What is Really Happening in the Chinese Economy?

On today’s show we are taking a look at the economy in China. China is the world’s second largest economy and it is the most systemically important from a consumer perspective. China is the factory of the world, at least for now. 

As China’s industrial sector boomed over the past 40 years. People moved from the farms into the cities in order to work in factories. The growth in manufacturing was only possible through the availability of inexpensive labor coming from the farms. 

We’ve seen entire cities built on speculation with the assumption that the space would be absorbed. 

At this point China’s problems are systemic. 

There are four major structural factors that are suppressing the Chinese economy. Three out of the four structural factors were present prior to the pandemic. But the disruption caused by the pandemic was so massive cause that it masked the presence of these for structural factors.

Call number one we see a drop in demand in domestic consumption. A lot of this has to do with declining consumer confidence from deflation, and a reverse in the wealth effect that comes from falling real estate values.

The second factor is that the credit markets appear highly leveraged. Borrowers have taken on about as much debt as they can stomach. With falling real estate prices, there is no opportunity to refinance and the mortgages remain. The banks are worried about large scale default rates. In the US in the 2008 era, the default rate peaked at about 10% which is incredibly high. But in the early 2000’s, some banks in China were reporting default rates between 22-25%. It took a large scale government bailout of the banks in order to prevent collapse of the financial system. 

The fertility rate in China is currently 1.09, one of the lowest in the world. 

We have heard about how the decline in China’s population is going to create massive problems for the Chinese economy, much like it did in Japan after Japan’s population peaked in the 1990’s. 

Even though China’s population has peaked and is declining, that’s not enough to create the residential vacancy we are observing. There is a drop in household formation which is creating a gap in demand for housing. China’s urbanization trend could continue if the agricultural practices were to modernize and become less labor intensive. 

Strangely, despite the falling population, the unemployment rate among young adults currently stands at 21%. The Chinese government announced that they will no longer report that statistic. 

The final structural problem is the diversification of supply chains away from China. Geopolitical tensions between China and the West has cause direct foreign investment into China to plummet as companies set up second source manufacturing outside China. 

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Host: Victor Menasce

email: podcast@victorjm.com