What to expect for the global economy in 2016? Part 2. An alternative view on the Chinese crisis

Nota bene :  As we write these lines, the Chinese stock market has extended losses that amount to -11% since the beginning of the year and contagion spread to the rest of the world. Negative data published on the Chinese economy, compounded by a lower fixing for the CNY by the People's Bank of China laid the ground for the market rout that is expected to extend over the next few weeks now that the circuit breaker mecanism has been removed by the regulatory authorities.  

Following our analysis of the economic outlook for the United States and the Eurozone we now adress the outlook for China.

China stands in a difficult situation at the beginning of this new year. All the economic and financial indicators are in the red. The last figures for the Caixin Manufacturing PMI reported by Markit Economics indicate that the situation is even getting worse : 

The Caixin Manufacturing PMI in China dropped to 48.2 in December of 2015 from 48.6 in November and below market expectations. While the reading was the lowest in 3 months, factory activity has been in a contraction since March. Production declined for the seventh time in the past eight months, driven in part by a further fall in total new work. Client demand was weak both at home and abroad, with new export business falling for the first time in three months. Manufacturers continued to trim their staff numbers and reduce their purchasing activity in line with lower production requirements. Meanwhile, deflationary pressures persisted, as highlighted by further marked declines in both input costs and selling prices. Manufacturing PMI in China averaged 49.40 from 2011 until 2015, reaching an all time high of 52.30 in January of 2013 and a record low of 47.20 in September of 2015. Manufacturing PMI in China is reported by Markit Economics.

A broader review of a range of indicators compiled by World Economics reinforce this vision of an economy that has lost its steam and that is struggling since 2012. One indicator that is especially revealing is the consumption of electricity that is roughly stagnating since Q1 2015 (cf. figure below). This contradicts the official estimation of GDP growth at 6.5% in 2015, a figure that is in itself well below the double digits growth of the 2ks, and even below the official target of 7% growth set out by the Chinese Communist Party in its last gathering. 

The Consensus has it that China is undergoing a laborious but much needed change of its growth model from an economy driven by manufacturing exports and fixed investment to an economy driven by the consumption of services .  This is the explanation for the Chinese slowdown according to 99% of the people asked to give their opinion about China - from financial economists to taxi drivers.

What if all these people were wrong ? What could then be the actual explanation for the puzzling Chinese crisis? (Let us skip the euphemistic word 'slowdown' still used by the Chinese officials and some international media).

My view is that China is not suffering from the exhaustion of a supposed model of growth that needs to be replaced by another model. Instead China is experiencing a severe but classical crisis that was induced by a real estate bubble followed by a credit crunch. Indeed, after the 2008-2009 financial crisis that led to the Great Recession in the United States and in Europe, China experienced a strong contraction in foreign demand for its manufacturing exports. In order to maintain the illusion of a double digits growth despite the extinction of one of its two main growth engines, the Chinese authorities turbocharged the second engine - fixed asset investment - through a gigantic credit expansion equivalent to 15% of its GDP.

However, this credit boom generated an accumulation of bad loans and a subsequent debt overhang. It is difficult to see how the government can deal with this situation without a massive recapitalization of the banks and of the other shadow banking vehicles that are now in a situation of quasi-bankruptcy. This is compounded by a huge Real estate crisis that has been unfolding over the last few months following overcapacity of residential floor space all over the country, especially in Tier 2 and Tiers 3 cities.

Much like the United States in 2006-2007, China experienced in 2014-2015 a silent but brutal reversal of its housing cycle, compounded by a financial crisis as most of the financial industry players extracted a large part of their income and profits from the real estate and construction sectors. It is even more severe than the US subprimes crisis in a way, as the Real estate sector was also used as a primary source of fiscal revenue by the Chinese municipal and provincial authorities through land sales transactions. Hence, the Chinese manufacturing recession and housing and banking crises are compounded by a looming public debt crisis. 

Given all that, it is no wonder that the Chinese growth rate fell well below pre-crisis levels. This has nothing to do with a supposed voluntary or involuntary change of economic model. China is experiencing a secular recession that has much more to do with what happened to Japan in 1991, to the East Asian economies in 1997, or to the United States in 2008. It has been demonstrated by many leading scholars and economists - cf. the work of Carmen Reinhart and Kenneth Rogoff or the publications of Olivier Blanchard - that after a financial crisis, growth rates tend to remain low for a long time in an economy. This is all the more true if the financial crisis has been provoked or compounded by a housing crisis. Hence, the deleveraging and restructuring process promises to be painful and to take many years.