Is China's Miracle Coming To An End?

David Sterman's picture

Tuesday, January 7, 2014 - 10:00am

by David Sterman

Give credit where it's due. Ever since China's government pursued vigorous reforms 35 years ago, the country's economic growth rate has been simply remarkable.

According to the World Bank, roughly half a billion Chinese people have been lifted out of poverty, and the economy is now 90 times larger than it was back in 1978

Rumors of the imminent demise for this growth machine in recent years have been clearly premature. I noted these concerns more than two years ago, as have noted short seller Jim Chanos and others, and the Chinese economy has still managed to grow more than 7% annually.

In fact, the Chinese government believes that this economy will grow an impressive 7.5% in 2014 as well, which would still be the most impressive growth rate in the world.

Trouble is, recent signs point to decelerating growth, perhaps closer to 5%, which would create a drag for the dozens of economies that consider China to be their major trading partner. The trouble spots include local government debt, an increasingly uncompetitive wage structure and a tricky set of adjustments that the government is making to shift toward domestic consumption.

Document 107
In recent years, unregulated financial entities have been making ever larger loans to local governments and businesses, and concerns are growing that such entities may soon face a wave of loan defaults. In response, the Chinese central government issued a seven-page memo in early December known as Document 107, which was aimed at a runaway shadow banking sector. As Nomura Securities economist Zhiwei Zhang told The Wall Street Journal a few months ago: "Local government debt has been growing at a speed of nearly 20% a year in the last couple of years. If this trend continues, it will definitely bring about systemic risks for China's economy."

How scary are the numbers? China's ratio of total debt to GDP, including government, corporate and household debt, now exceeds 200% of GDP, which is nearly twice as high as five years ago, according to debt ratings agency Fitch. China aims to break that cycle before it spirals out of control, yet as it applies the brakes, some debts that had been rolled over will simply default.

No Longer A Bargain
In recent months, investors have also been hearing that many U.S. firms have begun to "insource" their production, reducing capacity at Chinese manufacturing plants and boosting them at U.S. plants. That's because Chinese wages have been steadily rising, and when you add in other factors such as shipping costs and lead times, China is no longer the bargain it once was. According to China's National Bureau of Statistics, wages in the China's manufacturing sector have risen 71% since 2008.

To be sure, the U.S. will never again be home to the lowest-cost jobs that China was once known for. Instead, these kinds of jobs are increasingly migrating to lower-cost countries such as Cambodia, Vietnam and the Philippines. 

The Chinese government has been actively pursuing a policy of higher wages. Policy planners hope to reduce capacity in some industries, especially those that produce high levels of pollution, and higher wages bring the added benefit of higher domestic consumption. 

Over the long term, higher domestic spending and slower export growth would make China a much more appealing global trade partner. But the government, by promoting this shift too rapidly, runs the risk of slowing the economy too quickly. 

The only way to handle this transition smoothly is to help bolster service-oriented businesses to offset any weakness in the manufacturing sector. Yet the service sector is starting to cool. Four separate gauges of purchasing activity (in both the service and manufacturing sectors) all showed signs of slowing in December. That's the first time that all four have showed a simultaneous pullback in since last April.

Perhaps the greatest hope for China in 2014 is a resurgent global economy that boosts demand for China's goods. Yet the global economy is counting on China for the same kind of boost. Depending on how the chips fall, this could prove to be a virtuous cycle or a vicious cycle.

Risks to Consider: As an upside risk, China will intervene with fresh stimulus if the economy cools too quickly. Previous slowdowns have been met with vigorous policy responses, so the chances of a steep erosion in the Chinese economy are limited.

Action to Take --> The Shanghai Composite Index, China's equivalent of the S&P 500, has fallen to five-month lows, reflecting concerns of a slowing economy. Indeed, the country's current target of 7.5% GDP growth in 2014 is looking like more of a stretch. If growth falls short of that target by a few percentage points, investors are likely to grow concerned that the government has lost its ability (or desire) to maintain this economy's remarkable winning streak. 

The slowdown would surely be felt by the hundreds of U.S. multinationals that now count on China as a key growth market. Expect to hear more about this during the upcoming earnings season. If you've been tempted to invest in China, now that its market has fallen more than 15% from its February 2013 highs, you should wait. It's better to see how this cycle plays out, as you may have a chance to buy Chinese stocks at lower prices in the year ahead.

P.S. It's great to have an idea of what to expect from China over the next few months, but how can investors profit from these trends? That's where StreetAuthority's newest advisory, High-Yield International, comes in. Nearly 80% of the world's best-yielding stocks are outside the U.S., and we have no shortage of these cash cows to bring you -- such as one Canadian automaker that returned nearly 30% last year while paying a 14.2% yield. To learn about more big yields from overseas, click here now.


David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.