China’s markets are tumbling again as its economy continues to show signs of weakness. And while China’s government will intervene strenuously to reverse this, the unavoidable truth is that the country’s economic growth will continue to decelerate from its current 7% to a significantly lower growth rate — perhaps near zero. Indeed, it could come to look very much like the kind of near-zero growth that Japan has been experiencing since the 1990s.
With the recent plunge, the Shanghai Index is down more than 38% from its June peak, but it is still up almost 44% from a year ago. With this in mind, some analysts believe China’s stocks actually remain at high valuations.
But stock markets are generally a secondary indicator, and the real issues are better reflected in the growing list of concerning reports on China’s underlying economic trends. Auto sales actually declined 3% in June. Sales of smartphones are down 4%. Manufacturing surveys show contraction, and producer prices have now fallen for three consecutive years. Though the official GDP growth rate is still 7%, many economists estimate that it is closer to 4%, and one suggests that GDP growth is now negative.
Since 2008, China’s businesses have been on a borrowing and building binge, amassing the highest level of overcapacity and bad debt in history.
As one example, more than one in five homes in China’s cities is empty, with 49 million sold but vacant units, and 3.5 million homes that remain unsold . Meanwhile, private debt has grown by $15.5 trillion, making what I now estimate is an astonishing $2 trillion to $3 trillion in problem loans in the process. Private debt to GDP in China now stands at 215%, well above still-high private debt levels in the United States, the Eurozone and Japan. And a rapid rise in private debt has been the principle factor in essentially all major financial crises, from Japan’s in 1991, to Asia’s 1997 crisis and to the 2008 crisis in the United States and Europe.
The fact of China’s overcapacity will inevitably bring continued deceleration — probably for years — since if it already has far too much real estate, iron, steel, aluminum and other commodities, business activity must slow down while demand catches up. And for that same reason, there will continue to be downward pressure on nonagricultural commodity prices. Even oil prices are impacted in this downdraft.
True, China will move assertively to stem China’s stock market and GDP decline, but this is no easy task. For example, the People’s Bank of China is now considering a half-percentage-point reduction in banks’ reserve-requirement ratio, potentially releasing over $100 billion in funds for banks to make loans. Though this may temporarily buoy the perceptions of market participants, it won’t make any durable difference. More lending is not the antidote, and even if it were, the amount being freed up with this reported move is immaterial.
This contemplated action follows a massive campaign to prop up stocks: China has suspended new IPOs, injected funds into state-owned entities that lend to brokers to purchase shares, extracted pledges from brokerage firms to buy shares, relaxed margin requirements, allowed apartments as collateral for margin loans, banned stock sales for large owners and vilified short sellers. And it will surely pull even more levers to try a prop up its markets.
But even if China’s policymakers have short-term success in this regard, overcapacity levels are so large that the economy will continue to decelerate, commodity prices will remain under pressure and markets will eventually and inevitably seek their own level.
And the world is feeling the effects of China’s woes.
Throughout the Asia/Pacific region, countries have built an overdependence on China’s demand for their exports, incurring large amounts of their own internal private debt in the process. The combination of China’s slowdown and devaluation is bringing the specter of crisis to these countries. Countries throughout Africa and South America are facing a similar plight. Corporations in the United States and Europe will be less impacted, but China is now so large that many of them will also feel some measure of this pain.
How should China address its problems? The reality is that there is no quick fix. But since high private debt levels and overcapacity brought these problems, then addressing high private debt and overcapacity has to be central to the solution. China should prudently slow lending and growth, allowing demand to begin to catch up with overcapacity.
But it also needs to require its lenders to broadly restructure debt with overburdened corporate borrowers — leaving them better positioned to lead a more measured growth after the slowdown.
Ultimately, programs to systemically restructure private debt are the crucial missing link to restored financial vibrancy. Yet because the crucial and central role private debt plays has not been widely recognized, this approach to crisis management is absent from almost everyone’s thinking.
That’s a big problem. And it means unless there is a change in mindset, we may have to get used to the sort of roller coaster ride we saw in trading Monday. Or even worse.
Richard Vague is a managing partner with Gabriel Investments and the author of The Next Economic Disaster. The views expressed are his own.