China, the world’s second-largest economy, is in crisis, according to analysts and economists who point to a longstanding faltering in growth that has finally reached critical mass for U.S. investors, many of whom are likely to recalibrate investment goals going forward.
For years, investors have looked to China’s historic expansion as the leading edge of an emerging market boom that offset the flagging growth potential in the developed world. That’s been especially true since 2008, when the U.S. credit crisis triggered a massive downturn in major developed economies that has left often-unprecedented levels of debt in its wake.
China has loomed large as a way to lift emerging markets out of a funk that has been linked to civil unrest in once-high-flying developing countries such as Brazil and Turkey. But it appears China’s problems are too big, and many countries—commodity producers, in particular—will feel the pinch of a China slowdown.
“Many have asked when China would find itself in an economic crisis, to which we [Stratfor] have answered that China has been there for a while—something not widely recognized outside China, and particularly not in the United States,” Stratfor’s George Friedman said in a commentary issued this week.
The latest estimates of Chinese GDP growth, for instance, now have some concerned that expansion there could fall below 7.4 percent, or even below 7.0 percent—if Chinese statistics are to be trusted—this year, following June data that showed a slower manufacturing pace, a drop in exports and a CPI level in China that hit a one-year high.
Friedman is among those who don’t trust China’s statistics, saying that they serve a political or public relations function for internal as well as international audiences. He reckons growth there is probably more like 5 percent.
A Growing Chorus Of Concern
Friedman’s comments come about a week after Princeton Economist Paul Krugman expressed concern in his New York Times column that China’s slowdown is now not only unmistakable, it’s deeply rooted in fundamental issues.
“The country's whole way of doing business, the economic system that has driven three decades of incredible growth, has reached its limits,” Krugman said last week in his column, which Friedman cited in his comments. “You could say that the Chinese model is about to hit its Great Wall, and the only question now is just how bad the crash will be."
Chinese policies over the years have allowed inefficient businesses to keep growing through bank lending in an effort to avoid unemployment spikes—something the government there feared.
These inefficiencies have led to higher production costs and ultimately to inflation in a vicious cycle that now threatens China’s economy.
“The increase in inefficiency is compounded by the growth of the money supply prompted by aggressive lending to keep the economy going,” Friedman said. “As this persisted over many years, the inefficiencies built into the Chinese economy have become staggering.”
What happens next is anyone’s guess.
From an ETF standpoint, many investors already seem to be trimming their exposure to China’s growing threat.
There are more than 20 ETFs that tap into Chinese equities, and many of them have been very popular with investors. Funds like the iShares China Large-Cap ETF (FXI), which in nine years since inception has accumulated more than $5.2 billion in assets, and the SPDR S'P China ETF (GXC), with $868 million in assets, speak to the demand for exposure to Chinese stocks.
But these funds haven’t been performing well in 2013, feeling the weight of crumbling confidence in China’s growth story amid asset outflows.
FXI is now down nearly 12 percent year-to-date—the mega-cap fund is heavily focused on financials—while the more broadly diversified GXC has bled 6.4 percent of its value so far this year after rallying roughly 15 percent in 2012. This downfall has come accompanied by net asset outflows of more than $2.28 billion from FXI and $119 million from GXC since Jan. 1.
Also facing net asset outflows year-to-date, the $184 million HAO exclusively taps small-cap stocks, which are often said to be more closely connected to domestic themes such as consumer demand and local growth. CHIQ is a consumer-focused fund, meaning its holdings are the same companies that have their fingers on the pulse of China’s consumer cyclical and non-cyclical sectors.
HAO rallied nearly 25 percent in 2012, and has slid 3.5 percent so far in 2013, while CHIQ has now bled 4.7 percent since the beginning of the year, after gaining nearly 18 percent in 2012.
“The macroeconomic outlook for China continues to deteriorate,” Guggenheim’s Scott Minerd said in a recent research note, saying that the chances of a financial crisis there over the next six months are rising.
Tough Choices Ahead
“Chinese officials have shown they are willing to tolerate a lower growth rate than originally anticipated as they attempt to reduce the moral hazard in the financial system. This, combined with instability in Japan as Abenomics continues, puts all of Asia in a precarious situation,” Minerd said, referring to Japan’s massive monetary stimulus program.
“If the bad news becomes worse and volatility rises further, there will inevitably be greater knock-on effects for the global economy and markets,” Minerd said. “China’s economic growth will likely continue to slow in the near term, given the chaos in the banking system and the potential squeeze of credit to the real economy.”
Stratfor’s Friedman argues China is unlikely to collapse economically, much as Japan and South Korea averted economic calamity.
Instead, he sees the government there focusing on containing social and political backlash while allowing the economy to deteriorate slowly, stretching out the decline.
“The Chinese economic performance will degrade, but crisis will be avoided and political interests protected,” Friedman said. “Since much of China never benefited from the boom, there is a massive force that has felt marginalized and victimized by coastal elites. That is not a bad foundation for the Communist Party to rely on.”
“China could very well face an extended period of intense inwardness and low economic performance,” he added.
A faltering China could also translate into higher demand for the safety of U.S. Treasury bonds, he said, which would pressure U.S. interest rates further.
Moreover, other emerging markets are also likely to be hit if overall demand from China slows down. China is one of the biggest producers and biggest consumers of various commodities.
“The past 30 years is a tough act to follow,” Friedman noted. “China in fact has had an extraordinary period of growth. The last 30 years have been remarkable, marred only by the fact that the Chinese started at such a low point due to the policies of the Maoist period.”
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