Amid weaker U.S. growth and volatility in capital markets, China stands out as a beacon in the minds of many investors. It is widely assumed that China will continue to grow at about 7% without interruption and will, in time, surpass the United States as the largest economic power in the world.
This China growth story is one that investors take for granted. But investors are in for a rude awakening when they realize how much of the China story is false and how quickly it may come unraveled.
There is evidence that Chinese growth figures are manipulated by bureaucrats to please the political leadership, but that is not the biggest problem with the growth story. Instead, the composition of growth and its non-sustainability are the Achilles Heel. Economic growth is the sum of consumption, investment, government spending and net exports. Major economies work to achieve a sustainable balance among these elements. For example, too much government spending may result in high burdens of debt or taxes, or too many exports may result in trade wars, and so on. A sustainable mix is what is needed for strong long-term growth.
China’s problem is an over-reliance on investment to the exclusion of consumption. Investment makes up 45% of Chinese gross domestic product compared with about 20% in the U.S. Investment can be sustainable if it results in improvements to productive assets such as ports, roads and other critical infrastructure. China’s problem is that much of its investment is wasted on white elephant projects such as empty cities, monumental train stations, and unused airports.
If reported GDP were adjusted for wasted investment, actual growth in China would be seen to be much lower today. If the costs of massive air pollution and other environmental degradation were also deducted, real growth would be even lower.
A frequently proposed solution to this wasted investment problem is for China to rebalance its economy away from investment toward more consumption as in the United States. But there are enormous obstacles to this. The first is that any reduction in investment would depress Chinese growth immediately while the benefits of increased consumption might only be achieved over long periods of time. The other problem is that Chinese citizens are reluctant consumers because of their need to save for retirement or health care due to the lack of a Chinese social safety net.
Also, Chinese workers are demographically dominated by those in their 40s and 50s who have the highest propensity to save, not spend. China has a shortage of younger people, who are more likely to spend, due to the “one child” policy that began in 1980. Thirty years after taking effect, that policy has depleted China of a large portion of its younger generation. China’s rebalancing effort would have been more effective around 2002 when the demographics were most favorable and before investment ran out of control into full-scale waste. That opportunity has now been lost.
Even China’s much vaunted export prowess will not be the engine of growth it was in the past because of low-cost competition for manufacturing and assembly jobs from even newer emerging markets such as Indonesia, Vietnam, Malaysia and the Philippines.
Finally, China is on the verge of a financial collapse of unprecedented magnitude. This is due to China’s policy of paying bank depositors low rates of interest in a manner similar to the U.S. Federal Reserve’s zero interest rate policy. These low rates send Chinese investors in search of higher yields elsewhere. Because of capital controls, Chinese citizens are not able to invest in foreign assets such as U.S. or Canadian stocks and bonds. The only investments available to most Chinese other than low-rate bank deposits are gold, real estate and so-called “wealth management products.” These wealth management products are offered by banks but are not guaranteed by them. Investor assets are pooled into the products and then invested in commercial projects with the proceeds shared among the investors.
The banks promise high returns on these products, which resemble the notorious collateralized debt obligations popular in the U.S. before the Panic of 2008. Actual performance on the wealth management products is below the promised returns in many cases. Banks cover this up by selling new products and using the proceeds to pay off the old ones. This is exactly how a Ponzi scheme operates.
Eventually some event such as a project failure or admitted fraud will start a panic in which investors demand that the banks redeem their wealth management products all at once. The banks will be unable to do so and will suspend redemptions on the products. Investors will claim that the products were backed by the banks but the banks will deny this. A run on the banks will commence that only government intervention and bailouts can contain. The result will be a general collapse in Chinese asset values for real estate, stocks and bonds as investors hoard cash, buy gold and move to the sidelines.
China’s growth is already overstated due to wasted investment and the hidden costs of pollution. Growth will slow even more as China tries and fails to move from investment to consumption in its growth composition. Finally, growth will collapse completely for a time, as financial panic grips the entire country.
Since China represents about 10% of global GDP, any problems in China will not stop there but will ripple around the world in dangerous ways. This could hit the U.S. in 2015, just as the U.S. debt and deficit problems begin to negatively impact our own economy. A continuation of the depression that began in 2007 is likely and a new more dangerous stage of the depression is possible.
Investors should be well-prepared for these scenarios with significant portfolio allocations to hard assets such as energy and transportation stocks, land, precious metals and fine art.
James Rickards is portfolio manager for the West Shore Real Asset Income Fund and the author of “The Death of Money” forthcoming April 8 from Penguin Random House. Follow on twitter @JamesGRickards