Murphy’s Law says that what can go wrong, will go wrong. It is thought to be named after Captain Ed Murphy, an aircraft engineer who, frustrated with the work of an incompetent colleague, is alleged to have remarked, “If there is any way to do it wrong, he will.” This section is dedicated to combing the financial markets for risks that are lurking out there, preparing to pounce.
Question: is China a slow motion train wreck or has the Communist Party found the secret to generating high and stable growth? China has the potential to cause global markets serious problems. Its economy is huge and has been growing at a relentless pace for a number of years. Furthermore, its growth has been one-dimensional, based on building and making ‘stuff’ using bank credit. This is evident from the below two charts.
"The numbers are so far off the scale that there is no precedent"
The first chart illustrates the extent to which China has consumed vastly more cement per person per year than any other country on the planet, particularly when GDP/capita is taken into account. Even Bill Gates was moved to tweet a few months ago about what he thought was the most mind-blowing fact he had learned in 2014, namely that China used more cement in the three years from 2011 to 2013 than the US used in the entire 20th century (6.6 gigatons versus 4.5 gigatons).
The second chart shows the extent to which China’s use of bank credit is also off the scale in relation to its GDP/capita. Given the best fit line, China’s money supply as a % of GDP should be 125% given its GDP per capita of $8,280. In fact, it’s 208%.
What these observations mean for China’s future growth prospects is very hard to say. China has far too much cement capacity and the same goes for other commodities too, steel being a good example. Shutting much of the capacity (an inevitability) would be deeply painful for banks and employees alike, but perhaps not terminal. Laid off employees would eventually be rehired in more value added activities and the banks would be recapitalised as they have been in the past.
The problem is that the numbers are so far off the scale that there is no precedent, and no precedent means a lack of predictability. Another measure on which China scores highly is average GDP growth adjusted for the volatility of GDP growth (think of it like a Sharpe Ratio for economies, the higher the better). As can be seen in the table below, China has achieved high and stable growth. The only country that comes close is India, with an “Economic Sharpe” of 3.1 times versus China’s 4.6. Perhaps it has been learning a few tricks from its bigger emerging cousin.
Whether these are accounting tricks or some sort of growth miracle is of course the big question.
Published in Investment Letter, November 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.