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A Real Estate Developer Flaps its Wings in the US and a Factory in China Closes

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We read a lot about the rise of China, and its growing economic power, but what is the source of this? Did China all of a sudden decide to start growing its GDP? Or was there an underlying catalyst for this unprecedented 30 year run?

China has always run a trade surplus with the US. It does not really run a significant trade surplus with any other nation, and in fact runs deficits with a few others in Asia. So the relationship is, China makes stuff, the US buys it, the US pays in US$, the Chinese then take this money, and put it in US Treasury bonds. Because their own economy could not handle the large influx of currency, and there are not enough domestic investment opportunities to place $3 trillion in bets (see Carl Walter's brief video for an excellent explanation), it goes into the most liquid market in the world – US Treasury bonds. So in the words of my former colleague David Scott (Deutsche Strategist in the early '00s), “China makes the cars, and sends them back with a check slipped under the windshield wiper.” China made all this stuff for Americans to consume, being paid in the most universal of IOUs, the US dollar. Now they sit on $3 trillion of them, and have an economy squarely focused on building for the US consumer. Their domestic economy is half that of a developed country's (35% of GDP vs 70% in the US or Europe) and so the only real source of growth in the future will be from selling more and more and more stuff to the US.

So what could take this off the rails? Well, what if the US consumer stops consuming? And why would this happen?

Since WWII, every US economic downturn has ended with a measurable jump in home building. This makes sense; the amount of material required to build a home – cement, wood, copper, etc – is labor intensive to extract, the house is labor intensive to build, and it usually is not built unless there is a real expectation of a buyer at the end of the process. This held true for every recession, until now. In the '00s, household formation was at the rate of 1.1mm/year more or less, while homes were built at the rate of +2mm/year. We all know how this ended. Now, there are 300-400,000 new homes a year being built, at roughly half the rate of new household formation. It is estimated there are 4-5mm unfinished and semi-finished homes in the US, and 11mm households are underwater. Until these completed home prices rise above building costs, e.g. Las Vegas, the US will not see any additional home building. The effect on consumption will be pronounced, and is unlikely that new building (and therefore increased consumption) can be expected.

So what does this mean for China? Nothing good. Their #1 customer has gone on strike, and they are left with a bunch of IOUs that are expected to decline in value versus the Renminbi over the coming years. So the expectations of a strong powerful China may be a bit premature. China's economy is still a one-trick pony, and they placed all their bets on the US. Now those bets are starting to sour. China will have to retool, and refocus on its domestic economy. The rest of Asia learned this in 1998, and China will no doubt make adjustments. But it is doing so from a weaker position than other Asian nations in 1998, in terms of durable institutions, open government, and a general willingness to change. It will be interesting to watch.

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Guest Wednesday, 17 April 2024