All feasts must come to an end. China is no exception

The re-emergence of China has dominated recent economic and political discourse. The Chinese economy is forecast to expand by around 60 % in the period between 2007 and 2012, compared to around 3% for developed economies. While China’s rise is important, its drivers are frequently misunderstood and poorly analysed.

China’s economic structure is deeply flawed and fragile. The Chinese growth story may be ending. As an old Chinese proverb, probably apocryphal, holds: “There is no feast that does not come to an end.”

Good times, desperate times...
Prior to the global financial crisis, China’s impact was mostly in manufacturing, especially consumer goods, and demand for commodities. With its large, low-cost labour force, China became the world’s manufacturing centre of choice, exporting around 50% of its output. This helped reduce inflation, lowering living costs throughout the world.

China also emerged as a large purchaser of commodities. It is now the largest purchaser of iron ore and other non-ferrous metals. It is also one of the biggest purchasers of cotton and soybeans.

Between 1990 and 2010, China’s share of world coal consumption increased from 24% to 50%, in part driving a doubling of coal prices. In the same period, China’s share of world oil consumption increased from 3% to 10%, contributing to a 233% increase in oil prices.

Chinese savings and foreign exchange reserves (totaling over $3.2 trillion) were a major source of capital for financing developed countries, especially governments. China exported savings of around $400 billion each year, helping reduce interest rates in the US by as much as 1.00% per annum. Its role as an exporter of capital flows is surprising given China’s average income per capita is around $4,000, well below that of the US and Europe.

Following the global financial crisis (GFC), China’s role became even more important. China, together with some of the other BRIC — Brazil, Russia, India and China — countries such as India and Brazil, contributed a large portion of global growth in 2010 and 2011.

As Western governments ran up large budget deficits in an effort to maintain economic growth, the ability to borrow from China, especially its large foreign exchange reserves, became important. Most recently, the European Union (EU) and the International Monetary Fund (IMF) sought the financial support of China to resolve the European debt crisis.

The country’s increasing importance and foreign praise has led to Chinese hubris. The 30 July 2009 editorial in the English language People’s Daily, an official publication, boasted that China, under the leadership of the Chinese Communist Party (CCP), had coped successfully with the financial crisis, earning worldwide attention: “High-level figures from the Western political and economic spheres... envy China’s superb performance... as well as ‘China’s spirit’ — the kind of solid, unbreakable ‘Great Wall’ at heart to ward off the financial crisis.”

Lock and load....
In the first phase of the GFC, China was badly hit, with growth slowing and lay-offs of 20-25 million migrant workers in export-based Guangdong province alone. Like governments throughout the world, China responded with massive monetary and fiscal stimulus.

In late 2008, China announced a fiscal stimulus package of renminbi 4 trillion (about $600 billion) over two years. The fiscal measures were modest equating to a budget deficit around 2.2%. The major response was via the large policy banks, which are majority government-owned and controlled.

The banks were directed to extend credit and finance infrastructure projects on a large scale. If additional credit growth over and above normal lending is taken into account, then the Chinese government’s stimulus totaled around 15% of gross domestic product (GDP), amongst the largest in the world.

New lending by Chinese banks in 2009 and 2010 was around 40% of GDP. New bank loans in 2009 and 2010 totaled around $1.1-1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50% over the past two years.

Around 90% of this lending was directed towards investment in building, plant, machinery and infrastructure by state-owned enterprises (SOE). In 2010, China allocated over $2.6 trillion to investment expenditure - the highest proportion of GDP of any major economy in the world. According to the World Bank, almost all of China’s growth since 2008 has come from “government influenced expenditure”.

The short of it...
China’s use of rapid growth in credit to restart growth has increased the volume of credit outstanding to 130-140% of GDP and as much as 160-170% when off-balance-sheet-lending is included.

In the 1990s, a similar increase in the growth of lending resulted in sharp increase in bad debts. The biggest state-owned Chinese banks were insolvent, requiring government bailouts that cost around 40% of GDP, only ending in 2004.

The current loans have financed, in the main, property and infrastructure projects.  Increased lending created asset bubbles in property and shares (both now unwinding).

It is doubtful whether the cash flows from the investments will be sufficient to cover all the debt, increasing non-performing loans in the banking system. Governor of the central bank — People’s Bank of China (PBOC) — Zhou Xiaochuan, observed candidly that the large credit flows “pose bank lending quality risks”.

With characteristic hyperbole and an eye for media attention, James Chanos, a hedge-fund investor argues that China is “Dubai times 1,000 or worse”. Predictions of a financial and banking collapse are overstated. Property loans are conservatively structured and also the government has a variety of policy tools to manage problems.

Predictably, in February 2012, the Chinese government instructed its banks to roll-over $1.7 trillion of loans to local governments, to avoid the risk of default. It was tacit recognition that the loans were at risk and may not be able to be repaid on schedule. There was lip service to the fact that Chinese banking regulators would check to ensure that the loans were capable of being repaid. Having already borrowed from the playbook of western governments to resuscitate the Chinese economy from the GFC, Beijing now adopted “extend and pretend” strategies, deferring the day of reckoning on the loans.

As China analysts such as Michael Pettis, a professor of finance at the Guanghua School of Management at Peking University, have observed, the bad debts will absorb significant financial resources and restrict domestic consumption.

The government will recapitalise the banking system by lowering deposit costs and ensuring a wide spread between their borrowing and lending rates.

The Chinese government and PBOC will continue to keep interest rates low, negative in real terms after adjustment for inflation. Low interest rates will make it easier for borrowers to meet repayments. Low or negative real returns entail writing down the loan principal in economic terms while maintaining its nominal value. The banks effectively pass this cost onto depositors in the form of low or negative returns on their savings. Given few alternative investment opportunities, savers have to accept this or take speculative positions in other assets like property.

The PBOC will ensure a wide spread between the bank’s deposit and lending rates, probably around 1.5-2.5% higher than normal. This increases bank profitability and helps build up the bank’s capital base.

Just like the Japanese after the collapse of the bubble, Chinese householders will be forced to pay for the restitutions of their insolvent banks. Savers will pay a disguised tax - low deposit interest rates and high borrowing rates. In effect, the bailout will entail a large transfer of wealth and income from households to other parts of the economy, amounting to several percentage points of GDP.

This will reduce wealth but also slow consumption growth, at a time when external demand for Chinese products and Chinese trade surpluses is decreasing.

The long of It...
The long-term effects of this debt fund investment boom are more complex. Revenues from many projects will be insufficient to cover the borrowing or generate adequate financial returns.

Over-investment in non-productive, low-return projects will ultimately reduce growth.

The bulk of investment has been by SOEs in government-backed infrastructure projects — the tiegong¬ji (meaning ‘iron rooster’), a homonym for the Chinese words for rail, roads and airports.

The ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (km) of rail track to the existing network of 80,000 km. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with superfast trains. Undeterred by accidents and the high cost, further expansion of the high-speed rail network is underway. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 km per hour, nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 km per hour.

China is constructing around 12,000 km of new expressways at a cost of over $100 billion. China’s road network of over 60,000 km of high-speed roads is only slightly less than the 75,000 km in the US. China is planning to expand the high-speed road network to 1.8 lakh km even though China has only around 40 million passenger vehicles compared with 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

While some of the investment is productive, the need for rapid ramp up has meant that an unknown amount is unproductive.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

Crowing roosters or eating crow...
Analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (Icor), calculated as annual investment divided by the annual increase in GDP. China’s Icor has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s Icor rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 of debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Sino-philes dismiss the lack of efficiency, arguing that the decline was because of falls in the growth rate due to the collapse of global demand. This assumes that global demand will rebound, strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programmes of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. The real issue is whether the specific projects are appropriate.

High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While super-fast trains are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may yield higher economic benefits.

Ironically, given the motivation of the plan to increase employment opportunities, this capital-intensive state investment has created relatively few jobs. Instead, the programmes, which are overseen by the Chinese Communist Party, have been used to achieve political objectives.

Over building...
China’s investment boom may also be exacerbating industrial overcapacity. The greater portion of investment has been in infrastructure, rather than manufacturing.

A 2009 report prepared for the European Chamber of Commerce outlines the overcapacity. In its analysis of six major sectors, the report identified the following capacity utilisation rates: steel 72%; aluminium 67%; cement 78%; chemicals 80%; refining 85%; and wind power 70%.

In 2008, China’s steel capacity was 660 million tonnes against a demand for 470 million tones; but the difference is similar to the European Union’s total steel output or the combined output of Japan and Korea. China’s excess in cement is larger than the total consumption of the US, Japan and India. Yet, China continues to add capacity.

If China be unable to absorb this new capacity domestically, then it might seek to increase exports, in order to maintain production and growth. This would increase a global supply glut. To the extent that Chinese growth is driven by such spending on unproductive investments, it is both wasteful and ultimately economically destructive.

The government’s response highlights the severity of China’s problems of late 2008 and early 2009. China’s economy, especially its export sectors, experienced a large external demand shock, stemming from rare synchronous recessions in the developed world.  Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

The unsound foundations of Chinese economic and financial strength have been largely ignored. But then all food tastes good to the starving man.

The end of the meal...
China’s recovery from the initial effects of the GFC was no miracle. Like the rest of the world, it was the result of “Botox economics”. Using the advantages of a centrally controlled, command economy, Beijing boosted output through government spending and directed bank lending to maintain growth.

Unfortunately, China now faces significant problems. The weakness of its two major trading partners (US and Europe) means export demand is likely to remain subdued. Domestically, the side effects of debt-driven investment are now emerging.

China’s ability to sustain high growth levels is questionable. Specifically, its capacity for further stimulus is uncertain. In 2009, Premier Wen Jiabao admitted that the “stabilisation and recovery of the Chinese economy are not yet steady, solid and balanced”.

Lack of stimulation...
The conventional view is China will be able to continue to stimulate demand using its large foreign exchange reserves, large domestic savings and low levels of debt.

China’s $3.2 trillion in foreign exchange reserves are invested in predominately in US dollars, euro and yen, primarily in the form of government bonds and other high-quality securities. These assets have lost value, through increasing default risk (as the issuer’s ratings are downgraded) and falls in the value of the foreign currency against the renminbi.

Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the securities and a rise in the renminbi against the relevant currencies with large losses. The reserves also force China to buy more US dollar, euro and yen securities, to defend the value of the existing portfolio, increasing both the size of the problem and risks.

In reality, China will ultimately have to write-off these reserves, recognising its losses. This equates to a real loss of wealth as China has issued renminbi or government bonds against the value of these investments.

China also has far greater levels of debt than commonly acknowledged, although the bulk is held domestically. The central government has a low level of debt — around $1 trillion (17% of GDP). In addition, state-owned and supported entities have debt totaling $2.6 trillion (42%): local governments about $1.2 trillion (19%), policy banks $800 billion (13%); the ministry of railways $280 billion (5%) and government-backed asset management companies set up to hold non-performing bank loans $300 billion (5%). The total debt, around $3.6 trillion, is 59% of GDP.

The debt levels are exacerbated by what Michael Pettis in his book The Volatility Machine describes as an inverted debt structure - where borrowing levels increase when the economy has problems. Irrespective of current moderate debt levels, when the economy slows, China’s debt levels, both direct and contingent, will increase rapidly.

China also has a limited flexibility in managing its currency. The renminbi has risen 30% since Beijing adopted a policy of managed appreciation and revalued its dollar peg in July 2005.

As growth and exports slow (the trade surplus has fallen to 2% and foreign exchange reserves are falling), China needs to let the renminbi fall to cushion the adjustment. In an US election year, the risk of trade protectionism and the prospect of being referred to the World Trade Organisation for currency manipulation limit China’s policy flexibility.

No consuming passions...
The failure to redress the balance between consumption and investment lies at the heart of China’s economic dilemma.
Consumption totals around 35-40% of China’s GDP, a decrease from over 50% in 1980. Even by the thrifty standards of Asia, Chinese consumption is low, with Japan, India, Taiwan and Thailand at 55-60% and South Korea and Malaysia around 45-50%. American consumption is around 65-70% of GDP.

In contrast, Chinese fixed investment is around 46% of GDP, an increase over the last decade of 12% from 34%. At a comparable stage of economic development, fixed investment in Japan and South Korea was around 10-20% of GDP, much lower than China’s.

There are numerous theses about China’s low rate of consumption. China’s consumption has been growing at around 8% per annum over the last decade but growth in consumer spending has been slower than that of the overall economy. Between 2000 and 2010, gross fixed investment grew at an average annual rate of over 13%, while private consumption grew at around 8%.

One factor has been an underdeveloped social welfare state. Chinese workers lost their state-provided healthcare and education when the SOEs were reformed almost a decade ago.

The Chinese save to cover the expected costs of education, retirement and healthcare. Despite the fact that government expenditure on health, education and social security has doubled, it remains around 6% of GDP, compared to an OECD (the Organisation for Economic Cooperation and Development) average of 25%. The government is increasing pension coverage and extending basic healthcare but new spending remains modest.

Another factor is the falling share of national household income (wages and investment income). In contrast, corporate earning has risen, faster than wages. This reflects a combination of low interest rates which has encouraged capital intensive heavy industries. This means that China’s high growth rate has not created a commensurate level of new jobs or boosted incomes.

Investment-driven growth also favours SOEs and large projects. These firms generally reinvest their profits and pay modest, if any, dividends. Lending policies, exchange rate policy and control of input costs such as land and energy favour infrastructure and manufacturing rather than services, limiting employment and income growth.

Higher savings and lower consumption have been encouraged by an inefficient banking system, low interest rates, limited access to individual credit and limited investment products. Chinese saving rates have increased to around 24% of income from a low of 12-15% around 20 years ago. Companies have also increased surpluses, contributing the bulk of domestic savings.

The transfer to banks and companies from low interest rates is significant. In general, in developed economies, nominal interest rates approximate nominal growth in GDP. This would ensure that savers earn a fair share of growth. Over the past decade, nominal lending rates in China have been about 6%, well below nominal GDP growth rates of 14%. Assuming that Chinese interest rates have averaged 4-6% below the required rate, this equates to a net transfer from savers of around 5% of GDP each year.

This transfer keeps China’s cost of capital low, facilitating its investment strategy as well as helping cover the non-performing loans made by banks. At the same time, China was investing around 10-12% of its GDP each year in low-yielding foreign assets, through its current account surplus and currency reserves. This equates to about one third of its total consumption.

All these factors have reduced consumption.

Iceberg ahead…
China faces significant economic challenges and related social and political pressures.

Externally, China’s major trading partners - Europe and the US — find themselves trapped in a period of low growth and high unemployment as they deleverage. China will be forced to reduce its excessive reliance on exports as trading partners no longer tolerate rising trade deficits.

China’s foreign exchange reserves will lose value as the credit quality of investments deteriorates and the value of the foreign currencies declines, as part of a deliberate policy of adjustment.

Domestically, China’s ability to use debt-fuelled investment to power its continued growth may have reached a limit. High inflation, in part driven by rising commodity prices as a result of a weaker US dollar, has required increasing rates to reign in domestic demand at a time when external demand is weak. Inflation and social unrest are driving wage increases to buy social stability but decreasing China’s competitiveness.

The policy options are increasingly limited. Rebalancing household consumption and investment as a share of GDP is seen as an important element in any solution. Chinese premier Wen Jiabao argued that “we should focus on restructuring the economy, and make greater effort to enhance the role of domestic demand, especially final consumption, in spurring growth”.

But the level of consumption growth needed to rebalance China is large because of its low existing consumption base. If China grows at 8% per annum, consumption needs to grow by around 11% (3% above growth) to increase the share of consumption from 35% to 36% of GDP in a year. Assuming a growth rate of 8% and consumption increases of 11%, it would take around five years to increase consumption to 40% of GDP. To increase consumption to 50% over 20 years, it would take consumption to grow at least 9%, 2% above an average projected growth rate of 7%. If growth slows, then the difficulty of the task increases.

Increasing consumption at the required rate requires an increase in household income, reduced savings or a combination. It needs a rapid increase in wage levels and employment levels. It will require reform of the welfare system, especially health, education and pensions. It requires changes in the banking system, especially the process of allocating credit and higher interest rate levels, which would boost incomes and also increase the cost of costs to businesses. It requires changes in regulations that favour manufacturing, including reduction in subsidies for certain industrial inputs. It requires land reform and changes in the mobility of the labour force. The required reforms have barely commenced.

Fragile compact...
China’ fragile social compact is based on a trade-off: economic improvements at the expense of political and individual freedoms. The Chinese Communist Party’s future and power are dependent on successfully managing this compact. But difficulties are increasingly apparent.

Higher wages increase the cost structure, decreasing competiveness when the scope for devaluing the renminbi is constrained.

Encouraging consumption at the expense of savings reduces the supply of cheap deposits to policy banks, reducing the party’s ability to control credit and investment. The flow of deposits is also needed to cover the expected sharp increase in non-performing loans.

China needs to provide employment for approximately 750 million workers, including 200 million internal migrant workers. Reduced export demand means that China must rely on internally driven growth to provide employment.

Employment levels in export manufacturing and related sectors have stagnated since 2007. Government policies to resuscitate the economy favoured 150 central and 1.2 lakh local SOEs. The private sector has not grown in relative and absolute terms. China is now heavily dependent on SOEs to generate jobs.

Higher interest rates reward savers but increase the cost of capital to SOEs. Reducing the ability to direct credit also reduces the ability to engineer growth through the SOE sector. Given the bias of SOEs toward heavy and construction industries, lending-driven fixed-investment finance remains the favoured means of creating employment.

The Communist Party’s existing system of political privilege and influence relies on the large captive domestic saving pool that can be directed into specific projects. Liberalisation threatens this arrangement. Changes that improve income levels, education standards and social security may drive demand for greater political freedom and transparency, threatening the Party’s hegemony.

Necessary reforms require political choices, including loosening government and CCP control over the economy. It is not clear whether that is something Beijing is willing to embrace.

In Snail House...
Social inequality in modern China has become an increasing problem.

Within China, a new class of wealthy individuals, usually affiliated with the CCP, apes their overseas peers - at least in their consumption of luxury goods. Despite taxes on imported goods, sales of luxury goods grew at 25% annually in 2010, more than twice the rate of increase of overall consumption. For handbag-maker Louis Vuitton, the “Middle Blingdom” is its largest single market, accounting for 15% of its global sales. China’s share of the global luxury market is forecast to rise to 44% by 2020, despite average wages of about 25% of that in developed countries. Wealthy Chinese, analysts note, now have everything they need and are progressing to buy a whole lot of things they don’t need as well.

A viral 2010 email captured the anger about China’s growing differences in living standards. To purchase a 1,076-square-foot (100-square-metre) apartment in central Beijing costing 3 million renminbi ($450,000), a peasant farmer would have had to work since the Tang dynasty that ended in A.D. 907. A Chinese blue-collar worker on the average monthly salary of 1,500 renminbi ($225) would have had to work since the opium wars of the mid-nineteenth century. Prostitutes would have to entertain 10,000 customers; a thief would need 2,500 robberies.

Snail House, a popular Chinese TV soap opera, combined house prices, sex, corruption and political intrigue. A woman becomes the mistress of a party official to obtain his help to buy a flat, while a young couple struggles unsuccessfully to raise the deposit for an apartment.

Another email described the fate of ordinary Chinese with sardonic humour: “Can’t afford to be born because a Caesarean costs 50,000 renminbi [$7,500]; can’t afford to study because schools cost at least 30,000 renminbi [$4,500]; can’t afford to live anywhere because each square metre is at least 20,000 renminbi [$3,000]; … can’t afford to die because cremation costs at least 30,000 renminbi [$4,500].”

Inability to maintain economic growth now threatens to expose these deep-seated fault lines within the Chinese society.

 © 2012 Satyajit Das. All rights reserved. Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)