why it’s good that China’s growth is slowing

One of the reasons for the current selloff in world equity markets is worry that China’s growth is slowing.

I think these fears are based on a misunderstanding of what’s going on in the Middle Kingdom.

As I see it, a reformist regime in Beijing is trying to break a recurring cycle of wasteful residential/commercial construction and creation of inefficient, low value-added, highly polluting basic industry that has marked many regions of the country.

The problem:

1.  Every local or regional government official is a member of the Communist Party.  Officials get promoted if the areas they’re in charge of show full employment and rising GDP.

The easiest way to achieve both is to support the building of large housing complexes and of (inefficient but) labor-intensive plants that produce, say, steel or chemicals.  The fact that, once up, the housing tracts may remain empty, or that there are already too many such plants spouting pollution in China (and that, in consequence, they have little chance to make profits) is a problem for another day.  Maybe the officials in question will already be promoted to higher office and be gone before anyone works this out.

2.  The easiest way to get funding for dubious projects is to call on the head of the local state-owned bank.  That person is also a Party official who, like the mayor or governor, is judged on producing growth.  For the banker, it’s loan growth.  Even if he has doubts, it’s very hard to say no to a higher-ranking Party member.  So the bank ends up facilitating the building of these white elephants, while also piling up a bunch of toxic loans that will eventually undermine its balance sheet.

3.  Banks have already gotten repeated orders from Beijing not to do this kind of dodgy lending.  But “the mountains are high and the emperor is far away,” as the saying goes.  So banks acquiesce to local pressure.  They also appear to be using the time-honored ploy of financial institutions around the world of creating and funding non-bank entities that will actually carry out lending that’s forbidden.  So off-balance-sheet liabilities are piling up.

4.  There’s also an issue of corruption, of lavish gifts given by the project sponsors to Party officials to get the worthless projects rolling.  Beijing has been talking for at least a half-decade about how seeing Party members enrich themselves through their control of economic development undermines the legitimacy of the Party and can lead to social unrest (which is perennially the Party’s greatest fear).  The current regime appears to be taking this issue very seriously and to be cracking down on corruption in a way that’s very visible in the falloff in sales growth for Western luxury goods makers.

my take

Breaking the tendency of local/regional governments to create “phantom” GDP will take time.  And, to the degree it’s successful, it will result in GDP growth that is not only lower, but unpredictably so.

I think investors in China-related equities will be relatively unaffected by lack of predictability and modest weakness in overall GDP growth.   Just avoid real estate and basic industry for now.

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