China's Slowdown

Over the past three decades, China has seen its economy grow significantly.

This chart shows the relative level of GDP on an inflation-adjusted basis between China and the U.S. since 1980. Although the U.S. economy has more than doubled in size, China’s has increased by multitudes. Obviously, much of this growth performance is starting at a low base. In 1980, the Chinese economy was quite small. Only two years earlier, Deng Xiaoping, the leader of the Chinese Communist Party (CPC) that emerged after Mao Zedong’s death in 1976, had started the process of liberalizing the economy.

China’s growth has followed a well-trod path of export and investment promotion and consumption repression. This model of development emerged after WWII and was used by Europe and Japan to recover from the war’s devastation. Simply put, policies are deployed that suppress consumption. These policies include financial repression—saving deposit rates are kept low and financial choices restricted to provide a reliable supply of low cost funds for investment. Exchange rates are managed to keep the currency undervalued; this not only keeps import prices high, encouraging the consumption of domestic goods compared to imports, but it also supports exports. Investment is fostered, but since consumption is restrained, most of the investment either goes into infrastructure or export industries.

Since WWII, the model of export promotion has clearly outperformed its rival, import substitution. The latter model calls for high tariff barriers to foster infant industries. Latin America tended to follow the import substitution model with, at best, mixed results. On the other hand, Europe and Asia, who followed export promotion, showed stronger growth.1 Although some analysts have asserted that export promotion is a superior development model, they often neglect to note that for export promotion to work, there must be an “importer of last resort” to buy this production. The U.S., in its economic and financial superpower role, has been an integral element of the general success of export promotion. As the global economic superpower, the U.S. is the supplier of the reserve currency and the de facto importer of last resort.

In this report, we will discuss the general geopolitics of China and how the past three decades of economic development fit into this geopolitical construct. An analysis of China’s current economic situation will be discussed, focusing on the sustainability of its current policies at this stage of development. From this vantage point, we will examine potential paths China may take to cope with slower growth, focusing on the geopolitical impact on Asia. As always, we will conclude with potential market ramifications.

The Geopolitics of China

Geopolitics studies how nations exercise political power within geographic constraints. Natural geographic elements, such as mountains, rivers, arable land, temperature ranges, etc., all affect how a nation can exercise power within a given space. For example, island nations have a tendency to develop into naval powers.

China’s distinctive geographic circumstance is tied to water and rainfall.

(Sources: Stratfor, Pakistan

This map of China shows two features. The first feature is population density, shown by the brown colors. The second is the red line; this is the 15” isohyet line which measures the extent to which rainfall averages this amount or more. To the east of the line, rainfall is ample; to the west, rainfall is less than 15” and thus less able to support agriculture. As one would expect, more people live where it is easier to grow crops. However, due to China’s large population, its ratio of arable land to population has always been low.

This means that, for all its land mass, China is, in reality, a small country surrounded by near-desert areas. The high population areas are mostly ethnic Han; in fact, the Han represent about 92% of China’s population. To the east of the 15” isohyet, the economy is based on agriculture and trade; to the west live mostly nomadic groups of herders.

Throughout its history, China has faced two threats. First, outside land invaders, such as the Mongols, have attacked the Han regions. Second, leaders have been unable to maintain unity among the Han and instability developed. Thus, a successful Chinese government must protect the core Han regions from outside invaders and maintain unity among the Han.

To achieve the first aim, Chinese regimes have worked to extend their borders, creating buffer regions. For example, controlling Tibet ensures its southwest is secure; no land army could successfully attack by traversing the Himalayas. Similarly, the borders with Myanmar, Laos and Thailand are jungle and offer protection.2 To the west, with the exception of the famous “Silk Road,” most of Xinjiang and Inner Mongolia are impassable. Manchuria is also mountainous and arid. With the exception of the border with Vietnam, the current borders of China provide a significant buffer for the core Han regions.

The second aim, keeping the Han unified, is mostly a problem of balancing economic growth with social cohesion. Historically, China’s economy performs best when the coastal regions are trading with the outside world. However, this means the interior regions become relatively poor compared to their compatriots on the coast. During the first half of the last century, coastal trading with Western powers lifted China’s growth, creating an income divergence with the interior. When Mao overthrew the Nationalists, he effectively closed off the coast to trade in order to unify the Han.

The tradeoff that Mao accepted was that Han unity was more important than robust growth. Even though China has a large population, the low population to arable land ratio dooms it to poverty. For most of its history, the Chinese population was simply too poor to allow the economy to grow by domestic demand alone. Unfortunately, relying on exports creates income divergences and makes it hard for the government to maintain Han unity. Deng accepted this risk when he liberalized the economy in the late 1970s. His successors have been trying to address the income problems ever since.

Although China does have a long coastline, a naval invasion is very difficult. The British did make incursions into China but these were mostly to force the emperor to make trade concessions. Japan successfully invaded Manchuria but was unable to extend its gains. The two risks China faces on its coast are the aforementioned income divergences that trade brings and blockades. When China is poor and unified, blockades are not a serious problem. However, a China that is integrated into the world does face a blockade risk. After all, it does not have a “blue water” navy at this point and is vulnerable to trade interference.

The Chinese Economy

The export promotion model, as noted above, has become the preferred development program for emerging countries. Its success has rested on two important factors. First, the model fosters investment which becomes the basis for growth. Because emerging economies tend to have little investment initially, virtually any investment spending reaps significant growth improvements. Second, because domestic consumption is restrained by policy, exports become a more reliable source of demand to support the new investment.

However, as the economy develops, the model tends to become a victim of its own success. As the investment base is built, the economy needs to create a method of investment allocation. Investment allocation is perhaps the most difficult task for any economy. Good investment requires some forecast of the future. The decision to build a factory only pays off if the goods produced can be sold at a profit. In a developed economy, the financial system is the primary conduit for investment decisions. An investment can be tested against market conditions that offer reasonable insights into the cost of money. And still, even in the most sophisticated financial markets, bad investment decisions occur.3

In an emerging economy that lacks a developed financial system, most investment decisions are made by governments or by powerful elites. Initially, the lack of a financial system isn’t a major problem because the investment base is so primitive. Essentially, any investment offers a substantial return because of the general lack of investment goods. However, as the emerging economy develops, the lack of a more sophisticated investment allocation system causes problems. Malinvestment, the problem described by Austrian economists, becomes more common as governments and elites make investments based on political or personal agendas. Favored industries develop excess capacity while other necessary, but politically unattractive, industries are denied funds. It is also worth noting that the financial repression of households, which provides the investment funds, is usually borrowed from government-controlled banks. Loans are made on the basis of political connections and poor investments eventually become bad debt problems.

The second problem that develops is that export markets become less reliable. As the emerging economy grows, it begins to take market share away from domestic producers in the developed markets that are targets for exports. Protectionist measures often follow. In addition, pressure develops for the emerging economy to appreciate its currency to undermine its export competitiveness.4

Once this point has been reached, the emerging economy must begin to adjust its development model away from investment and export promotion. This requires ending financial repression against households and driving up the cost of investment. In addition, the development of a financial system to allocate investment is necessary.

Unfortunately, the act of restructuring the economy will tend to undermine the fortunes of those who have benefited from the investment and export promotion model. Political and economic power usually develops simultaneously and so the groups that prospered during the development phase have no interest in changing an economy that has benefited them.

This is exactly where China sits today.5 Export growth has slowed due to the weak economic conditions of its trading partners. There is obvious overcapacity in several industries; perhaps the most obvious area of overexpansion is in real estate. Many analysts fear China has a growing bad debt problem in its banking system. These issues have been festering for years; the Hu Jintao government, predecessor to the current Xi Jinping administration, consistently called for restructuring. However, very little progress was made. In fact, the Hu government would take steps to restructure but the subsequent growth slowdown would concern policymakers and they would take steps to stimulate the economy. Investors and other market participants have taken the stance that Chinese governments will “talk the talk but not walk the walk” on restructuring. Thus, during the Hu period, as the economy slowed, the leadership would panic and respond with policy stimulation. Investors have been conditioned to respond to slowing growth by increasing Chinese (and commodity) investments, anticipating stimulative measures.

The current government appears to understand the need to address the transition from investment and export promotion. The Xi government does seem committed to seeing the restructuring through, although the path to making these changes isn’t obvious.

Restructuring will require slower growth. The conventional wisdom is that China needs to grow at +7.5% to absorb the number of peasants moving from the rural areas to the cities. However, this general rule is probably no longer true. There is growing evidence to suggest that China has reached the “Lewis turning point.”6 Wages are rising and China is no longer the low-cost producer for cheap goods requiring low-skilled labor. The Xi government can probably slow growth below 7% without triggering widespread unrest.

In addition, assuming the restructuring ends the practice of financial repression, it would be reasonable to expect that the consumption portion of GDP would rise. China’s consumption compared to its GDP is remarkably low.

This chart shows the composition of China’s GDP. Consumption only accounts for 36% of GDP and has been on a downward trend since industrialization began.7 As China restructures, even with slower growth, if consumption rises, the standard of living should not necessarily decline. If so, social unrest could be avoided.

The problem for General Secretary Xi is containing the party elites. Many members of the CPC have become wealthy in the development process and have no interest in changing the current model. They want investment to remain subsidized by households and want to continue to promote exports, even if there is resistance from foreign markets.

Thus, the geopolitical risk from the Chinese slowdown is a high level of unrest that may result in some low probability but high risk outcomes, such as:

  • An internal CPC conflict that leads to a coup. We suspect this may have been behind the ouster of Bo Xilai last year (see WGR, 4/2/2012, “The Purge of Bo”).
  • A collapse in the Chinese financial system as well-connected CPC members, in a bid to protect their assets, begin to engage in high level capital flight. It is well known that some capital flight has already occurred (see WGR, 7/16/2012, “The Mystery of Chinese Capital Flight”). If it accelerates, it may cause havoc in the Chinese financial system.
  • As tensions rise within the CPC, a foreign military adventure is taken to distract the population from the lack of restructuring progress. This tactic would also allow the leadership to blame foreigners for the lack of progress.

Overall, it appears that the Xi administration has decided that restructuring is necessary. However, there is no real path to follow—no other large economy has been able to successfully restructure from investment and export promotion.8 Thus, the risks of an unsuccessful adjustment are not small.


The primary market ramification of China’s slowdown is weaker commodity markets. Already, commodity prices have slumped as Chinese demand weakens. We believe commodities still hold a place in portfolios. There is still the risk of a military adventure, and all the major industrialized nations’ central banks continue to engage in currency

debasement. However, China’s demand has had a serious effect on prices.

If China’s leadership becomes belligerent toward its neighbors as its growth slows, we would expect a rise in defense spending in the Pacific Rim which would support that industry. The U.S. “pivot” toward Asia is due, in part, to keep allies in the region from escalating tensions as China tries to adjust its economy.

If conditions in China deteriorate and capital flight increases, we expect the U.S. to be a primary target for these flows. Much like what was observed in the 1997-98 Asian Economic Crisis, the U.S. benefited from Asian investors seeking a safe investment venue.

Overall, China’s attempt to restructure is a major event for the rest of the decade. A successful transition will be very good for the world. However, the process is fraught with risk and could lead to unpleasant outcomes.

Bill O’Grady

August 5, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

1 It is interesting to note that the U.S., for the most part, followed import substitution. Alexander Hamilton was a proponent of the infant industry argument, for example. This policy was not universally accepted, however. Commodity producers in the

South and West were opposed to tariffs, fearing trade reprisals would hurt their foreign sales. Disagreements on trade policy were one of the factors leading to the American Civil War.

2The British and Americans tried to build supply lines through Myanmar during WWII at great cost, highlighting the difficult geography of this region.

3Case in point is the technology bubble of the late 1990s.

4The U.S. forced Japan and Germany to appreciate their currencies during the mid-1980s in part to help American companies that were suffering from import competition. Over the past two decades, there have been persistent calls by politicians and industry groups to force China to appreciate its currency as well.

5And exactly where Japan was in the mid to late-1980s.

6Named after Sir William Arthur Lewis, it is the point where an emerging economy has developed a large enough capital base to absorb all the subsistence rural labor. Once achieved, wages begin to rise and export competitiveness declines.

7Normal consumption levels are 50% to 65% in a developed economy. The U.S., due to its role as supplier of the reserve currency, has consumption levels of 71%.

8Japan has endured a 20+ year period of economic stagnation due to its inability to adjust and Germany has enjoyed success by effectively “colonizing” the Southern tier of the Eurozone, creating conditions were these nations have been forced to absorb its exports.

© Confluence Investment Management

© Confluence Investment Management

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