Musings Report #11 3-15-14 China: What Happens Now that the Low-Hanging Fruit Has Been Picked?

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China: What Happens Now that the Low-Hanging Fruit Has Been Picked?

Anyone tracking the global economy has an eye on China, for obvious reasons. China has led the world's growth for the better part of two decades, and now the growth story has entered a new phase. China is weakening its currency (renminbi/yuan), and trying to throttle its vast credit/shadow banking expansion even as it claims to be expanding at a phenomenal clip (7+% annually).

I think we can shed some insightful analytic light by saying that the low-hanging fruit in China has been picked, and this creates an entirely new set of problems and challenges.

The first thing to note about nations experiencing rapid growth is mathematical: when China's economy (in purchasing power parity (PPP) or nominal dollars) GDP was $500 billion, an expansion of $50 billion equated to 10% a year.

Now that China's PPP gross domestic product is around $8 trillion, a 10% growth rate would require an expansion of $800 billion--larger than the entire GDP of Indonesia or Turkey.

Obviously, fast growth is easy when low-hanging fruit are abundant, and it becomes progressively more difficult to maintain as the economy expands.

This pattern of rapid growth, maturity and stagnation can be seen in the S-Curve, a pattern that natural and human-made systems alike track.

When a country lacks infrastructure, or the infrastructure has been destroyed by war, then building infrastructure is the dominant activity in the low-hanging fruit/fast growth phase. Nations such as Japan and Germany experienced rapid growth after World War II for much the same reason China has boomed: building infrastructure.

But China has reached the maturity phase in a mere 20 years: every major city has a subway system, thousands of miles of rail and highways have been laid, tens of millions of housing units have been built, and so on. As a result of this single-minded pursuit of building, China now sports nearly numerous empty cities, train stations, malls and highrise residential towers.

Observers in Beijing see (well, not very far, due to the severe smog) endless growth of housing, due to strong demand. But this rosy view overlooks the fact that housing throughout China is out of reach of the 20 million migrant workers pouring into the cities: they earn a few thousand dollars a year, and even the cheapest condos cost well over $100,000 (in USD) in 3rd tier cities and much more in 1st and 2nd tier cities. Collage graduates earn around $10,000 annually, so a double-income middle class household can only own a flat if the entire family's savings are devoted to the down payment, which is usually 50% of the purchase price in China.

So all these stories of housing demand being permanent are misleading, because only a tiny sliver of the millions of people coming to cities can afford even the cheapest flat in the suburbs.

The other problem is that the low-hanging fruit have all been stripped via an unprecedented expansion of credit. Credit has a pernicious characteristic: it inevitably leads to diminishing returns as low-value, high-risk projects get funded in the rush to build anything and everything everywhere.

In other words, once the high-value low-hanging fruit has been picked, the sensible, high-value investment opportunities have all been taken and all that's left is marginal malinvestments.

In the U.S., this led to the famous McMansions in the middle of nowhere. In China, the general faith is that every building project, no matter how marginal, will soon be filled. But as pointed out above, this presumes the 20 million poorly educated rural migrants and the 8 million students graduating from college every year will soon be earning middle-class incomes. Once the fast growth phase has ended, this becomes much more problematic. And indeed, reports of unemployed college graduates are now common. As for migrants, most toil in very marginal jobs with low, insecure pay.

Another systemic problem arises when the low-hanging fruit have been picked: expectations of future prosperity have been pushed into the stratosphere, and these expectations will inevitably be disappointed as growth slows.

Rapid industrialization leads to rampant pollution. China has spent very little of its GDP on environmental investments, and now the bill is coming due. It is mathematically impossible for China to spend what needs to be spent (say, 5% of GDP for a decade) on cleaning up the environment and maintaining 7.5% annual growth. Promising people both only sets up a profound disappointment as neither goal can possibly be met.

Lastly, China lacks the cultural capital of maintaining infrastructure. In the 20 years of picking low-hanging fruit, buildings have been routinely torn down and replaced every decade. The idea that a building will have to last 50 years, never mind 100 years, does not compute: ifa building starts ageing, the solution is to tear it down and replace it with something grander.

This was possible in the fast-growth phase, but it is impossible in the mature/stagnation phase for the same reason noted above: it's possible to tear down and replace 1,000 major buildings a year in the early years, but it becomes physically and financially impossible to replace tens of thousands of ageing buildings a year.

Those familiar with construction and this lack of infrastructure to oversee and fund maintenance foresee tens of thousands of buildings that will slowly but surely become uninhabitable as elevators break down, pumps stop working, leaks cause concrete to spawl, etc.

Right now China is at the top of the S-Curve, and these problems of stagnation and decline are still ahead. The most severe challenge in my view is not material or fiscal, it's psychological: when sky-high expectations crash to earth, social discord starts its own S-Curve of rapid growth.

Summary of the Blog This Past Week

What's Cooking at Our House: Paella 3/15/14

Is the Deep State Fracturing into Disunity? 3/14/14

What Happened to Flight 370? An Analysis of What Is Known 3/13/14

How The Fed Has Failed America, Part 2 3/12/14

The Fed Has Failed (and Will Continue to Fail), Part 1 3/11/14

Ukraine, A Geopolitical Choke Point 3/10/14

I found the puzzle of what happened to Flight 370 very interesting, and it was a guilty pleasure to write about it. Though I reckoned my series on how the Fed has failed America the most important of the week, Friday's piece on the fracturing of the Deep State was by far the most popular, with over 15,000 views on my servers alone.

Best Thing That Happened To Me This Week

Another tough decision this week; home-made biscotti is tough to compete with, though the sprouting of some Scarlett Runner beans quickens the heart of any gardener.

Market Musings

Patience. That's not a very exciting strategy, but I continue to see plentiful evidence that the trends that have been in place for months or even years are topping and set to reverse or enter a trendless chaotic period. I see no clarity being possible before late April or May at the earliest, and September-October at the latest.

Could the situation in Ukraine be a "black swan" trigger for other crises? Or will the credit bubble in China be the proximate cause of the next turn? All we can do is wait and avoid risk.

From Left Field

Is This The Worst Scooter Driver In China? -- if you need a chuckle at someone's expense, this is the ticket--comically bad driving in only 1:04 minutes.

Dylan Winter and the Starling Murmurations (4: 18 video) (via John S.P.) -- beautiful short film

Bill Gates Says Neither People Nor Governments Are Prepared for the Huge Changes Coming to the Labor Market -- it's called "the end of work as we know it"; wages are no longer an adequate means to distribute the surplus of an economy....

The Town That Turned Poverty Into a Prison Sentence (via Alexander B.)
Most states shut down their debtors’ prisons more than 100 years ago; in 2005, Harpersville, Alabama, opened one back up

Farm-to-Table Living Takes Root (via Chad D.) -- when the golf course becomes a farm...

Farm Bill Reflects Shifting American Menu and a Senator’s Persistent Tilling (via Joel M.)

Where Have All the Lobbyists Gone? (Kent W.)
On paper, the influence-peddling business is drying up. But lobbying money is flooding Washington, DC like never before. What’s going on?

Climate change puts ancestral farming indicators under stress in Bolivia's highlands (via C.N.F.)
It's in that season they look for guidance to the southern lapwing, a long-legged plover that likes grasslands. If the female drops her eggs on the crest of a furrow, a lot of rain is expected and farmers will plant potatoes rather than quinoa, which requires less water. But if she deposits them inside the furrow, it supposedly will be a dry year.

NASA-funded study: industrial civilisation headed for 'irreversible collapse'? (via Steve K.)
Natural and social scientists develop new model of how 'perfect storm' of crises could unravel global system

A Tale Of Two Bubbles - China

China Expands Into a World of Peril: Beijing Faces Mounting Vulnerabilities on the Global Stage

China's Credit Nightmare Explained In One Chart

China's Pollution Problem (In 1 Stunning Chart)

China's smog is 'Nuclear Winter' bad (via John D.)
A Chinese crop scientist says the smog is approaching levels "somewhat similar to a nuclear winter" and warned that it could have devastating consequences for the nation's food supply, reports the Guardian.

"If you do not change direction, you may end up where you are heading." Lao Tzu

Thanks for reading--

charles