James Saft, Reuters Columnist
That creaking sound you hear just might be the Chinese export-driven economy model about to break.
While most of the world’s attention is focused on the interminable and badly sung opera in Washington, China just released a set of data that indicate a serious slowing in demand for its products, particularly from its emerging market trading partners.
Chinese exports in September fell 0.3% from a year ago, customs officials said. While demand for Chinese products flagged in the European Union, the main culprit seems to have been emerging markets, which have been hit hard by slowing capital flows. Exports to Southeast Asia fell to a 17-month low, while those to South Africa were also hit hard.
Emerging markets had a hard summer, as expectations, now reversed, that the Federal Reserve would slow its purchases of bonds made borrowing money internationally more difficult.
And yet, despite the fall in exports, the rest of China’s economy, which is still predicated on demand from abroad, is carrying on as if nothing has changed. Imports were sharply higher in the month, especially of the sorts of raw materials needed for export industries and to invest in infrastructure to support more exports. Credit creation also rose, with doubtless much of it going to support imports and property investment.
Imports of crude oil and iron ore set a fresh record in September, while copper shipments jumped 18 percent to set an 18-month high.
For decades, China’s economic model has been relatively simple: use a lower wage base to drive exports and re-invest most of the profits into the infrastructure and factories needed to create yet more exports. Though this approach worked brilliantly for years, there were two big longer-term weaknesses with this plan. Both of them may be coming into play just about now, which would both explain decreasing demand for Chinese goods and make it more difficult for China to cope.
Wage growth in China has far outpaced inflation, making it less competitive. Wages in Chinese manufacturing have more than tripled in eight years, while the supply of rural workers streaming to cities has slowed. Boston Consulting Group sees more so-called on-shoring of jobs back to the United States, driven by wages, automation and energy and transportation costs.
The paired weakness is in China’s consumer economy, which has been small and has suffered as the economy remains focused on investment, often in houses, for which there is little natural demand.
China’s playbook
It is unclear if slowing exports are being driven by cyclical trends, like weakness in emerging markets, or secular ones, like the migration of manufacturing. September’s figures may also look worse than they were due to a crackdown this year on phantom imports, which have been a popular way for companies wanting to bring money into the country to skirt Chinese capital controls.
If there is a sustained fall in demand for China’s products, its options may be somewhat limited. Given the centrality of investment and exports to China’s economy, the government has a track record of reacting forcefully to slow-downs. The tactics include easing monetary conditions, which stimulate loans and investment even in the absence of strong demand for the end product.
But such easing may be a bit difficult right now.
China’s annual consumer inflation rate rose to a seven-month high of 3.1% in September, driven by food inflation, in particular vegetables. While this was driven by weather, and thus may subside, it will serve to limit the central bank’s ability to loosen conditions.
In some ways, the biggest issue isn’t limitations on government stimulus if China needs it. One of the advantages of a single-party state with strong control over banking is that the government can always foment credit growth.
The problem instead is what happens if exports don’t come back, if change is long-term and mostly in one direction. That will put a lot of pressure on China, not least because a lot of the investment there since the great financial crisis has been of very low quality.
It is not simply empty cities filled with “investment” apartments. It is everything from the cost and wastefulness of infrastructure investment to low-yielding research and development.
An IMF study from 2012 estimated that China’s over-investment is equivalent to between 10-20 percent of annual output every year. Not only does that imply very, very low returns on investment, it almost certainly points to lower growth over time if, or rather when, China is forced to move away from its export model.
That story, when it happens, may make US political dysfunction look like small potatoes in comparison.
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)