September 23rd, 2015 | By Nick Sargen
Among the challenges investors face in assessing China's prospects are a wide range of views about the economy and financial system. Many observers discount the official statistics that show the economy growing by 7%, considering that "hard data" such as manufacturing activity, electrical generation, and exports suggest much weaker growth. Capital Economics, for example, estimates growth is between 5%-6%, while Citi's economists believe the likely number is 4% or less. The counter-argument by China optimists is that the economy is transitioning towards services, which is faring much better than manufacturing.
Faced with a disparity of views, market participants have been looking at a range of indicators to draw inferences about China's economy. The most compelling evidence of weakness is broad-based declines in commodity prices, which have contributed to recessions in Brazil, Russia, and Venezuela, and sluggish growth in Australia, Canada, and South Africa. Meanwhile, South Korea and Taiwan have experienced steep declines in exports as a result of diminished demand from China.
Recent actions by Chinese policymakers to prop up the stock market and to alter exchange rate policy have added to concerns among investors. In my view, however, they are side shows. The slump in China's stock market, for example, has not fully retraced the run-up that occurred previously, and the linkages to the economy are not particularly large. Similarly, while the change in exchange rate policy was described in the press as "the largest devaluation in two decades", the Chinese currency's cumulative decline is in the vicinity of 3%, which is insufficient to matter.
As discussed below, the case for a "hard landing" in China comes down to whether a slowdown in investment demand will be offset by increased consumption, and the extent to which problems in the property sector will adversely impact financial institutions.
The case that Citi's economists make for Chinese growth to weaken significantly begins with the premise that the huge expansion in credit that occurred during the 2008-09 global crisis left the country with excess capital that has been poorly allocated. The so-called mal-investment is evident in a steady rise in the incremental capital output ratio (ICOR) from 2.6 for the period 1979-1996 to 4 for the period 1997-2013 , with estimates as high as 6 or even 8 in recent years. Over this entire period, the ratio of fixed capital expenditure to GDP rose from less than 30% to nearly 45%.
According to Citi's economists, a reduction in the share of fixed investment in GDP by 10% is overdue, and the question is whether this reduction can be achieved without overall demand weakening. In Citi's view, monetary and credit policy have limited power, because the corporate sector is highly levered and the banking and shadow banking system have extremely weak balance sheets. Also, while Citi's economists anticipate future cuts in interest rates and in the required reserve ratio, they contend benchmark lending and deposit rates have little impact on interest rates set in the markets:
"The boost in infrastructure and SOE investment since 2008 has been subject to severely diminishing and at times negative returns…A reduction in the share of investment in GDP by 10% is overdue… The question is whether the reduction in investment can be achieved without Keynesian aggregate demand damage."
Citi's economists conclude that a large fiscal stimulus on the order of 3% of GDP, which is targeted to boost consumption and financed by central bank purchases of government debt, would probably be sufficient to stave off a recession. However, they do not believe policymakers are prepared to undertake such measures. In their view, the most likely outcome is a growth recession, in which China's growth rate would reach or fall below 2% by mid-2016. This, in turn, would be accompanied by further declines in commodity prices, which would adversely impact commodity exporters and countries that export heavily to China.
In a recent commentary, emeritus Professor Robert Z. Aliber, a renowned expert on asset bubbles who has made several prescient calls over the past 40 years, presents a more troubling prognosis for China's economy and financial system. He maintains that China's growth model, which was predicated on Japan's development strategy, is confronting problems in the real estate sector and financial sector that are reminiscent of what happened to Japan in the 1990s.
A major problem is the overhang of unoccupied apartment units, which Aliber estimates to be in the range of 10-20 million units, the equivalent of 5% to 15% of China's urban housing stock. This development is a legacy of the government's efforts to provide affordable housing for millions of Chinese people who migrate to cities each year, as well as of speculative demand for real estate that has resulted in a huge disconnect between house prices and very low rental rates: "The incomes of these individuals do not allow them to pay higher rents; the disconnect between house prices and rents reflects that prices have increased in a speculative froth." One sign of economic weakness is that demand for housing appears to be slowing, especially in second and third tier cities, and Aliber foresees the possibility that pressures on property prices could ultimately rival that in Japan, which declined by 75%-80% in the 1990s. (Note: Aliber points out that Japan did not have a significant number of unoccupied apartments when its bubble burst.)
More generally, Aliber believes China is beginning an extended transition period in which the economy adjusts to imbalances that developed over the past 30 years of highly rapid growth. One of the problems he foresees for the financial system is that banks made numerous loans that were unprofitable, but firms remained in business because there was an ample supply of credit. He estimates that the imbedded loan losses of the banking system is 20% to 30% of bank assets. This does not mean the country's financial system will necessarily collapse, as he anticipates the Chinese government will socialize the losses by infusing capital into the financial system. Nonetheless, this will take a heavy toll, as he predicts the ratio of government debt to GDP could rise from 50% to 200%-250%. In such a scenario, Aliber estimates the decline in business investment as a share of GDP could be 15 to 20 percentage points. Also, if housing stats fell to 3 million units per year from 8 million currently, GDP would be essentially flat.
Thus far, the sell-off in risk assets primarily reflects concerns about a slowdown of China's economy and associated spill-over to other emerging economies. The market angst has been fueled by weak economic reports for China, across-the-board declines in commodity prices, and a series of policy mistakes. Financial markets, however, have not priced in the prospect of low economic growth foreseen by Citi's economist or zero growth as envisioned by Robert Aliber. Therefore, these scenarios represent outliers that investors need to weigh when basing their decisions.
One way of approaching the investment decision is to assign probabilities to various outcomes, as are shown below based on Citi's research:
However, my own take is that the lack of transparency about China's economy and financial system makes it virtually impossible to assign precise probabilities to these outcomes. In short, investors confront genuine uncertainty (in the Frank Knight sense) about how China will play out. Recognizing this, I would simply make the choice as follows:
Weighing these possibilities, we are comfortable overweighting credit risk in bond portfolios, because credit spreads are attractive. However, investors may wish to consider paring back risk in equity portfolios, where valuations are less compelling.
 See Michael Pettis' blog, China Financial Markets, "What does a "good" Chinese adjustment look like?" September 2014.
 See Robert Z. Aliber, "One More Note on China", (preliminary) September 6, 2015
 Ibid, p. 15.
 Aliber is a co-author with Charles Kindleberger of the classic Panics, Manias and Crashes, and he is currently writing a book on the causes of asset bubbles and financial instability.