Chinese Recession Ready to Move Into Services

If China's slowdown is more recession than rebalancing, the service sector is about to be hit.

Christopher Balding has been digging into Chinese economic data, most recently in Official Data Manipulated By Internal Weighting, where he looks at the official services PMI.
Second, not only was the Expected Business Activities Index and outlier, it was an extreme outlier. The average of the Expected Business Activities Index of 59.9 over the past 12 months while the non-manufacturing PMI was only 53.8. In other words, it was on average 6.1 points higher than the average.

Third, even given the extreme outlier nature of Expected Business Activity, it still required underlying statistical manipulation to meet the headline number. This was accomplished by overweighting the one variable that was above the average even by so large amount. Though we can’t know exactly how they weighted all nine components, if we take a simple model where all other eight components are weighted identically and Expected Business Activity is overweighted, we can arrive at a plausible estimate. Using this simple technique, I find that Expected Business Activity would receive a 36% weighting with all other components receiving an 8%. In other words, Expected Business Activity is 4.5 times more important than any other variable.
Balding accepts the number as hope among Chinese entrepreneurs. The service sector is literally not depressed, but the numbers show that the only thing keeping a depression at bay may be psychology.

On consumption, he's had a lot of posts recently, one from September is Is the Chinese Service Sector Growing Enough to Drive 7%?
Let’s take a slightly stylized version of the Chinese economy. Assume they have a 50/50 split between production and services, which isn’t exact but close enough for our purposes. Now let’s assume that production is growing at 2%. It is hard to find any output growing that fast, much less all output, but let’s assume that for the moment. For the remaining 50% of the economy to push total GDP growth to 7%, that would require the service sector in aggregate to grow at, in our somewhat simplified version of the Chinese economy, a total of 12%. So far, if we exclude top line NBSC data, I haven’t been able to find any service sector growing at double digits much less the entire service sector using key metrics. I am not the brightest guy around but I struggle to see how health service provision and consumption can increase in double digits when visits and medicines are growing so much slower. I fail to see how telecom services can positively contribute to service sector growth when virtually all its components are negative. Service and consumption need to grow significantly faster than 7% to push the entire economy up to 7% given the acknowledged slowdown in output and it simply is not merely a flesh wound.

If any rebalancing is taking place, it is from the shrinking of the industrial sector. The services sector is growing faster than the manufacturing sector and rising as a share of GDP, but it isn't pulling overall GDP higher.

However, we can also use Hayek's triangle to understand why consumption numbers won't slip until services numbers slip, and both will come after the industrial numbers slip.
This triangle shows the movement of capital and labor through the economy, starting with the mining sector and ending up with the final goods, which are 70% consumer goods. Along the way, the triangle is expanding as capital and labor are added to goods. You start with oil at the far left, and as you move right, it is broken into component parts, some of it turns into plastic, the plastic turns into a toy and is sold to the consumer.

Notice the difference in size. In a developed economy such as the United States, the sectors on the far left are very small, a few percentage points of the economy. Manufacturing is also seen as a small fading part of the modern economy, but this view is incorrect. Obviously, since everyone is a consumer and the goal of production is consumption, most goods are consumed. This is where the "70% of GDP is consumption" comes from, but it is not the true picture of the American economy, let alone the Chinese economy. Instead, the real picture is revealed by measuring gross output. Where GDP measures the output of final goods, GO measures all goods and services produced, including those of the intermediate stages. Instead of a measure of the total value of goods produced, it measures total economic activity, and it shows manufacturing is the single largest sector of the U.S. economy.
Let's put these two ideas together. One, sectors such as resource extraction are small, accounting for only a few percentage points of GDP and even GO in the advanced U.S. economy. These sectors are leveraged to consumer growth: a small change at the right of the Hayekian triangle above, causes a huge change at the far left. We can see this impact in nearly every recession. Recall the drop in consumption in 2008; it was quite mild. In the whole recession, GDP was barely dented. However, oil prices collapsed from $150 to $35 and other industrial commodities saw similar moves.

We can see the same effect in gross output. U.S. GDP expanded 0.12% in 2009, but GO collapsed 8% that year and private (ex govt) GO plunged nearly 10%.
The slowdown in economic activity often begins on the left side of the triangle, such as the housing slowdown in the U.S. which was well underway heading into 2008. This is the classic boom-bust cycle discussed by Austrian economics, most simply stated (and stripping out the theory) as an expansion in credit which leads to malinvestment in the capital goods sector. The recession begins in those sectors and the permeates throughout the whole economy over the course of many months or even years if intervention slows the process.

Today in China, the industrial sectors are contracting and the resource sector, located all over the globe, is similarly in contraction. The recession has begun in the higher stages of production and is slowly working its way through the economy. If there is a slowdown in consumption, it is unlikely to hit until well into 2016——if it even hits at all because Chinese have the ability to maintain consumption growth from savings. The intermediate stages should really feel the slowdown in the next few quarters and by mid-2016, it won't require digging into the data to see the effects.

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