OK, so that wasn’t the exact title of the IMF’s paper from the end of last year – it was Investment-Led Growth in China: Global Spillovers – but you get the gist. First a little preamble. Many people who were China bears last year have become less bearish or even outright bullish, no doubt on the back of an improvement in Chinese economic data and a corresponding rally in China’s equity markets.
But I don’t think the better data – if you believe the data – should inspire confidence, and you could actually argue the opposite: the growth rebound in China is likely due to yet more government-encouraged unproductive and unprofitable lending.
The quality of China’s growth has become increasingly poor, and the rate of growth is utterly unsustainable. The bigger the bubble, the bigger the eventual bust.
Morgan Stanley’s Ruchir Sharma wrote a piece in the Wall Street Journal this week about how China’s total and private debt has exploded to over 200 per cent of GDP and how the Bank of International Settlements has previously found that "if private debt as a share of GDP accelerates to a level 6 per cent higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress".
In China, private debt as a share of GDP is now 12 per cent above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the US in 2007 and Spain in 2008.
The IMF has long been warning of the threat posed to global financial stability by the great Chinese credit bubble, and its study on global spillovers referenced above makes interesting reading.
It estimates that for each percentage point deceleration in China’s investment growth, 0.5 to 0.9 per cent is subtracted from GDP growth in regional supply chain economies such as Taiwan, Korea and Malaysia.
Commodity producers such as Chile and Saudi Arabia are also likely to suffer substantial growth declines while countries such as Canada and Brazil would experience a "somewhat significant output loss and slowdown".
There would be "a substantial impact on capital goods manufacturing economies such as Germany and Japan", and one year after the shock, commodity prices, especially metal prices, could fall by 0.8 to 2.2 per cent from the baseline levels for every 1 per cent drop in China’s investment rate.
So what kind of correction in China’s investment growth rate is likely?
China’s growth in fixed investment from 2002 to 2011 was 13.5 per cent per year, a rate that greatly exceeded China’s GDP growth rate and meant that fixed investment is now running at about 50 per cent of China’s GDP.
No major countries have sustained such a high investment rate as a percentage of GDP – since 1960, the only countries to have managed a ratio of more than 50 per cent for at least two consecutive years are Republic of Congo 1960 to 61, Botswana 1971 to 73, Gabon 1974 to 77, Mongolia 1981 to 87, Kiribati 1982 to 83 and 1985 to 90, St Kitts & Nevis 1988 to 90, Lesotho 1989 to 97, Equatorial Guinea 1994 to 98 and 2000 to 2001, Bhutan 2001 to 2004, Azerbaijan 2003 to 2004, Chad 2002 to 2003, and Turkmenistan 2009 to 2010.
Judging by other countries at China’s stage of development, a more reasonable investment/GDP ratio is maybe 30 to 35 per cent.
Achieving this ratio will require a sharp drop in China’s investment growth rate to perhaps mid-single digits, and if China’s slowdown proves to be hard rather than soft, then the investment rate will likely fall even further.
Taking two other post-bubble economies in the region, Japanese investment growth has been negligible since the early 1990s, while Korean investment growth has averaged low single digits since the mid 1990s.
According to the IMF’s model, a drop in Chinese investment growth from 13.5 to 4.5 per cent implies a 4 to 7.2 per cent hit to the GDP of countries such as Taiwan, Korea and Malaysia. Some commodity prices would fall by almost 20 per cent. Ouch.
If you want to get extra gloomy, you can also consider that such a large economic shock would also be accompanied by a reversal of the huge decade-long emerging market equity and bond inflows to the region, which is something else that the IMF has repeatedly warned about
It is quite easy to see how a Chinese rebalancing and slowdown can develop into an Asian/ emerging market financial crisis.
Mike Riddell heads up three portfolios at M&G: Emerging Markets Bond, International Sovereign Bond and Index Linked Bond.
Performance of manager vs peers since Feb 2010
Source: FE Analytics
He has returned 27.17 per cent since he started running the funds in February 2010, compared with 21.35 per cent from his peer group composite.
All three of Riddell’s funds have outperformed their sector over three years.