China's Most Misleading Indicator


Among investors and economists who study China, few arguments are more contentious than growth - more specifically, how to measure it. Officially, China's economy has been growing at an annualized rate of nearly 10 percent for the past three decades. But plenty of analysts will argue that those figures are highly optimistic.

Why should this debate matter? After all, China has pulled hundreds of millions of people out of poverty in recent years, while building the kind of sparkling new infrastructure that makes the West envious. Whether GDP has grown by 10 percent a year or 9 percent shouldn't much matter - either way, aren't things getting better?

The problem is that GDP isn't simply a measure of growth. It's a metric widely used to get a better understanding of economic trends, put risk in perspective, and make crucial business and investment decisions. In China, this creates two distortions. First, if GDP data is faulty, those metrics may be significantly understating risk. Second, even if the data is accurate, China differs in crucial ways from most developed economies - and metrics linked to GDP can consequently be misleading.

Take one of the most common measures of a country's credit risk, debt-to-GDP ratio. In China's case, going by official numbers, debt reached 255 percent of GDP at the end of last year. Yet if one makes the (quite reasonable) assumption that actual GDP was 10 percent lower than the official figures, debt has reached 283 percent of GDP. With no real-world changes, in other words, China's risk profile has worsened significantly.

This has implications for regulators and investors around the world. Groups such as the International Monetary Fund and the Bank for International Settlements typically monitor debt-to-GDP levels when evaluating a country's credit risk. With China's credit growing roughly twice as fast as GDP in recent years, they've been sounding the alarm.Yet given China's chronic deflation, debt has been rising even faster when measured against cash flow. Since June 2013, operating revenue for listed companies in China has increased by 13.6 percent, far less than the 24 percent that official GDP grew by in the same period. Liabilities, meanwhile, have grown by 49.7 percent. By this metric, the IMF and the BIS may be substantially understating risk.

Now assume that China's official figures are correct. There's still reason to think that metrics linked to GDP are fundamentally flawed.

Per-capita GDP, for instance, is commonly used to assess consumer power. This is usually reasonable: Household income makes up nearly 90 percent of GDP in the U.S., and thus per-capita GDP is a pretty good proxy for spending power. In China, however, disposable income makes up only about 44 percent of GDP, because such a large portion of growth comes from fixed-asset investment that doesn't pass through to households.

As a result, businesses can enormously overestimate the ability of the Chinese consumer to spend and borrow.

For one example, Yum Brands Inc., the owner of Pizza Hut and KFC, has opted to sell its China division after it reported poor same-store sales growth in the third quarter of 2015, relative to nearly 7 percent official GDP growth. However, the Tsinghua UnionPay Advisors Restaurant and Catering Index shows that restaurant traffic was down across the board in the second half of 2015, compared to the previous year. Yum's 2 percent same-store sales growth shouldn't have been disappointing; it outperformed the market.

Real estate offers another case in point. Urban per-capita GDP is more than 100,000 yuan a year in Beijing, which translates to per-capita household income of about 50,000 yuan. If we calculate home-price risk for Beijing using per-capita GDP, we get a price-to-income ratio topping 40, on an average home price of 48,000 yuan per square meter. However, if we use a better measurement - household income, or the cash people have to repay debts - that ratio tops 80, suggesting a far riskier real-estate market than many investors may realize.

The mistake, in each case, is to forget that GDP doesn't pay employees or make debt payments. It's a fictitious number. Cash flow is what matters in buying office supplies, repaying the bank or making payroll. And cash flow is what investors and analysts should be taking into account.

When you dig beneath the surface of China's economic data, common metrics can be less than reliable. Too often, investors accept the headline numbers and fail to ask if they're the best available. GDP matters in China. But it isn't everything.