Economic data from China for July has been nothing short of disastrous. Year-on-year, retail sales for the month were up 2.5%, fixed investment rose 3.4%, and industrial output increased 3.7%. All were well below consensus. Keep in mind that Chinese data can’t be fully trusted too, as evidenced by the recent decision to withdraw publication of China’s youth unemployment figures, after the most recent figure hit 21.3%. The central bank reacted to the latest data by cutting the benchmark interest rate by 15 basis points to 2.5%.

Economic woes a long time coming

Despite what you read in the media, China’s economic downturn hasn’t come suddenly – it’s been 15 years in the making. In 2008, the Chinese government provided enormous stimulus to prop up the local economy in the face of a Western economic cataclysm. That stimulus helped fuel one of the biggest property bubbles that the world has seen, much of it financed with debt from a bloated financial system and encouraged at every turn by the Communist Party and local governments.

It led to the building of ‘ghost cities’ as far back as 2010 when famous US-based market shortseller Jim Chanos declared that China was on a ‘treadmill to hell’. And Edward Chancellor, a well-known financial author on past economic bubbles, said at the time that China exhibited all the signs of a classic financial bubble. The comments were soon supported by absurd statistics such as China consuming more cement in the three years from 2010 than the US consumed in the entire 20th century.

It’s no surprise then that one of China’s largest property developers, China Evergrande, later defaulted on its debt in 2021, and another giant, Country Garden, looks like it’s about to follow suit.

The real surprise is that it’s taken so long for the bubble to unwind. So much so, that it was only back in 2020 that Thomas Orlik, Bloomberg’s Chief Economist, wrote a book titled, ‘China: the bubble that never pops’. Orlik paid far too much credit to Communist Party leaders for managing the bubble and economy, as he wrote then: “If China’s leaders appear confident in their abilities, there’s a reason for that.”

Stimulus hasn’t worked

The truth is that the Chinese leadership has propped up the real estate bubble on many occasions over the past decade, yet the stimulus has had dwindling results. It puts into perspective the non-stop parroting of economists for the Chinese government to provide more stimulus for the economy – it’s not like they haven’t tried, to the tune of trillions of dollars, and it’s arguably made things worse, not better.

The stock markets of Shanghai and Hong Kong have priced in China’s woes for a long time. The Shanghai Composite Index is about half the peak levels seen in 2007. Meanwhile, Hong Kong’s market is down 40% over the past five years and is also well below 2007 levels too. 

Shanghai Composite Index

Source: Trading Economics

 Hang Seng Index

 

Source: Trading Economics

 

Until lately, investors and businesses continued to plough money into China despite the numerous red flags through the years.  They seemed beguiled by the size of the country, the reported economic growth, the urbanization theme, the rise of technology giants, the low-cost manufacturing which produced goods for the world, and the government’s control over the economy with many comparing China’s governance favourably against the West (hard to believe now, though it was a widespread sentiment).

Lessons for investors

The bursting of China’s economic bubble has many lessons for investors, including:

  1. Economic growth isn’t necessarily correlated with stock market performance. Intuitively, GDP growth should flow through to corporate earnings which drive company value and the value of stock markets. That hasn’t happened in China. Recent academic research suggests that stock market performance doesn’t necessarily reflect economic performance, and there may be other factors at play such as the openness of economies. There is also evidence that stock markets lead developments in economies, which may explain at least part of what’s happened in China.
  2. Don’t fall for market thematics. I was worked as an equities analyst in China and Hong Kong, and subsequently as a Portfolio Manager of Asian Equities, and I can’t tell you how many times I’ve heard bullish presentations on China and other emerging markets based around broad thematics such as economic growth, consumption growth, favourable demographics, urbanization, low penetration of … (insert everything from banking deposits, to loans, credit cards, food, luxury items, to name a few).  These themes are often sexy and imply a long runway of growth. Yet as China and other emerging markets show, it’s usually never so simple. It’s worth digging beyond broad thematics.
  3. Be wary of government heavy-handedness in the economy. Government intervention in the economy thwarts private enterprise, and private sector growth is where real economic growth comes from. I remember researching China A-shares in my days as an analyst and it was so difficult to know if private companies would be allowed to compete with state-owned companies in a sector, or if a private company that succeeded would eventually fall foul of authorities and be disrupted or shut down (as happened with Chinese tech companies).
  4. Be sceptical of economic opinions. Remember the rise of the BRICS (Brazil, Russia, India, China, South Africa) economies? BRICS was coined by Goldman Sachs economist Jim O’Neill, and he gained much popularity from it. It turned out to be mostly wrong. The chief economist at Morgan Stanley for a long time, Stephen Roach, had been an unabashed supporter of the Chinese government’s management of the economy. He only changed his tune over the past year or so. His about-face on China is analogous to changing your view on a stock from strong buy to sell after the stock has fallen 90%.
  5. Don’t invest in things you may not understand. There have been a lot of investors who’ve put money into China who’ve never stepped foot in the country and/or have limited knowledge of China and Asia more broadly. There’s no substitute for due diligence and doing the work on countries and stocks.
  6. Read history for an investing edge. Edward Chancellor was right – China’s economic bubble had similar characteristics to other bubbles of the past. He knew it because he’d wrote a well-known book on it called Devil Take the Hindmost. Not many investors read history, though they should.

James Gruber is an assistant editor for Firstlinks and Morningstar.com.au