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Delfeld: The China Skeptic

 In 1990, China’s GDP was roughly equal to that of Taiwan, now it is ten times bigger...

Though China stocks are dirt cheap and could bounce,  I have been deeply skeptical that China's high economic growth could continue without significant political and market reforms.

That China has been an incredible growth story pulling many millions from poverty is undisputable. In 1990, China’s GDP was roughly equal to that of Taiwan, now it is ten times bigger.

But China’s investment led industrial growth already into its 15th year, is very long in the tooth.  Real fixed investment has increased at a faster rate than GDP in nine of the past ten years. Furthermore, research by Pivot Capital Management shows that the longest previous period of investment led economic growth was nine years experienced by both Thailand and Singapore.

And I have some unwelcome news. The country has substantial overcapacity in manufacturing, real estate and infrastructure as well as deteriorating credit quality and weakening export markets.  Unfortunately, its brittle political system will make the chances of adjusting to a consumer led economic growth remote at best.

All of these factors will lead to a growth rate far below that expected by the markets and that will, in turn, lead to a China crisis. When? Nobody can say for sure.

This conviction led me to write a 40-page confidential report entitled: The China Skeptic: Seven Troubling Trends.  

For China, investment is at 62% of GDP and the return on every marginal dollar invested in China is decreasing. In 2000, it took $1.5 of credit to generate a dollar of GDP but by 2008, it took $7 of new credit to generate a dollar increase in GDP. The global macro picture will accelerate the China crisis because it will shine a spotlight on China’s shrinking export markets and industrial overcapacity.  Some examples of Chinese overcapacity are its steel capacity equal to that of America, Japan, Russia and the 27 countries of the European Union all put together and an aluminum capacity eight times larger than America on a per capita basis. 

China’s role as a low cost base for global manufacturing is also less compelling given all the logistical issues that go along with supply lines spanning the Pacific. Apix Partners studied five manufacturing segments over a five-year period and found that China’s pricing advantage for goods arriving in California relative to domestic prices have declined to zero. Mexico's manufacturing wages are now below China wage levels. This is one reason net exports have contributed nothing to China's growth over the last four years.                      

This leads to the issue of credit quality and the possibility of China’s own homegrown debt bubble. Research shows that rather than China having a manageable public debt to GDP ratio of 35%, then inclusion of off balance sheet items like guarantees of local government bonds brings this number up to closer to an uncomfortable 62%.

China's five biggest state-owned banks wrote off $11 billion in bad loans last year and this is just the tip of the iceberg. In addition, China’s non-performing loan data is clearly being managed and does not even include the $200 billion of bad loans from Chinas top four state-owned banks that were moved  “off balance sheet” to state-run asset management companies. China’s bank lending explosion after the financial crisis led to credit to GDP rising to 140%, levels equal to America in 2008 and Japan in 1991 just before their market meltdowns.  

This expansion in state-owned bank lending power should also put aside cherished hopes that China over time will turn more control and ownership to private capital and management. One need look no further than China’s ten largest companies which are all state owned or controlled as are 34 of the top 35 companies listed on the Shanghai exchange.

Stephen Roach in the “The Next Asia” puts it this way.  “There are worrisome signs that China just doesn’t get it, that it is clinging to antiquated policy and economic growth strategies that presuppose a classic snapback in global demand.”

Since the Communist Party of China bases its legitimacy largely on producing high levels of economic growth and employment, internal pressures and sharp divisions as to how to deal with the slowdown within the party will emerge.  Unemployment is thought by many analysts to already be over 10% and will worsen to uncomfortable levels.

When it sinks in that China, rather than a provider of global growth, is actually in the same slow-growth high debt boat as America and Western Europe without its durable political institutions, all bets will be off the table.

China could be the growth story of the century – or maybe not.

For a free copy of my China Skeptic 40-page report, join the Value Bounce today to discover high quality stocks trading below their break up value.   


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Carl Delfeld is the founder of the Value Bounce.  His successful criteria for picking companies are influenced by his previous work at the Economist, with the US Treasure and State Departments, and with U.S. National Pacific Economic Council. 

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Growing up in Milwaukee, sports was everything and my ambition was to become a golf professional (this explains why I spend the bulk of winters in La Jolla).  But after a year on the college golf team, the study of economics, politics and history captured my imagination. A year at the Jesuit Sophia University in Tokyo where I was a cub reporter for the Economist  led me to the Fletcher School of Law & Diplomacy at Tufts/Harvard University. 

My first real job was as a banker in London and Tokyo with the First National Bank of Boston and then I opened up new markets in Australia and Hong Kong as an international stockbroker for the investment firm Robert W. Baird & Company. I also covered clients in New York with my favorite being the global macro hedge fund Tiger Management run by the legendary Julian Robertson.

It looked like I'd be a financial executive for life but then I got Potomac fever.  After managing a campaign in Wisconsin and working in Bush 41's presidential campaign, I moved to Washington as an advisor on international finance, trade and investment with the U.S. Senate Finance Committee and the U.S. Treasury. It was just fascinating to watch the big boys in action.

Then, out of the blue, I was appointed by Treasury Secretary Nick Brady as a U.S. Representative to the Asian Development Bank in Manila, Philippines.  This was a mix of finance, diplomacy, and politics on a global scale.  I wore quite a few hats; serving on the bank's executive board, helping American businesses snag lucrative contracts, negotiating $100 million plus financial deals, hitting the diplomatic cocktail circuit, launching new funds, and leading investment missions throughout the Pacific region.

With the election of Bill Clinton, I was sent packing. Returning to America, I co-founded the venture capital-backed Pacifica Group in Honolulu, wrote four books on global investing, joined the U.S Pacific Economic Committee and became a columnist with Forbes Asia.  

All this writing, thinking and research led me to want to share "lessons learned" with a much wider audience so I moved into the financial publishing business so I launched Value Bounce, Pacific Gains and the La Jolla Letter. 

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