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Trees Don’t Grow to the Sky

April 8, 2014

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Chinese Premier Li Keqiang stated that the economy would grow 7.5 percent in 2014, or maybe a bit lower – but not much. Data for January and February were softer than expected, and so far data on March do not suggest enough bounce to make the projected target. As a result, new stimulus measures have just been announced: reducing taxes to small and medium sized enterprises, pulling forward planned railway expansion, and reiterating the planned construction of low cost housing. We had anticipated these announcements, but remain underwhelmed by their potential impact. All three areas had been discussed in the government’s 2014 plans which generated the 7.5 percent target. The primary change is that financing for these efforts is being guaranteed by the central government, meaning they will be funded and go ahead on schedule. Some of the 2014 proposals have met with resistance from banks which are already overburdened with questionable provincial and local loans. Since we were already wary that Chinese growth is actually significantly weaker than the reported data, this new commitment that the government will do what it said it would does little to alter our view. Indeed, the need to make such an announcement only reinforces our concern.

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After 30 years of virtually unbroken growth, including immediately after Lehman, most in China believe the government is capable of surmounting all problems. However, it is clear that the excess capacity in coal, steel, iron ore and many other building materials and commodities is weighing heavily on economic growth. These were the bastions of growth over the past decade and all are being restructured simultaneously. Add in the railroad and petroleum industries, which have been brought back under central government control, and the lion’s share of the Chinese economy is in transition. Restructuring requires separating the wheat from the chaff – and dealing with the broken promises of the weak. To date, the government has absorbed those loses without any impact on lenders. They can afford to continue – but can they afford to do so at as the same time they fund new projects at the same rate of growth as when they didn’t have to absorb write-downs? We doubt it. Bottom line, the cost of restructuring the significant overbuilding in the investment sector – which represents over one third of Chinese GDP – is greater than the drag from shrinking the US government sector, which accounted for just 20 percent of GDP.

We suspect Chinese growth will disappoint until restructuring is much further along – which should take many quarters. Weak growth may accelerate the drive for financial sector reform. We also see agriculture and environmental control as areas where the government could ramp up investment. Playing the nationalist card, like South Korea and Japan, increased military spending and a weaker currency may be on the way as well. Bottom line, China still has several cards to play, but it may have to draw to an inside straight to meet what appears to be an unrealistically high growth target.

 

The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

 

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