Wed | Apr 26, 2017

Walter Molano | The China syndrome

Published:Friday | September 18, 2015 | 9:00 AM

The phrase, The China Syndrome, became popular during the late 1970s and early 1980s, when fears spread about the proliferation of nuclear power plants throughout the United States, Europe and the Soviet Union.

There were concerns that an accident could lead to the breakdown of the coolant system, which would create a superheated mass that would melt through the core of the earth and on to the other side of the planet, that is, China. Such an event occurred in March 1979, when a series of mistakes at the Three Mile Island Nuclear Power Facility led to the disintegration of the coolant pumps.

Ironically, the calamity occurred less than two weeks after the release of a movie, titled The China Syndrome, which depicted such a scenario. Almost four decades later, the risk is moving in the opposite direction. The recent financial meltdown in China is burning through the earth's mantle and searing the other side of the globe.

When the movie was released, China represented less than five per cent of global output. Europe, the US and Japan represented almost 80 per cent of total GDP. That's why events in the developing world rarely had any impact on global markets. However, the situation has changed dramatically.

The developed world now represents 50 per cent of global production. Europe and the US are each about a fifth of the pie. Meanwhile, China represents more than 15 per cent.

The combined BRIC economies, which are tightly correlated, are just as important as the US or Europe. This explains why the global markets reacted so violently to the recent equity sell-off in China. It was as if it was a replay of the Lehman fiasco or the euro debacle. There are deep concerns that the Chinese economy is losing traction.

Clearly, there is a long list of indicators that confirm the notion. As recent as six months ago, construction was expanding, but it is now contracting. Cement, a product that is only for local consumption, is down by a third since the start of last year. Electricity demand fell in July, and the PMI dropped below 50 in August.

There are rumours that China's GDP growth in 2015 could be closer to four per cent y/y, instead of the seven per cent y/y that was initially forecast. Such a large downward revision would impact the other BRICs and slash the expansion of global output in 2015 to two per cent y/y, from three per cent y/y. This is the reason why commodity prices and emerging currencies are in free fall.

Many people wonder why this is happening. The answer is multifaceted. To begin with, the post-crisis stimulus package ran out in 2014. In the aftermath of the Lehman collapse, Beijing introduced a US$586-billion programme to jump-start the economy. It was very successful, and it was the reason why most of the emerging market countries did not suffer during the downturn. It was also instrumental in sowing the seeds for the US and European recoveries.

Unfortunately, most Chinese policymakers believe that it was a big mistake. While the benefits were shared by China and the rest of the world, Beijing was left holding the bill. State and municipal governments are haemorrhaging with debt. The country faces a housing bubble, and billions have been spent on unnecessary infrastructure.

This leads us to the second driver of the ongoing downturn. Housing represents about 15 per cent of the Chinese economy. At its peak, the sector represented eight per cent of US output. The implosion of the sector is why the demand for cement and steel is evaporating. This has very negative implications for households, who are dangerously leveraged, as well as the banking sector.

The central government's balance sheet may be clean, but it may soon become responsible for bailing out households, local governments and the financial system. Beijing already spent US$200 billion in propping up the equity markets and another US$200 billion in international reserves defending the currency. The next bailouts will be for the financial sector.

The third cause for the deceleration of the Chinese economy is Xi Jinping's anti-corruption drive. China has a long history of witch-hunts and scapegoat drives, and it strikes fear into the soul of the population. After more than a decade of flamboyant spending, all signs of conspicuous consumption are out.

Moreover, the public humiliation of individuals associated with this summer's equity crash will make the general public reticent to invest in the markets. This will hamper consumption and investment, thus leading to lower levels of economic expansion.

The China Syndrome is real. The problem is that the meltdown is moving in the opposite direction. Perhaps, it should be renamed, The America Syndrome.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.