By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
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 nonferrous 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 (totalling 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 GFC, China’s role became even more important. China, together with some of the other BRIC 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 2 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 totalled 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 totalled around $1.1-1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50 per cent 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 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 of 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 tiegongji (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 (“Kms”) of rail track to the existing network of 80,000 Kms. 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 super fast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.
China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 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 programs 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 programs, which are overseen by the Chinese Communist Party (“CCP”), have been used to achieve political objectives.
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 over-capacity. 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 tons against demand of 470m tons 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 & 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.
NOTE Part II is here.