Over the weekend the Chinese vice-premier, Wang Qishan, who is responsible for overseeing the country’s financial sector predicted that the global economy could slump into a long-term recession, and urged China to speed up reforms to cope with any possible fallout. Wang would have known ahead of time what the HSBC Purchasing Managers Index (PMI) revealed on Wednesday—namely the lowest recording of industrial activity over the month of November for almost three years. In response, the Australian all ordinaries index fell 1.86 per cent, while share prices for mining giants BHP Billiton and Rio Tinto fell 3.05 per cent and 3.41 per cent respectively.
Given that 23 cents in every dollar worth of our exports goes to China, the local sharemarket response is predictable. But Australian investors, who generally invest for the short- or medium-term, are getting it wrong and displaying a worrying lack of understanding as to how the Chinese political economy actually works. In fact, the data coming out of China over the past week ought to delight all but the longer-term investors in our big miners.
The November PMI figure of 48 indicates that industrial activity has actually shrunk since a figure of 50 represents stagnation. The index is derived from responses from surveys sent to around 400 executives of manufacturing companies. It is important to realise that the companies surveyed consist overwhelmingly of foreign-invested or foreign-owned export manufacturers in China. If we examine the PMI figures since 2004, the index’s correlation with the demand for Chinese exports in the major global consumer markets of the European Union and the United States is almost perfect. Therefore, the disappointing PMI figure for November tells us what we already know—that demand for Chinese exports in the industrialised world is faltering, especially in the EU.
What does all this mean?
With its primary end-consumer export markets stagnant, growth rather than inflation becomes the main priority for the Chinese Communist Party. After all, the only thing keeping the political authority and legitimacy of the CCP afloat is the capacity of China’s state-led political economy to generate prosperity for urban elites, and jobs for the hundreds of millions of workers. And rapid growth is the only political cure-all in this context.
If the export sector is failing to generate growth and jobs, then the options are either a massive boost in domestic consumption or else a renewed focus on fixed investment. Since bank loans constitute around 80-90 per cent of all formal finance in China, one comes at the expense of the other: China can either save more to increase investment, or else save less to increase consumption.
At 33 per cent of GDP, domestic consumption in China is the lowest of any major economy in the world. Conversely, at 50-60 per cent of GDP, fixed investment in China is the highest of any major economy in the world and of any significant economy in the last one hundred years of economic history. Even Premier Wen Jiabao consistently warns: China’s economy is dangerously “unbalanced, unstable, uncoordinated and unsustainable.” China’s economists—such as those working for the People’s Bank of China (the Central Bank)—realise that raising domestic consumption and lowering fixed investment is the only sensible way ahead.
Domestic consumption in China is low for a number of reasons. For example, Chinese people choose to save rather than spend because they are aging and without pensions; there is no meaningful provision for healthcare; and education for their children is becoming expensive. Deposit rates for its citizens in state-owned banks (which dominate the banking sector) are absurdly low, meaning that the savings of the people are effectively subsidising fixed investment in the country. Most significant of all is that China’s approximately 150,000 state-owned enterprises (SOEs) receive over three-quarters of the country’s capital, with the 4-5 million privately-owned corporates left to fight for the scraps at higher lending rates. In addition to the fact that the most important sectors of the economy are shut off for private corporations and largely reserved for SOEs to compete amongst themselves, an enormous amount of the country’s wealth remains in the coffers of inefficient SOEs rather than the pockets of most citizens.
Even so, the model is unlikely to change. Cobbled together in the late 1990s, the plan is to ensure that the CCP—through de facto control of SOEs—remains the dominant dispenser of economic, commercial, business and social opportunity in China. As far as the CCP is concerned, losing this economic role and status eventually means losing political power.
Meanwhile, SOEs have become a dominant interest group within the CCP and will do all they can to protect their privileges. The problem is that while SOE balance sheets—bloated by money that is almost free and bulked up by exclusive sector access—grow by around 20 per cent each year, mean household incomes have been rising at a paltry 2-4 per cent each year over the past decade.
The point is that domestic consumption will not be a sufficient driver of Chinese growth for the foreseeable future. Although the actual process is more complicated than this, the heads of China’s big state-owned banks are effectively and regularly ‘briefed’ by CCP officials as to what lending levels should be, and who they ought to lend to. The only political (and short-term economic) option for the CCP is ramping up fixed investment—which means lending more money to SOEs since they dominate the construction, infrastructure, property and heavy industry sectors.
The upshot is that China will continue to fast-track the building of things—irrespective of whether the fixed investment projects are needed or not—and will need more Australian commodities in order to do so. Tellingly, the trend over the last decade is one showing fixed investment by SOEs going up whenever export markets subside. If it is not millions of high-end residential properties that may be bought but never lived in, it will be something else. The CCP has fewer levers for growth than is commonly assumed and this is the one they rely on more than anything else.
Commodities make up three-quarters of every dollar of exports to China. Selling off Rio Tinto and BHP Billiton because of a low Chinese PMI Index in November is a mistake. But an Australian business community and government relying on China continuing to buy our commodities to build more and more things it clearly does not need is the more serious error in the longer term.