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China's Slowdown May Be Worse Than You Thought

By Chris Mayer, editor, Capital & Crisis
Monday, May 12, 2014

The following idea might seem to belong in the "Who cares?" file. But I find it really interesting, and you may too...
There has been some buzz lately about how China may pass the U.S. as the world's largest economy as early as this year. This is according to the GDP figures.
Put aside for a moment the many flaws in the measure itself. There is still one thing that most people don't understand about China's GDP figures... and this little-known fact could have wide-ranging effects in the markets – especially for commodities.
Let me explain...
What most people don't realize is that the U.S. and China actually calculate GDP differently.
The economist and author Michael Pettis has a long and wonky blog post on China's GDP calculation methods. (I met him once for dinner in Beijing four years ago. What I remember most is that I dunked my first bite of food in some sauce that I did not know right then was about the spiciest you could put in your mouth. Hilarity ensued for my dinner companions...)
Here is a key excerpt:
"China and the U.S. compile their GDP data implicitly in very different ways, among the most notable of which is the way Chinese lenders, banks as well as households, treat a substantial portion of the debt as if it were implicitly or explicitly guaranteed by central or local government agencies. This means investment losses don't show up as losses (expenses), because it is politically difficult to do so, and are instead rolled over and so show up as assets."
In short, China's accounting is like Enron's or Lehman Bros.'... or the U.S. government's.
Pettis says if you were to make the necessary adjustments, you would find that China has overstated their GDP by 20%-30% compared with the U.S. That's a pretty big difference.
Although Pettis goes on to say, "Because their economies are implicitly structured in very different ways, which create very different balance sheets, the two economies cannot be directly compared."
So who cares?
Well, that's what I thought at first, except that I then see a number of investors making portfolio decisions based on what China's GDP does (or doesn't do).
If China is much smaller than we think, or is growing at a slower rate, then that has implications — for commodities in particular.
You have surely heard already about how China consumes two-thirds of the world's iron ore, 40% of its copper, blah blah blah.
China had a lot to do with the commodity boom that kicked off in the first years of the last decade. China's slowdown also had a lot to do with why most commodities have struggled since peaking in the summer of 2011.
I tend to agree with David Rosenberg, the chief strategist at Gluskin, Sheff & Associates. He said, "China's boom was a once-in-a-century event, and the grim reality is that it's over."
China's economy will eventually pass the U.S. in size. It seems only a matter of time. But I think the texture of China's growth will look different than it has. It should be less commodity-intensive, for one thing. That's only natural and fits with past patterns of other countries' development paths.
It's also natural to expect recessions. Business cycles happen, even to the Chinese. Bad debts happen, even though the Chinese might not recognize them as such. Reality usually wins in the end, though you can keep up appearances for a long time. (See the Soviet Union, which used to put up pretty GDP numbers that made the West quail with fear.)
Given China's growing size, a recession there is not likely to go unfelt over here — or around the world. I think when that Chinese recession finally happens, it will be a macro event for the ages.
Good investing,
Chris Mayer

Further Reading:

Chris recently shared an idea called the "coffee can" portfolio... He says if you take this concept to heart, "you'll be ahead of 99.9% of your fellow investors..." Learn all about it here: A Triumph of Lethargy and Sloth.
Last year, Chris showed readers why navigating the financial markets is like the challenge that faced the Oakland A's in "Moneyball"... "There is a lot of brainpower and financial muscle trying to 'win,'" Chris writes. "You need to look at the market differently to beat it..." Find out how in his must-read essay: Moneyball Investing: A Simple Way to Beat the Market.

Market Notes

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