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Is This China’s New Normal?

By Shelley Goldberg

Recent trade numbers from China, the world’s second-largest economy, reinforced the concern that the country’s economy has some major cracks in its framework.

Data released on September 8 is painting a grim picture for one of the world’s major economic forces.

Slumping imports and exports in China’s overseas shipments declined 5.5% in dollar terms from the prior year on signs of weak demand from overseas buyers, while imports plunged by 13.8%.

China’s trade surplus swelled to $60.2 billion in August, nearly matching the record monthly surplus set in February.

These statistics are exacerbating the existing fear of a more severe slowdown in China, and even the possibility of a hard landing.

In fact, last Monday, China’s statistics agency lowered its estimate for gross domestic product in 2014. The agency reported that the economy had expanded by 7.3% in 2014 compared with the 7.4% previously reported.

But many are questioning the viability of even these lower numbers.

Volatility has intensified throughout the global markets. This data is only the latest in a laundry list of disappointing economic news out of China. Industrial production, financial services, factory, real estate investment, and even the service sector have contributed to the world’s loss of faith in the Chinese economy.

A currency devaluation, at least five interest rate cuts, and the government’s bungled handling of a stock market bailout have failed to shore up the sagging economy. Now, there’s worry that the apparent confusion in Beijing could be a sign of more trouble to come.

It’s a Structural Thing

The move we’re seeing is structural rather than cyclical, and it’ll likely play out for years to come due to a number of macro factors.

First, the developed markets have reached a saturation point in terms of the amount of resources they require, as reflected in lower global commodity prices across the complex, from energy to metals to agriculture.

As the world becomes more efficient — not only in production but in the consumption of natural resources — the global rate of consumption growth is rising at a slower pace, even while the world’s population continues to grow.

In developed markets, there’s a growing emphasis on efficiency, renewable energy, and recycling. Fuel-efficient cars, power-efficient homes and businesses, and efficient farming are all reducing the consumption of resources along with what’s called the “circular economy,” or putting back into the cycle that which we’ve already taken out.

In less-developed nations, this practice will take time to materialize (decades in some cases), but we’re already seeing signs of it coming to fruition.

Secondly, there’s a labor and demographics issue.

Chinese working labor peaked in 2014, partly due to the imposed one-child policy from the 1970s. Wages became the number one problem as China was forced to compete with cheaper labor overseas from countries like Vietnam and Mexico.

Meanwhile, as growth rates in Japan, the United States, and Europe have all slowed, those countries’ economies have become less consumer oriented. Thus there’s less demand for imports of everything along the production chain, from raw materials to parts to finished goods.

It’s for these reasons the Chinese government aims to transition from an export-led economy to a retail consumer-driven one. But this isn’t an easy transformation, as it takes time to change the mindset of almost 20% of the world’s population.

In the meantime, production for many Chinese businesses has ground to a halt. Abandoned “zombie” factories are surfacing and workers have stopped receiving paychecks.

The likely result will be a disgruntled population and uprisings similar to the Arab Spring of 2010 and 2011 and the more recent riots in Greece. Such signs have already been exhibited in many cities and villages in China over the last few years.

Thirdly, while state-directed capitalism helped lift millions of people out of poverty, the model still has its limits due to its emphasis on asset creation and growth at any cost and a tenuous regard for return on capital. The result was a negative return on assets in many industries, steel being a perfect example.

China not only produces 50% of the world’s steel, it also consumes vast quantities of iron ore, thermal, and coking coal. The strategy led to a dangerous overcapacity as the investment spigot kept flowing regardless of the return expected on incremental capital formation.

Money Walks

Meanwhile, China is burning through its huge stockpile of foreign exchange reserves at the fastest pace in history, as it seeks to prop up its currency and abate the rising tide of money exiting the country.

China still holds the world’s largest cache of foreign reserves — a whopping $3.56 trillion as of the end of August, according to government statistics.

Yet the amount has decreased steadily from a peak of close to $4 trillion in June 2014. Slowing economic growth encouraged investors to direct money overseas in search of higher yields.

As a result, the People’s Bank of China (PBOC) was forced to sell huge amounts of assets from its foreign reserves to maintain the strength of the renminbi.

The exodus of investors’ money accelerated after August 11 when the PBOC made the surprise move to devalue the renminbi by the most in over 20 years. China’s foreign reserves dropped by $94 billion last month, according to Moody’s, as the central bank aggressively defended its currency.

The New Normal

Eventually, investors must come to realize that slower growth in China will be the new normal, just as they did with Japan, and now, most likely, with the United States.

Nevertheless, positive signs are on China’s horizon. First, a weaker currency makes China’s products cheaper for overseas buyers. That should help exports.

While economists feel the initial 3% to 4% drop in the currency’s value against the dollar would have a limited impact, the effect could be augmented if the currency yields to market pressure for further depreciation.

On top of that, Premier Xi Jinping has tendentiously introduced policies aimed at combating corruption, opening up the banking sector, and giving markets a free hand.

Over the last three to four months, Jinping has taken measures that don’t solely control or please the equity markets, but that support the real economy. He has also worked to create rescue funds, go after people who short the market, and cut interest rates, all of which focus on shoring up the capital markets.

In my option, we should keep new investment opportunities in China at arm’s length for the near term. Then, tread with caution and look for opportunities focused on changing demographics and strong links in the trading partner chain.

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