Amid bank runs, recent signs from the Chinese government indicate that further financial reform will be postponed and, in order to maintain growth, the credit spigots are about to re-open.
Policy is unfolding exactly as predicted by Peking University Finance professor Michael Pettis. In 2012, he used the following stark analogy:
"It is as if you saw a middle-aged man in terrible physical shape running a marathon, and you predicted that after five or six miles he would be forced to quit. If however he took out a syringe and shot himself up with crystal meth, he would be able to continue running a few more miles, but this doesn't mean that your analysis and prediction were wrong. It means that in a few more miles he will be worse off than ever."
The ranks of China bulls have been shrinking alongside steadily weaker economic data. Most recently, the flash HSBC China Manufacturing PMI index reading of 48.1 for March verified a steep contraction in economic activity (any reading below 50 indicates declining activity).
The Citi China Economic Surprise index – a weighted measure of economic data relative to economist expectations – has fallen off a cliff, hitting lows last seen during the depths of the financial crisis.
Citi Economic Surprise Index: China
SOURCE: Citigroup/Bloomberg
Another shot of meth from fiscal stimulus could provide a short term boost to economic activity but it merely postpones the reckoning. Corruption is rampant and the estimated $2-trillion invested in wealth management products remains a ticking time bomb of write-offs.
To propose an economic analogy of my own, China's situation is in many ways similar to the United States in the late-19th and early-20th centuries. The U.S. civil war marked total victory for the forces of industrialization and the process of urbanization unleashed spectacular economic growth. Even China's issues with food quality have an analogue in the Chicago Meat Packing scandal of 1906.
European leadership viewed the United States as economically backward and a source of cheap resources, but the Second World War eventually left the Americans as the world's dominant financial power. China may well do the same in the coming decades, but it won't be easy.
The United States had five financial panics between 1873 and 1907 as the sophistication of the banking system and government regulation failed to keep pace with the economy.
The study of economics has progressed exponentially since then, so it's highly unlikely Chinese officials will experience the same level of financial upheaval. Even so, issues like industrial overcapacity, environmental degradation and the massive wealth management "Ponzi scheme" make it clear that a massive, likely painful reorganization of the Chinese economy will be necessary.
For Canadian investors, the historical comparison suggests that a prolonged pause in China's economic miracle will almost certainly happen no matter how much fiscal spending occurs this year. The domestic stocks that have benefitted from China's growth in the past decade – mining in particular – are likely to underperform.
Follow Scott Barlow on Twitter at @SBarlow_ROB.