Is China’s Amazing Growth Story Over?

Over the past 30 years, China has experienced tremendous growth.

To put this all in perspective, when China began to open up to the world in 1978, exports for the full year were equal to one day of exports in 2010.

In 1980, China’s economy was the size of the Netherlands. In 2013, it added an amount equal to the size of the Dutch economy.

In 1990, China’s economy was the same size as Taiwan. Now it’s more than 12 times bigger.

China’s success isn’t a mystery – it’s been built on a tested and straightforward formula:

1) Rapid manufacturing export growth fueled by cheap labor, cheap land, and robust foreign demand.

2) Huge investments in infrastructure, property, and factories – driven by cheap debt and foreign investment.

Hundreds of millions of Chinese have been pulled out of poverty and some have been able to accumulate great wealth. This is a great success story. Unfortunately, the recipe for China’s success to date is also the source of its current troubles.

China’s Elite Are Worried – Should You Be?

You would think that with all this economic progress and momentum, wealthy Chinese would be brimming with confidence regarding their country’s future.

But they realize that the two trends above that drove double-digit growth in the past have now run their course.

Labor is no longer as cheap after rising at an annual 10% clip, debt isn’t an effective tool for boosting growth and is growing at twice the rate of economic growth, and foreign investment has slowed considerably.

In short, instead of money coming into China, it’s leaving.

And the perception of a weak currency is accelerating this outflow.

“Companies don’t want renminbi and individuals don’t want renminbi,” said Shaun Rein, the Founder of the China Market Research Group. “The renminbi was a sure bet for a long time, but now that it’s not, a lot of people want to get out.”

The Financial Times, in an article titled, “Chinese Doubt the Road Ahead,” cites a Chinese banker with close ties to a number of wealthy and powerful political families:

“There is a sense that we are approaching an inevitable breaking point, when the pressures in society will boil over and consume the rulers… “Almost all the elements are in place for an uprising like we saw in 1989. Corruption is worse today that it was then, people feel they can’t get ahead without political connections, the wealth gap is much bigger and growing, and there has been virtually no political reform at all. The only missing ingredient now is a domestic economic crisis.”

The signs of a nervous elite are clearly there.

A survey co-sponsored by the Bank of China showed that 60% of people with $1.6 million or more in personal wealth have begun the process of emigrating or are considering starting the process.

According to some of my contacts in the banking industry, Chinese companies raising capital offshore are keeping it there – as far away from Chinese authorities as possible.

A study by Bain & Co. shows that these emigration numbers are “rising dramatically.” Wealthy Chinese are snapping up offshore real estate and other investments to protect their wealth.

In the Financial Times, Hung Huang, a publishing and fashion mogul says, “You can feel the anxiety of the ultra-wealthy and even of the political elite. They feel there’s no security for their wealth or possessions, and that their assets could be taken away at any time.”

China is burning through foreign reserves at a blistering pace to stabilize the yuan and offset capital flight. In the last seven months, reserves have declined by $700 billion, and have dropped by $200 billion in the last two months.

This is automatically tightening monetary policy, squeezing liquidity, and risks holding back the very recovery in China needed to quell doubts.

So what’s next?

China is still plagued by too much government and too little market. The top down allocation of power and capital is no longer working.

Deep retrenchment and reform is the only remedy, but will be fiercely resisted by the Communist Party’s senior leadership.

In my next column, I’ll share an effective China hedge for a worst-case scenario for China.