Beating up on China’s economy has become a favourite pastime for some in financial markets.
To a growing number, the economy is a ticking time bomb – debt levels are sustainably high, it has an over reliance upon government infrastructure, the residential property market is in a bubble, as is the nation’s stock market. It’s all going to end in tears, the bears say, pointing to the example provided by Japan, another major economy that suffered a painful “lost decade” following the sharp unwind of its debt-fuelled economic miracle in the early 1990s.
While there are similarities between the two nations, albeit several decades apart, does that necessarily mean that China’s economy will suffer its own “lost decade”, or even decades?
Without answering the question directly – those who have attempted long range forecasting know all too well that it’s fraught with danger – Societe Generale’s cross asset research team, consisting of Patrick Legland, Daniel Fermon and Laure Fauchet, have produced an excellent note chock-full of excellent charts that attempts to assess whether China’s economy will fall into a Japanese-styled debt-induced funk in the decades ahead.
They look at the similarities, and importantly the differences, between the Japanese and Chinese economies in an attempt to determine whether history will yet again repeat, albeit on a much larger scale.
Here’s just three of their charts – evaluating potential bubbles in investment, property and stocks – that compares the two economies. It starts with the composition of economic growth.
The trio note that China’s reliance upon gross fixed capital formation, largely as a result of the government’s enormous infrastructure build, is unstainable at 45% of current GDP. In Japan it topped out at 36% of GDP in 1973, before steadily sliding lower as consumption growth took its place.
Based on Soc Gen’s assessment, they suggest that it will take many years to rebalance China’s economy.
“Investment is unusually high in China (45% of GDP), higher than it was in Japan and most other countries,” they wrote.
“Thus, it will take many years to rebalance the economy. Consumption is growing fast, but not fast enough to offset the decline in investment. Part of the slowdown is expected to come from property investment, which represents 15% of GDP.”
Next, they look at the similarities between the similarities between the property markets of each nation.
Like Japan in the late 1980s, Legland, Fermon and Fauchet believe that China is now in the middle of its own property crisis.
“With many cities facing oversupply and lower affordability, China is braced for a prolonged decline in property investment and prices which could slow GDP growth. Social housing and credit easing can only offset part of the slowdown in private investment. And like for Japan in the 1980s, the major risk is that property has been used as collateral for many borrowings,” they wrote.
While it’s well known that increased leverage can exacerbate losses in the advent of a downturn, Soc Gen note that Japan’s property bubble was concentrated in commercial property, rather than residential as is the case with China. They also point out that residential transactions require large down payments, and that China’s urbanisation rate still has a long way to go to catch up to levels seen in Japan prior to its property crisis.
The last bubble they eventuate is sure to be a favourite, particularly given the events this year: the infamous Chinese stock market.
While it took a total shellacking from June to August this year, losing 45% from peak to trough having run up more than 150% in the 12 months prior, Legland, Fermon and Fauchet note that there is a significant difference between the bear market seen in China and the mammoth, multi-decade bear that is still unfolding in Japan: the sheer size of the bubble.
“In 1989, Japan’s market capitalisation to GDP had reached an unsustainable level of 145%,” they point out.
“The Chinese ratio is much lower today at 55% (down from 80% mid-2015). Thus the equity bubble is relatively small compared to the size of the economy, and valuations have normalised somewhat (P/B: 2x). As equity financing is key for China’s debt deleveraging, capital market reform should not be sacrificed for short-term stability.”
Although there are similarities and differences between the three bubbles, Soc Gen stop short of stating whether China is likely to suffer the same fate as Japan.
Looking ahead, they suggest that fiscal easing and infrastructure investment will to continue to support growth in the near term, although it’s only likely offset some of the structural slowdown. They also believe that fiscal easing, rather than monetary policy easing, will be a more effective measure to boost growth in the years ahead. Soc Gen also expect the PBOC will continue to devalue the renminbi, albeit in a “largely controlled manner”.
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