Given the rally in the markets from the start of the new year, a friend and I were discussing the likely direction of the markets. Now, we aren’t chartists nor are we professional economists or analysts* but my friend has a good sense for business and I…, well, I read a lot.

He was wondering about the potential implications of a slowdown in the Chinese economy and its impact on the world economy, and by extension, the world’s stock markets.

Based on what I’ve read, I think some serious shit could happen and I’ll lay out the conditions for it.

The Chinese Economy

It’s no secret that China’s economy is slowing down. It’s also no secret that the Chinese government has been trying to transition the Chinese economy from an investment-driven one to a consumer-driven one.

To a certain extent, China has been pretty successful in helping Chinese companies grow and gain the technological capabilities necessary for them to be world-class competitors.

If we just look around us today, many Chinese brands like Alibaba, Huawei, and Xiaomi have sizable shares of their respective industries. Within Asia, countries like Tencent (which owns the all-in-one app, Wechat) has also become so entwined with people’s lives that it’s going to be hard for their Western counterparts to gain a foothold. So, the bottom line is that it’s no secret that China’s investment-driven strategy has produced some results.

However, what many people outside of China probably don’t realise is how the Chinese government directed investment spending in China. It turns out that the Chinese government was leaving it up to the banks and its related entities.

And while the rest of the world recovered, this worked fine. Unfortunately, the returns started to slow down once the low-hanging fruit was picked and obviously, lots of money has been either lost through corruption or just bad investments.

The best examples of this are how much money was flowing into overseas property markets like Canada’s and Australia’s or how Chinese companies with non-existent business models (think bike-sharing firms like Ofo) expanded in so many markets so quickly.

In short, to paraphrase the Washington Post article in the link above, China’s debt-fuelled stimulus is getting less and less effective. Which brings us to the better question: What’s next?

China’s Gameplan

I’m not an expert on China but if I had to guess, China realised that returns on investment were slowing down due to diminishing returns and/or corruption were those who had access to the money were just misappropriating it and moving the money overseas into property and other forms of wanton spending.

Therefore, their solution to “pay off” the debt that was circulating in the economy was to have their domestic economy take over. If their households started to consume more and take on more borrowing in order to do so, the previously issued debts of the firms could be “rolled over” into newly created debts that would be borne by the consumers.

The second thrust would be for Chinese firms to expand overseas as much as possible to earn foreign currency. This would directly help pay off the debts created as it would be a return on the investment.

The third thrust is to have the RMB become more widely accepted as a reserve currency which is pretty much a variant of the first strategy as the world takes on more debt which “offsets” the amount of debt owed by Chinese firms.

What Could Go Wrong?

As 2018 showed, the Chinese consumer is not exactly picking up the slack from the firms. Although in part due to Trump’s trade war and the Huawei situation, Chinese consumer spending is projected to slow and evidence of it is showing up in the projected fall in iPhone sales as well as the drop in car sales.

As for the second thrust, Trump’s trade war, as well as a projected slowdown in most major economies, is making this strategy a no-go. Ofo looks like it’s preparing to go bankrupt which shows you how tight credit is in the startup space.

The third thrust is also unlikely to work even with China’s “One Belt, One Road” idea because that idea pretty much depends on China lending money to developing countries to build all sorts of infrastructure like ports and railroads. This means taking on more credit risk for the Chinese financial system which is the opposite of what China needs.**

Conclusion

Don’t get me wrong. It’s not like I don’t want China to succeed. China’s economy slowing will mean a lot of pain for the rest of the world. After all, it is the world’s second-largest economy. Much of Asia also depends on China to buy raw materials or supply us with goods.

What I’m saying is that China needs a lot to go right for it to restructure its economy and given the state of affairs in the world today, it really needs Trump to stop his ridiculous trade war and the fed to loosen credit so that Chinese firms can breathe easy.

Notes:
*Well, not likely those guys are likely to be any more accurate.
**Lending money to third world countries for infrastructure projects in which neither borrower nor lender has much experience executing is a disaster. China may have another agenda through this but that’s another story altogether. See Sri Lanka’s experience with their Hambantota port.

Advertisements