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). Part I is here.
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 totalling $2.6 trillion (42%): local governments about $1.2 trillion (19%), policy banks $800 billion (13%); Ministry of Railways $280 billion (5%) and government backed asset managements 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 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 lower than China.
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 health care and education when the SOEs were reformed almost a decade ago.
Chinese save to cover the expected costs of education, retirement and health care. Despite the fact that government expenditure on health, education and social security has doubled, it remains around 6% of GDP compared to an OECD average of 25%. The government is increasing pension coverage and extending basic health care 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 has 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.
China faces significant economic challenges and related social and political pressures.
Externally, China’s major trading partners – Europe and 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 fuel 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 is 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 President Wen 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 5 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 CCP’s future and power is 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 CCP’s ability to control credit and investment. The flow of deposits is also needed to cover the sharp expected 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 favored 150 central and 120,000 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 favored means of creating employment.
The CCP’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 meter 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 Chinese society.
NOTE Part III is here.
© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)