China is desperate to avoid a hard landing in the form of negative GDP growth. So far, we are a long way away from hitting rock bottom.
Even with today’s growth numbers for the third quarter of 2014 coming out at 7.3 percent and therefore below the 7.5 target set by the regime this is not a hard landing—yet.
Unfortunately for China, however, Ernest Hemingway might see his words about bankruptcy ring true again. In “The Sun Also Rises,” someone asks: “How did you go bankrupt?” To which the other person replies: “Two ways. Gradually, then suddenly.”
As of this moment, China is slowing gradually, down from 12 percent in 2010 to the lowest rate since the financial crisis in 2009.
Real numbers, however, point to even lower growth. Bloomberg’s estimate of Chinese GDP, consisting of data such as electricity consumption and cement production, estimates growth to be at 6.4 percent.
But why would growth slow even further, and how could China go bust? After all it owns more than $4 trillion in foreign exchange reserves.
To answer these questions, one has to understand that Chinese “miracle” growth was fueled by an unprecedented expansion of private, not public debt.
Goldman Sachs estimated total Chinese debt to GDP to reach 242 percent in 2014. That’s $22.36 trillion for GDP of 2013. In a default case, foreign exchange assets of $4.4 trillion aren’t going to be enough—and that’s beside the technicality that they are foreign and can’t be used to extinguished debts denominated in yuan.
Of course, there are numerous ways China can manage that debt, by printing more money for example. However, real growth will still decline because that debt has been “invested” in mostly unproductive ventures by the private sector. Of the 242 percentage points, 169 were racked up by the private sector mostly for unused houses and excess production capacity.
To illustrate, China now has 1,647 shipyards compared to 10 in South Korea and 15 in Japan. As for real estate, the amount of floor space under construction relative to floor space sold across 40 cities has increased from 3.4 times in 2007 to 5.8 times in 2013, according to the National Bureau of Statistics.
This would all be ok, if the assets underpinning the debt actually earned a return. The beauty about this model is that new construction, whether it is shipyards or houses, shows up as GDP straight away. However, continuous production, GDP and return on investment needs a feasible project.
Empty houses and underutilized shipyards do not fit that bill. If the investments don’t return a cash flow, the borrowers (mostly private enterprises) firstly won’t have the money to repay the debt and secondly won’t have the money to invest more in the future. Hence the decline in fixed asset investment growth by private enterprises from 35 percent in 2012 to below 20 percent in 2014.
As of this moment, most borrowers are just reducing investment activity and are still servicing their debt. However, we have seen the first defaults of private companies in China already at the beginning of the year. This process is called deleveraging. It entails getting rid of unproductive debt and unused assets, sometimes through bankruptcy, and starting over.
The longer the slump drags on, more companies will reduce investment and default on their debt. Then the whole deleveraging dynamic will change from gradually to suddenly very abruptly.