The most interesting note I have seen on China for a while has just come out of Pivot Capital ( http://www.pivotcapital.com/reports/Chinas_Investment_Boom_the_Great_Leap_into_the_Unknown.pdf ). This paper contends that it will become harder for China to fund or justify its recent infrastructure led boom and this will induce a step change in its growth trajectory, along with a series of knock-on affects in the commodities market, resource exporting nations, and Asian economies.  

China: A Capex Boom

Capital spending has become the dominant growth driver in China. In both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods (e.g. postwar Germany and Japan or South Korea in the 1980-90s). Pivot Capital estimate that GFCF (Gross Fixed Capital Formation, a broad definition of investment) accounted for 70% of China’s growth in 2008 and close to 90% of China’s growth in H1 2009. Amazingly, the ratio of GFCF to GDP is expected to exceed 50% this year, which would be well above the highest GFCF to GDP ratio any Asian country reached in their mid 1990s booms. The longest period any country maintained GFCF to GDP in excess of 33 % was nine years (Thailand 1989-97, Singapore 1991-99, chart 3). China is now in its twelfth year. 

Chinese Investment

Chinese Investment

Investment Efficiency 

However, the  efficiency of China’s investments is decreasing. In the third decade of expansion, the Incremental Capital Output Ratio (defined as the ratio of Gross Fixed Capital Formation to GDP divided by real GDP growth – the lower the ratio, the more efficient capital spending is at generating growth) in China has markedly deteriorated compared to the previous two decades, as well as to other high-growth countries in their pre-peak investment stages. In 2009 China’s ICOR will be more than 2 times higher than the 80s and 90s average.  

Investment Efficiency is Falling

Investment Efficiency is Falling


China is also an outlier compared to the other “BRIC” countries in terms of the credit to GDP ratio (140% as of H1 2009) and is already beyond the levels that historically have led to sharp and brief credit crises in the past. If loans continue to grow at the current 35% rate, credit to GDP ratio will be close to 200%  in 2010, even with GDP expanding at 10%. This is a level similar to the pre-crisis Japan in 1991 and USA in 2008. All this indicates that credit in China is not going to be able to grow for much longer without risking a major crisis. 

Credit Efficiency: 

The effectiveness of domestic Chinese credit in generating growth is collapsing. In the period from 2000 to 2008, it took on average $1.5 of credit to generate $1 of GDP growth in China. This compares very favourably with the peak $4 of credit for $1 of GDP in USA in 2008. However in H1 2009 in China this ratio was already at around $7 to $1. 

Credit Efficiency

Credit Efficiency

Government Debt: 

But they can afford it right? China’s government does not have much explicit debt (23% of GDP) and sits on $2tn worth of foreign exchange reserves. However, not included in the public debt figures are the liabilities of the local governments, which the Ministry of Finance estimated at $680bn as of the end of 2008. In addition to that, a large part of the loans extended this year (estimated at $350bn) went to finance public infrastructure projects guaranteed by local governments. Furthermore, when the Chinese government bailed out its banking system in 2003, it set up Asset Management Companies that issued bonds to the banks at par for the non-performing loans that were transferred to them. These bonds, worth about $260bn, are explicitly guaranteed by the Ministry of Finance and the Central Bank and sit on the balance sheets of the big four banks. The Chinese government also explicitly guarantees $400bn worth of debt of the three “policy banks”. In total, these off-balance sheet liabilities are equal to $1.7tn, which would bring China’s public debt to GDP ratio up to 62%, a level that is comparable to the Western European average. 

 Not only that, but how much could the Chinese central bank actually spend?  

Looking at the sum of local money and gross external debt we see that M2 monetary aggregate in China is $8.4tn (which is higher than M2 of $8.3tn in the US) and it is currently growing at 28%. China’s gross external debt was $374bn as at end of 2008, which in Emerging Market space is second only to Russia in size. Compared to a sample of Emerging Markets, China’s reserves in relation to its liabilities are not that spectacular so in that sense China is perhaps technically not in a position to “spend” its reserves. 

Chinese Reserves Coverage Ratio

Chinese Reserves Coverage Ratio

In conclusion, capital investment and credit growth in China have reached critical levels and their effectiveness at boosting growth is falling.

But where has all this money gone? Into more infrastructure & more manufacturing capacity.

Manufacturing Capacity: 


China currently produces 500mn tons of steel, more than EU, Japan, US and Russia combined. According to the Ministry of Industry and Information Technology, China has capacity to produce 660mn tonnes per year, meaning that idle capacity in China is about the size of capacity for Japan and South Korea combined. In addition, there are 60mn tonnes of additional steel capacity currently under construction. 


At 1.35bn tonnes, China consumes more cement than the rest of the world combined. China’s estimated spare capacity (about 340mn tonnes) is more than the consumption in India, USA and Japan combined. 

Chinese Steel Production

Chinese Steel Production


China accounts for more than a third of the world’s capacity and production of aluminium. Out of China’s 15mn tons of capacity more than 1.5mn tons are idle which is just about the same level as the total aluminium capacity of Brazil or India. China’s position as the world’s largest aluminium producer is all the more astonishing given the lack of surplus cheap energy typical of specialized aluminium exporting nations (e.g. Iceland, Canada or Russia). 


China is the world’s second largest energy consumer, and unfortunately also one of the least efficient when measured by energy consumption: per unit of GDP. By this measure China consumes close to six times more energy than Italy and three times more than the USA. Heavy industry is notoriously inefficient with China’s steel makers using on average 20%, cement manufacturers 45% and ethylene producers 70% more energy per ton of output than producers elsewhere. 

Chinese Aluminium Production

Chinese Aluminium Production

Real Estate & Urbanisation: 

At a reported 45%, China’s urbanisation rate is low not only compared to the rates of 70-80% for developed countries, but also to the world average of 50%. If China was to reach the urbanisation rate of Russia (73%) in the next 40 years, it would need to add a city the size of New York every year. However, the numbers are not neccesarily what they seem. China’s definition of an urban centre includes, amongst other things, population density of above 1,500 people per square kilometre. By that definition Western cities like Houston (2.2m people with density of 1,375/km2) or Brisbane (1.9 m people with density of 918/km2) could technically not be counted as cities. Perhaps more pertinent, a lot of the Chinese so-called “villages” and “townships” are in fact highly industrialised. Qiaotou, home to 64,000 people, produces 60% of the world’s buttons and 70% of its zippers. Songxia with 110,000 people is the umbrella capital of the world: it produces 500mn umbrellas per year. According to a recent OECD report4, “…there are likely many more villages and undesignated towns in China that would in most OECD countries be formally designated as towns, and far more towns, both statutory and undesignated, that would be administratively defined as cities. The scale of China’s urbanisation is therefore likely to be considerably understated by official definitions.” 

Real Estate Prices 

While market prices ranging from $600-1,000/m2 in the regions to $2,000-3,000/m2 in major cities may not be absurd in a global context, affordability ratios would indicate we are in uncharted territory. Price to income ratios have reached 15-20 times in major cities and around 10 times in regional cities. This compares with 9 times in London and 12 times in Los Angeles at the peak. 

Chinese House Prices to Income

Chinese House Prices to Income

Planes, Trains, and Automobiles 

China is geographically about the same size as the US. The Chinese population is strongly centred in the east and the south of the country whereas the US is more evenly distributed. 

Currently, there are 4.2mn kilometres of paved roads in the USA, of which 80,000 km are expressways. China has 2.7mn kilometres of paved roads, of which 60,000 km are expressways. Currently there are 250mn vehicles in USA versus 43mn vehicles in China. 

In total there are 600,000 bridges in the USA, of which 450,000 are in use. There are currently 500,000 bridges in China, with 15,000 bridges built every year for the past decade. These numbers are especially astonishing given that the USA has 5 times more rivers than China. Six out of the top ten longest conventional bridges and a spectacular half of the top 10 longest suspension bridges are in China. 

China’s 80,000km of railway tracks puts it into the third position globally (after the USA at 226,000 km and Russia at 84,000 km). In theory China could approximately double their rail capacity to approximate US railroad saturation. Planned railway infrastructure spending for the years 2009-2012 is projected to be USD 420bn, which would be enough to build 63,000 km of rail network. 

All in all it seems at least possible (likely?) that China will be unable to continue to drive growth through capital investment in the medium term. So what will replace it? 

Will Private Consumption Replace Capital Expenditure? 

Private consumption in China currently accounts for about one-third of GDP. If we assume optimistic investment growth rates of 10% for 2010 and 0% for 2011, leaving the trade balance where it is now, private consumption would have to grow at an average real rate of 20-30% for the next two years for overall GDP real growth levels to hit the magic 10%. For comparison, average real consumption growth rate averaged 8.2%, a full 1.3% lower than the real GDP growth rate in 1997-2007. This means that private consumption would have to grow at anywhere between 3 to 4 times faster than in the past decade to compensate for the this retraction in investment. 

Can Chinese Consumers Afford to Spend? 

The headline unemployment rate of 4.3% only takes into account urban people registered as unemployed and may be a poor reflection of reality. The Chinese Academy of Social Sciences performed a study in mid 2008 that estimated the urban unemployment rate to be 9.4%, more than double the official headline. Then there are 140- 160mn migrant workers, as well as unemployed people in rural areas. Estimating the true level of unemployment is practically impossible. However, aAlmost 1mn graduates from the class of 2008 are still unemployed, and according to surveys about 60% of this year’s 6mn graduates have not found work yet, an indicator that unemployment is a problem for the white collar urban workers. Furthermore, the latest PBoC survey of 20,000 households from 50 cities carried out in Q2 2009, stated that a record low 8.6% of the surveyed sample considered their income “adequate” (this is down from 32% in Q1 2007). This is hardly star material for the consumption boom starting in China. 

It is hard to over-emphasize what this shift to consumption-driven economy means for China’s overall growth rates. On a simple mathematical level it means that average growth rates are going to be capped at 7-8%, so that the overall economy grows at 5-6% for the foreseeable future, and probably slowing down even more later on. It also has enormous consequences on what China imports from the rest of the world as it shifts from commodity and capital goods heavy into (most likely locally produced) consumer goods and services driven economy. 

Pivot Capital’s Predictions: 

Based on activity patterns and the timing of the various stimulus efforts we believe that Chinese y-o-y growth will slow down already in Q1 2010 and that the decline should accelerate in Q2 2010. Anything that is cyclical and dependent on Chinese investment demand would obviously be the most vulnerable to a Chinese growth disappointment. That would include industrial commodities as well as equities and credit of industrial and consumer cyclicals.

Some more debate on the pros and cons of a possible slowdown in China’s GDP can be found here: http://duncanseconomicblog.wordpress.com/2009/08/05/chinas-growth-pettis-vs-ross/ and here: http://ablog.typepad.com/


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