If you’re trying to understand what’s going on with China’s economy, then looking at GDP should be really far down on your list of things to do. In fact, it’s pretty much useless.
Still, whenever it comes out, the world sits up, dusts off its reading glasses, and gives it entirely too much attention. In Q1, Chinese GDP came in at 6.7%. This should bore you.
And no, we’re not saying this because China’s GDP number is fake, as many suggest. That’s not the point.
The point is that its meaning is, at best, overplayed. At worst, it’s misunderstood.
To understand why, you have to understand what is going to make China a healthy economy. It’s actually not a growing GDP — it’s a shrinking one.
Dodging a bullet to fall into a landmine
To understand what’s going on in China, you’ve got to understand what China did to escape the financial crisis: It stimulated. The government pumped the economy with trillions to stave off a slowdown, and China rolled along while the rest of the world languished and started the onerous process of deleveraging.
Those trillions were spent on everything you think of productive things, but also the unproductive things you think of when you think of a China bubble: empty buildings and roads to nowhere. These things add to GDP growth, but they also add to debt, and all of that debt is somewhere in China’s $30 trillion state-backed banking system, building up nonperforming loans and gumming up the gears of the Chinese economy.
And that’s where we are now. China is trying to move away from this finance-fueled growth and move to an economy that runs on consumer spending. It wants to bury unproductive state-owned enterprises (SOEs) in old industries like coal and steel that relied on debt for growth and grow its services industry.
To do that, though, it has to get rid of all of this debt. But it’s not doing that. In fact, what this Q1 GDP number is telling us is that China is doing just the opposite of that. It’s not heading toward more stability — it’s building toward more volatility.
Pray for shrinkage
You don’t really need to look at GDP to understand any of this. All you need to see is credit expansion. When credit starts contracting, that’s when we know China’s turning a corner.
Economist Michael Pettis put it best on his blog:
It is only when credit growth begins to decelerate much more rapidly than nominal GDP growth that we can begin to talk hopefully about China’s moving in the right direction, and it is only when credit growth falls permanently below the growth rate of the economy’s debt-servicing capacity that China will have adjusted.
In Q1, Chinese credit soared a whopping 58% from this time last year. The economy is not adjusting and growth is still being fueled by credit.
And, by the way, if you think China can just put this off until the services sector is strong enough to carry the economy, you’re wrong. The government recognizes that reform has to happen as soon as possible, and the services sector is in no way strong enough to carry China through this deleveraging unscathed, as Bloomberg economist Tom Orlik pointed out in a note on Friday morning.
The services sector continued to account for a larger share of output. That’s a positive, but not a panacea for China’s structural woes. Services output is being artificially inflated by the unsustainable growth of the financial sector. Outside the financial sector, the creation of millions of low-skill, low-wage service sector jobs for waiters, shop assistants and security guards will do little to push China toward a consumer-oriented economy.
In short: China’s GDP growth is basically empty calories. The number is hollow. It will become relevant only when it starts shrinking — then we’ll know China is doing the important work of shrinking debt-bloated SOEs and building an economy of substance.