Big Trouble in Big China

After the stock rout, the economic situation in China has a lot of the world’s smartest investors worried, according to Bloomberg:

Hedge fund manager Paul Singer said that China’s debt-fueled stock market crash may have larger implications than the U.S. subprime mortgage crisis, echoing warnings from fellow billionaire money managers Bill Ackman and Jeffrey Gundlach.

“This is way bigger than subprime,” Singer, founder of hedge fund Elliott Management, said at the CNBC Institutional Investor Delivering Alpha Conference in New York in response to a question about China’s crash potentially affecting other markets.

China’s economy is built on an export-oriented model that prioritizes investment in factories for export, as well as in infrastructure that supplies the factories and gets the exports to the ports. The model worked brilliantly for many years, but the law of diminishing returns is setting in. As China has gotten larger, its economy has a harder and harder time growing faster than the rest of the world and other countries are challenging China for low-cost manufacturing. Many Chinese industries now struggle with overcapacity—too many factories were built—and the country is struggling to keep costs down even as workers demand cleaner air and water, better wages, better schools.

Chinese authorities have for their part, for a combination of reasons, tried to keep the economy growing. Besides putting more and more money into infrastructure projects that offer less and less payoff, China has relied on its credit system to support state-owned enterprises. One result has been a string of bubbles—in factories, in commercial and residential real estate, and, most recently, in the stock market. Two things are worrying about the stock market bubble and the government’s efforts to keep it inflated. First and foremost, it is a sign that Chinese policy is still wedded to a pro-bubble policy, and that the government doesn’t really know how to shift the economy to a new and different basis without massive side effects. Officials appear to see no choice but to continue on a course that is probably unsustainable. Second, the difficulty they’ve had in stopping the stock rout, and the extreme measures they’ve had to take, points to the possibility that China is coming closer to the point where the government won’t be able to prop the bloated system up anymore.Any kind of major economic meltdown in China would have huge consequences—political as well as economic—around the world. Developing countries that depend on commodity exports would be hammered. From OPEC to South Africa to Argentina, Australia, and Brazil, countries that have prospered by selling commodities to feed China’s endless appetite will face lower prices and slack demand. The deflationary pressures in Western economies would intensify, and price competition in manufacturing would intensify as Chinese factories sell off goods at any price to try to survive.No doubt there are hedge funds out there that think they can time this. We don’t claim that kind of crystal ball. But the signs that the Great China Bubble may be bursting have more and more of the smart money worried. That is something that policymakers as well as portfolio managers need to be thinking about, hard.