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Vitaliy Katsenelson
Vitaliy Katsenelson
Articles (126)  | Author's Website |

Focusing On China's Economy

August 08, 2009

The following is three articles from our columnist Vitaliy Katsenelson.

The second is mainly to correct the first article but it made a few good remarks. I find the third one most disturbing.

The Simple Math of “Staggering” Chinese Growth

Chinese non-export economy grew 23% in June! Before you start googling for that number, let me warn you. You won’t find it. I’ve computed it using fifth grade math.

Here is what we know: exports constitute about 35% of the Chinese economy and they dropped over 20% in June, while the Chinese economy (GDP) grew 8%. So the “X” is the growth rate of 65% of Chinese non-export economy.

0.35 x (-20%) + 0.65 x (X%) = 8%. If you were to solve for X you get 23%.

Enough with math, let me put this number in perspective. Chinese non-export economy grew at 3 times the rate of their GDP. I only have two, very contradictory, explanations for this:

1) The Chinese government is lying through its teeth about its economic miracle growth. It has the incentives to interrogate economic data until it confesses to the party line numbers. This is very plausible, as for months, the Chinese government was showing positive GDP growth while its consumption of electricity was declining. Obviously this doesn’t make much sense. Also, China is not famous for production of intellectual type goods (i.e. software, creation of toxic financial products – that is our specialty) which scale a lot better and don’t require proportional electricity consumption to grow GDP. China makes stuff and to make stuff you need a lot of electricity. Also, even if the growth is completely driven by building high story buildings (even if they collapse), highways, schools - these activities still require a lot of electricity.

2) The numbers are real, the monetary base was up 28.5% in June (again if you can trust that number) and thus the quality of growth is horrible. I’ve discussed this scenario in great detail.

I hate to leave on open-ended note, but only time will tell what is actually going on in China.

P.S. I was not surprised to learn that Jeremy Grantham of GMO – a value investor for whom I have a tremendous respect is [url= http://contrarianedge.com/2009/07/28/the-simple-math-of-staggering-chinese-growth/ ]concerned about the future of Chinese economy as well[/url].

Reappraising China’s ‘Staggering’ Growth

I am not writing this under duress, neither my family nor I were kidnapped by the Chinese government; I simply made a mistake in my last note about China called “Simple Math of Chinese ‘Staggering’ Growth” and would like to correct it. The Chinese non-export economy is not growing at a 23% rate. This figure would have been right if China only exported and did no imports, which is obviously not the case: imports are about 25% of GDP (exports are 35%, leaving net exports at about 10%). 

If we were to assume that exports and imports are declining at the same pace of 20%, then the impact of declining net exports on the growth of the total economy would be about -2% – a much lower number than the -7% I used in my misguided note. Also, the non-net-export economy (about 90% of the total) would have to grow at about 11% (not 23%) to offset declining net exports and for the total economy to grow 8%. Here I am assuming that exports and imports declined at the same rate. Chinese imports declined at a slower rate than exports in June and were dropping at about the same rate as exports in May. 

China, as any other country, imports two type of goods: finished goods (i.e., earthmovers, planes, etc.) and raw materials. Raw materials I’d break into two categories as well: the obvious ones – commodities like oil, copper, etc. – and parts, goods that go into finished products that are assembled in China and then exported or consumed internally.

There is little or no value added to finished goods, but there is a lot of value created in raw materials. Sorry to be going economist on you (I am not one), but to understand the import/export relationship, let’s take a closer look at this example: a contract manufacturer that makes cell phones. The manufacturer imports a lot of parts that go into the phones (the processor, wires, sensors) from other countries and sources some parts (maybe memory) in China. It assembles these parts into a final product and exports the product to the US and Europe. The value-added component here is, for the most part, assembly – the cheap labor. If exports of cell phones drop by 100 renminbi, does it impact the economy proportionately by 100 renminbi? No, if, let’s say, 70 renminbi worth of components were imported from Taiwan, the impact on the Chinese economy is only 30 renminbi (Taiwan’s exports suffer a 70 renminbi loss). As you can see, if we ignore imports and focus solely on exports, we overstate the impact exports have on the economy. I did just that. Wrong! 

Things get even more complicated because of the multiplier effect – though net exports are only 10% of the Chinese economy, there is a large number of additional jobs created around them. Plus, don’t forget the capital investment that growth of exports brings to the country: factories are built and infrastructure (roads, airports, etc.) is needed to support these factories. Capital investment and export manufacturing-related infrastructure projects will decline with plummeting exports. To make things worse, we have overcapacity in China. Huge factories were built to accommodate demand than will not actually be realized for years. Developed-world economies are readjusting to a “new normal,” consumption of many products will readjust to lower levels, and thus fewer goods will be produced. We can already see this by listening to conference calls of large multinational companies – they are cutting their production in China at a very fast pace. Finally, a very large portion of imported commodities likely goes to support a non-export economy, thus imports true impact on export economy is hard estimate.

The inconvenient truth is that it is very difficult to measure the true impact that declining exports have on the Chinese economy – it is lower than I estimated in “Simple Math of Chinese ‘Staggering’ Growth,” but likely higher than the number I came up with above. The bottom line is that the growth of non-net-export economy is lower than I originally estimated, but it is still staggering considering its significant acceleration on top of already high growth.

All in all, though I am not glad I made the net-export mistake; at least, it sent me on a mental refresher course of economic concepts that unfortunately I’d forgotten.

P.S. More stories are coming out about outrageous real estate projects in China. This video of empty skyscrapers in China reminds me of empty condo buildings in Miami.

China’s growth an accounting miracle

I hope you are enjoying the last month of summer. I’ve gone fishing twice this month – caught absolutely nothing. Actually I don’t think I’ve caught a single fish over the last five years. But I’ve been mainly reading, listening to music and drinking beer while I was fishing. So the fish probably did not take me too seriously. I’m taking the wife and kids to Steamboat this weekend. We had a lot of fun there last year, thus I’ve been waiting for it since.

Now we are learning how China has achieved its “miracle growth.” The country showed positive GDP growth while its electricity consumption declined in the beginning of 2009 – creative accounting that makes Enron’s accountants appear as dilettantes. A paper published by John Makin at American Enterprise Institute explains it well:
“Once China had announced its 8 percent growth target, it began to disburse funds directed at a sharp increase in public works spending. It is important to understand that the disbursal of funds is recorded as GDP growth. So the government can easily control the pace of growth by the pace at which it releases funds that have already been allocated in the stimulus package to the creation of higher production or growth numbers. Funds disbursed for fixed-asset investment by state-owned enterprises or provincial governments are counted as having been spent when they are disbursed. In fact, the funds go out to the state-owned enterprises and provincial governments and may be held until actual projects are identified and undertaken.” (Emphasis is mine.)

But wait, it gets worse:
“…Ambitious planners count shipments [consumer products] as retail sales while end-use demand may be absent. In such cases, the “sales” are made to happen by virtually giving away the products that have already been produced and counted as GDP growth.”

I am not convinced if China will have inflation in the long-run. It appears that deflation is a more likely scenario as China is ridden with overcapacity – the country was geared for much higher global growth. I can, however, see inflation erupting in a very short timeframe as money has been thrown at the consumer/companies, and we are seeing this in the stock market and real estate. But in the long run, inflation appears an unlikely outcome: overcapacity and slower demand from the US and Europe will force Chinese producers to cut prices to increase utilization and stimulate demand.

Lately, we’ve started hearing whispers of the Chinese renminbi contending for the status of the world’s reserve currency. On the surface it more or less makes sense. The US is struggling and Europe has structural problems. John Mauldin correctly put it, “EU was designed for prosperity not for adversity.” It will be hard for the EU experiment to survive in the long run. But that’s a topic for a different discussion.

China on the other hand is chugging along. I heard (though not confirmed) the Chinese stock market now has a greater market capitalization than Japan’s. Though the Chinese economy has the size of a global currency contender, it lacks one not-so-little element that the global economy will require for renminbi to become the world’s currency – political stability. We forget that China is still not a democracy. I am not sure what to call the political system of the People’s Republic of China but I don’t think it’s the “people’s” nor is it a “republic.” The rule of law is a nascent concept in China. Something is only legal if the government thinks it is legal.

And finally, I’m sure China doesn’t want the renminbi to be the world’s currency as it would drive up the value – a suicide for an export-based economy.

P.S. I highly recommend you read Peter Drucker’s paper called Managing Oneself – it is terrific. I’ve read it the first time about six years ago, had a huge impact on my life. Also, a friend forwarded a very interesting article by Anatole Kaletske (I’ve never heard of him until today), he makes a very interesting case that European Central Bank has outdone even our mighty Fed in quantitative easing.

Vitaliy Katsenelson


About the author:

Vitaliy Katsenelson

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email or read his articles click here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy’s book Active Value Investing (Wiley, 2007).

Visit Vitaliy Katsenelson's Website

Rating: 2.7/5 (3 votes)


Ben Gee
Ben Gee - 8 years ago    Report SPAM
China's export is down by 21% and China's IMPORT is also down by about 17%. So China's NET export is down by only 4%. Therefore, China's non export economy only has to expand by 10% to give China an over all growth of 8%. Mr.Katsenelson's grade 5 Math does not work. He needs first year college Economic for this.

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