China’s Crisis Years

China is seeing a series of long and short-term bad decisions come to a head. Demographic destruction is catching up with low return investment and changing supply chains.

Demographics

Mao introduced the one-child policy four decades ago. This lead to a rapid slowdown in the birthrate that stopped China’s population growth. The problem is that many couples chose to abort female babies in favor of males who could carry on the family name. This lead to a China with approximately 40 million more men than women under the age of 40.

The imbalance may be even larger as China only recently made significant adjustments to its data suggesting birthrates were even more in decline than previously thought.

The Chinese population is aging faster than any population ever has. China is now older than the US and the birth rates have continued to fall rapidly. Recent reports suggest that it has fallen another 20% over the past two years.

The primary reason for the rates continuing to fall is the cost of raising children in the cities and increasing economic uncertainty. Economic uncertainty is being driven by a real estate market that continues to slow.

Infrastructure Economy

Living in China, it is hard to not be impressed by the scale of building. Where we might see a single apartment building raised to house 80 or a 100 units, Chinese developers will build multiple buildings at one time to house 2,000 or more units. The same approach can be seen in the building of high speed rail and highways.

This building represents as much as 30% of China’s economy and more than 50% of the revenues for local governments.

This all stopped when Evergrande ran into financial trouble. For the first time since Deng was the leader of the country, there was doubt that real estate was a sound investment.  People who had purchased apartments, and were making mortgage payments, could not move in because the developers had run out of money to finish the apartments.

While the apartment construction was a symbiotic relationship between consumer and local governments, the infrastructure building was often based on provincial or federal targets. I often rode on a beautiful ten lane toll way that was nearly empty. It was empty because it did not connect major cities. To get to the cities, we would have to exit and transit over a two lane country road for 20 minutes to get to the city.

High-speed rail construction was curtailed a couple of years ago because they had built lines to cities with no traffic. Coal power plants have been built in provinces to a point that they can not sell power because there is not enough demand and the next door province is also overbuilt.

China’s infrastructure is extremely overbuilt, just not in the right geographies.

Changing Supply Chains

The shifting relationship between the US and China is well known. The falling export numbers out of China are certainly driven by slowing economies in the US and Europe. That will not be the story in another year as production capacity in Mexico and the US comes on line to replace Chinese production.

Perhaps the greater threat to China is the pre-factory production capacity. For the past two decades, China has benefited from a neo-colonial production philosophy. They built relations with the leaders of governments in Peru and Indonesia and the Congo to bring raw ore to China where Chinese facilities, unconstrained by western environmental concerns, could convert the ore to metal. The key being that low-cost labor was employed.

This is what started the growth of China’s economy.

Now, those countries are realizing that ore upgrading is something they can do at home. Peru and Indonesia are building their own upgrading facilities. This moves economic value and jobs out of China, even if Chinese money is used to build the factories. The now dated factories in China go from being world beaters to idle capacity.

This is the storm that is hitting China. Excess capacity with a workforce that is shrinking and growing old. The students who are graduating from University do not want to work in the factories. In fact, they were told that getting to University meant they did not have to work in the factories. More than 20% of them sit idle now without jobs.

Consider this, there is no negative value in GDP. Building an apartment that is unoccupied is positive, just like tearing it down five years later is positive.

China is going through the great mark to market that all investors face. Making investments that have zero or negative returns can last a long time without proper accounting zero interest rate world. When money starts to cost something, even the largest portfolios feel mark to market pain.

We are witnessing a great transition that will absolutely leave China changed forever. China had two revolutions in the last century. It is likely there will be at least one this century if these factors keep moving the same direction. What shape it will take is yet unknown.