CHINA CRASH 2012: Here's Why It's Finally Happening

 

For decades, experts have been predicting a crash in China. They warned that the centrally planned, export-dependent economy, could not sustain itself year after year.
But through multiple crises, China has motored along, lifting hundreds of millions of people out of poverty in the process.
But things appear to be different this time. Corporate profits are tanking, and the Shanghai Composite is at the same levels it was during the depths of the 2008-2009 crash. A hard landing has hit the corporate sector.
And many are questioning whether policymakers are really in control of the slowdown this time, or if the economy is in fact heading for a hard landing i.e. four straight quarters of below five percent growth.


Chinese leaders are on notice.
A recently announced infrastructure stimulus showed that Beijing is starting to worry about the depth of its economic slowdown.
But it also signaled that its economic rebalancing has been put on hold.
How did China get to this point? When did exports and infrastructure start driving the economy? And what is driving bearish sentiment now?
We look at how the Chinese economy has changed since 1978 and the biggest challenges it has lying ahead.

China has changed rapidly in the last two decades. This is Shanghai in 1990

And this is Shanghai in 2010

Big changes came to China in 1979 when policymakers implemented reforms to open its economy

The contribution of exports to GDP surged from 4.6 percent in 1978, when reformists like Deng Xiaoping began to implement market-oriented reforms. The ratio of exports to GDP climbed to 19.2 percent in 1997 as the country became increasingly exposed to global demand. Source: Bank of America

The reforms significantly improved quality of life, lifting hundreds of millions out of poverty.

the Cultural Revolution

The failures of China's 'Great Leap Forward' and chairman Mao's cultural revolution hurt the nation's economic growth.  But after Deng Xiaoping began pushing through reforms in 1979 and the economy started to grow, the livelihood of the Chinese started to improve. 
Data from the IMF shows that per capita GDP rose from $226 in 1978, to $1,042 in 2001. In 2011, Chinese per capita GDP rose to $5,447.

The Chinese economy was the tenth largest in the world in 1978.

In 1978 the Chinese economy was the 10th largest in the world, with GDP totaling $148.2 billion. By 2007, China had knocked Germany out of third place and its GDP totaled $3.5 trillion.

Then in the 1980s, China had its first volatile decade, but the government was able to right the ship.

China experienced a tumultuous decade after 1978. GDP growth reached 11.7 percent in 1978 and fell to 5.2 percent in 1981, as the government clamped down on investment to curb inflation. GDP growth then surged to 15.2 percent in 1984, only to fall to 8.8 percent in 1986, and then jump back to over 11 percent in 1987, with inflation surging to 18.8 in 1988.
Bank of America's Ting Lu writes, "due both to an internal turmoil and policy tightening, growth slumped to 4.1% in 1989 and bottomed at 3.8% in 1990."

China has a long history of driving economic growth through government investment. This chart shows that fixed asset investment (FAI), a measure of capital spending, surged to 61.8 percent in 1993, the highest level since China began its economic reforms in '78-'79

After the Asian Financial Crisis and the Dotcom Bubble, the Chinese economy saw a major boom through 2007

The Chinese economy slowed down during the Asian financial crisis and began to recover in 2000. But the end of the global-tech bubble hit Chinese exports and impacted the country's economic recovery.

Source: Bank of America

China benefited greatly after it joined the World Trade Organization and saw its economy thrive

As China became a member of the World Trade Organization in 2001, the country started pushing more aggressively on reforms and saw foreign direct investment pick-up as well. From 2002 - 2003, credit growth jumped from 15.3 percent to 22.3 percent, fixed asset investment (FAI) rose to nearly 53 percent in the first two months of 2004.
Source: Bank of America

As always, Chinese investment in infrastructure assets grew massively each year.

Bank of America Merrill Lynch

However, the government intervened in 2004 - 2005 to prevent the economy from overheating

Some time in 2004 the Chinese government began to worry that there had been too much investment and was worried about the rise of non-performing loans.  "In 2004, land seizures were stopped temporarily, loans to many projects were cut, and a number of officials and merchants were even arrested for breaching central-government policies," according to Bank of America's Ting Lu.
Source: Bank of America

China was slated to overtake the U.S. to be the world's largest economy by 2027.

President Obama shakes hands with Chinese premier Wen Jiabao

Goldman Sachs famously projected that China would overtake the U.S. to be the world's largest economy in the next 15 years. Source: Goldman Sachs

And then came the financial crisis ...

After the Lehman collapse the Chinese economy was hit by a decline in exports. This chart shows the dramatic plunge in exports in 2008

It was only in mid-2008 that Chinese policymakers thought they had tightened too much at a time when the country's exports were starting to be impacted by the global economic slowdown. Exports fell to -2.2 percent in November 2008 from the previous month. By May they had fallen to -26.3 percent. The accompanying chart shows the stunning drop in imports and exports during this time period.
Source: Bank of America / Societe Generale

In response China announced a 4 trillion yuan ($635 billion) stimulus package to revive economic growth and create jobs

Job seekers queue for a job fair in China's Shaanxi Provinc

49 million rural migrant workers are expected to have lost their jobs between October 2008 and April 2009, according to the World Bank. At the end of 2008, China announced a 4 trillion yuan ($635 billion) stimulus that over two years would finance low-income housing, rural infrastructure, water, electricity, transportation etc. This was expected to help revive economic recovery but also to tackle the massive unemployment problem.
The massive stimulus helped create millions of jobs in under two quarters, according to SocGen's Wei Yao, but it also created bubbles in the property sector, worsened excess capacity, and cause bad debt levels to rise.

Most of the stimulus was focused on infrastructure projects

Societe Generale

Part of the stimulus was used to develop China's high-speed railway

A section was also set aside to rebuild areas damaged by the Sichuan earthquake

It was also used to build the Qingdao Haiwan Bridge, the world's longest sea bridge

But this infrastructure stimulus hasn't been without controversy as many of the bridges have collapsed and there have been accidents on the high-speed rail line

The massive infrastructure stimulus however hasn't been entirely smooth. Bridges and roads have collapsed, and the country has also had derailments on its high-speed rail line. Some specifics:

• Former railway minister Liu Zhijun was ousted from the Communist Party of China on charges of corruption, after 40 people were killed and hundreds more injured in a high-speed train accident.
• Six major bridges have collapsed since July 2011.
• 99 road cave-ins have been reported in Beijing in the July-August period this year.
• Some of the infrastructure projects have been dubbed "bridges to nowhere" and there are frequent reports of high vacancy rates on trains.

The infrastructure boom also led to the creation of ghost cities like the Kangbashi District in Ordos

Or Thames Town which is modeled on English homes

Meanwhile China had its own property bubble ...

As Chinese property prices began heating up fears of a bubble emerged

Starting in 2005, Chinese property prices began to surge, and many pointed to the ghost cities as evidence of a ballooning property bubble. The government began to roll out property curbs to control home prices.  Property prices fell between 2008–2009 as a result of the curbs, and as the Chinese economy was impacted by the sub-prime-led crisis in the U.S., but began to tick higher in 2009 after China's massive infrastructure stimulus.

After a sharp fall in housing prices and sales in 2008, prices began rising again

Societe Generale

But the government has promised to keep property prices in check

Before Beijing launched its current round of infrastructure stimulus, it had warned that it would maintain a Bank of America's Ting Lu thinks a new consensus has emerged among policymakers that aims to lower prices by increasing the supply of homes. The government's decision to increase land supply while maintaining its tightening measures is its new tactic of controlling home prices.

And this is where things get really painful ...

The Chinese trade surplus is deteriorating rapidly.

Chinese profit growth has gone negative

Chinese corporate profits are being hit by weak demand, wage inflation and high taxes

• Declining orders, rising inventories, higher wages, and taxes are impacting corporate profits and many companies are going bankrupt.
• Non-performing loans are on the rise.
• More than 380 of the 760 companies listed on the domestic stock markets expected year-over-year declines in net profits when they reported semi-annual results.
• The bearish sentiment on China can be attributed to two key things according to Yao. First is "the market’s uneasiness to accept a structurally lower growth rate," and more importantly, it's the fact that "the burden of the economic slowdown is disproportionally greater on corporates," according to SocGen's Yao.

The Shanghai composite has crashed to its lowest levels since the crisis

And GDP growth is still dipping

Societe Generale

So the government has been forced to halt efforts to "rebalance" the economy

In China's11th five-year plan , the National Development and Reform Commission (NDRC) pushed for a shift from an investment-driven economy to one led by domestic demand: "First, we will promote development by relying on the expansion of domestic demand, take the expansion of domestic demand, especially consumption, as a major driving force, and transform economic growth from being driven by investment and export to being driven by consumption, investment, domestic and foreign demand combined in a balanced manner."
But the recent slowdown in the Chinese economy prompted the government to push nearly 1 trillion yuan of infrastructure stimulus. And president Hu Jintao's APEC speech prompted many to point out that China may have slammed the brakes on its rebalancing.

And GDP growth has become less about exports, and more about stimulus again

Adding to the challenges, Chinese wages have been rising in the rural and urban sector

A sharp difference in rural and urban wages prompted rural workers to seek jobs in the non-agricultural sector. But by 2003 and 2004, labor shortage in the rural sector caused wages to rise at a faster pace than urban wages, according to Yao.

Wage inflation has caused China to lose manufacturing jobs

Per capita income for urban households was up 13 percent year-over-year in the first half while the per capita income for rural households was up 16.1 percent on the year. And this has been pushing manufacturing out of the country to places like Vietnam, Cambodia, Myanmar etc.

China's labor problems are getting worse as the one-child policy has skewed its dependency ratio

China's one-child policy is expected to impact its labor supply and the economy not only by limiting the labor pool but also by increasing the dependency ratio. China also has other problems, for instance, nearly 85 percent of those born after 1980 have never worked on farmland  according to Yao. And they are more likely to choose to be unemployed rather than undertake manual labor, and are more likely to change jobs often.

And China's state-owned enterprises no longer dominate the economy

Chinese state-owned enterprises are making way for private companies:

• The government laid off 46 million public sector employees between 1995 and 2001.
• State owned enterprises (SOE) went from employing 60 percent of the urban population in 1990, to about 19 percent in 2010.
• SOEs' share of fixed asset investment (FAI) is down to 33 percent as of February 2012, down from 58 percent in 2004.
• But SOEs still dominate energy, telecommunications, and financial sectors.

And it's only going to get more difficult because of the slow global economy and pressure to strengthen the Chinese currency

The global economic slowdown is expected to continue for another two or three years, and will be a blow to Chinese exports. To add to this difficulty, Li Zuojun, deputy director at the Development Research Center of the State Council (DRC) writes that "the international environment for China's overseas investments is deteriorating" because countries don't trust the Chinese and suspect they will steal their technologies or are doing it to control their resources.
Finally, calls for renminbi appreciation by western countries are also impacting the Chinese economy.