassed from a profitless succession of current account surpluses.
Rather, Smith suggests that real wealth is founded on the skills and productivity of a country's citizens. This is the central concern regarding the sustainability of the Asian economic model. Power without profit can prove ephemeral. This is an axiom the Japanese are all too familiar with. We cannot say we have not been warned.