Why Every 1% Drop in China’s GDP Hurts so Badly

Why Every 1% Drop in China's GDP Hurts so Badly

While economists and financial journalists debate largely irrelevant decimals of a China missing or hitting GDP growth target by 0.1% let’s illustrate why the downshift to a more sustainable growth would be so painful. 

Based on our models of supply side economics (which we will present later), China is not supposed to grow above 4-5%, even at the most optimistic scenario. Any growth above that rate is effectively borrowed from the future – using, among other things, a widely acknowledged credit (over)expansion. Therefore, in the short term, the growth rate might dip down to 1-2% – you need time to correct at least partially some excesses. The economy there would require time to work off excess inventory and digest at least some over-capacity (if ever!) But we still hear when people still say: “Well, even if China’s growth slows down to 5%, isn’t it is still one of the highest globally?” True, it is, but that statement is incomplete…

Even minor adjustments to the pace of growth in demand results in much higher divergence between capacities planned for many years out. The real problem is that many industries built and planned their capacities for 8-10% growth for many, many years to come! (Figure 1. shows the Chinese steel industry example, which has accounted for roughly 85% of the increase in world steel output.)

Therefore, even relatively small misses on the compounded rate of growth results in a tremendous capacity over-built. Let’s contrast the possible overexpansion in the capacity using the officially targeted rate of growth of 7% versus what we think should be more realistic long term pace of 5%. The power of compounding is straightforward:

  • 7% growth compounded for 7 years results in 61% expansion
  • 5% growth compounded for 7 years results in 41% expansion

The resulting gap of 20 percentage points between the capacity and realistic demand would be notable and felt across the globe. I would not blame government officials in China failing to keep exact records of the excessive expansion, but I would fault corporate executives and government Planners for their eagerness to fall into the trap of rosy-colored eyeglasses. The magnitude of the whirlwind of capacity overexpansion across many industries in China is staggering: steel, cement, residential construction, commercial construction, textiles, semiconductors, transportation (rail, ports, roads), automotive, etc.

What should we all do here? We are already seeing early warnings of an upcoming global tsunami: rout in commodities, most global currencies weakening against the greenback, blowing out credit spreads, early panic in stocks markets. Even Sotheby’s auction pricing for most praised artwork is dropping and coming in sometimes below asking price. Unfortunately, there is a lot more to come. Our models and indicators point towards the most pessimistic forecasts.

Any silver lining? Yes, pollution levels would drop and joggers in Pudong in Shanghai would finally enjoy their morning runs …

Why Every 1% Drop in China’s GDP Hurts so Badly

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