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Satyajit Das: “All Feasts Must Come to an End” – China’s Debt & Investment Fueled Growth (Part 2)

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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.

Iceberg Ahead….

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)

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  1. Bam_Man

    In the “Chinese brand” of Communism you have a totalitarian police state, a slave-labor economy dominated by well-connected oligarchs and no social safety net for the masses. Now you’re telling me that this system doesn’t seem to have much of a future? Are you sure?

    1. Crazy Horse

      Aren’t you a little confused in your choice of terms?

      “In the “American brand” of Capitalism you have police state not subject to the Constitution or the rule of law, a debt-slave economy dominated by well-connected oligarchs and a weak social safety net for the masses. Now you’re telling me that this system doesn’t seem to have much of a future? Are you sure?”

      Do you see your error? China’s economic system no more resembles Communism than a vulture resembles a hummingbird. It is simply a more transparent form of Capitalism than Capitalism’s current expression in the USA.

  2. Harley Warren


    When you put it in those terms, sounds like it’s the course we’ve taken, though nothing to that scale.


  3. alexbc

    Very lucid article. Most commentators are finally acknowledging that Pettis has been right (for like 10+ years now) about China’s development. A few notes, however:

    “Assuming 8% growth…” – There won’t be 8% growth. The necessary slowdown in investment, coupled with rises in consumption, will bring the growth rate down to about 3%. Most growth is driven by investment, meaning the rapid rates can’t be sustained without it. Slower growth would be better for China; it would distribute the wealth among households, rather than to SOEs and the state. This is a difficult transition, though, highlighting that China may actually face more political issues than economic ones. Slower growth means a loss of prestige for the state

    “Thrifty” – Asia isn’t thrifty by culture or by nature, but by policy. The single biggest mistake many commentators have made about China is not recognizing that low consumption is an essential part of the growth model – the wealth transferred from households to the state (via low real interest rates) funds the investment at the expense of personal incomes for households. It’s a policy decision, plain and simple.

  4. Hugh

    “China’s high growth rate has not created a commensurate level of new jobs or boosted incomes.”

    It is always a little disconcerting reading Das. As here, he has wealth inequality and kleptocracy staring him in the face and for all his analytic skills it takes him to the very end of his piece to even get around to mentioning that oh yes, wealth inequality might be a little destabilizing, but he still doesn’t get that this is a feature of the system, and not an unintended consequence. Sure what is going on in China –kleptocracy– is unsustainable. It’s unsustainable here and in Europe as well. This doesn’t keep the kleptocrats and looting elites from kicking the can down the road for as long as they can.

    “China’s major trading partners – Europe and US – find themselves trapped in a period of low growth and high unemployment as they deleverage.”

    “Deleverage” is one of those strange words I see crop up that seems to mean one thing but really means something quite different. The casino for the 1% is still open. It isn’t really the rich or corps that are deleveraging. Just look at the soaring stock markets despite slow economic growth everywhere. Deleveraging rather is code for austerity and dumping liabilities on to the 99%s of the world.

    1. charles sereno

      Some will argue that the introduction of “kleptocracy” (Deng Xiaoping) led China into a better future than it might otherwise have had. Along that same line of thought, the growing cohort of the old, once thrown under the bus, might also provide “green shoots” for a “Greater Sustainable China.” I just don’t believe that the end justifies the means.

      1. Blissex

        «the introduction of “kleptocracy” (Deng Xiaoping) led China into a better future than it might otherwise have had»

        This is a very good point that I wanted to make myself, so I have to agree a lot, and add a bit of value by explaining.

        But first let me recommend reading the memories of Zhao Ziyang. The first half is the account of Tiananmen and the party infighting, but the real meat for me is the second part, where he describes the economic policies of China under Deng, and their motivations, and other sometimes astonishing details (his point that the main responsibility of the Secretary of the Communist Party is spiritual leadership of the nation for example, something that he apparently took very seriously, while the country is actually run by the prime minister team).

        My impression is from that book and other details that the CCP takes very seriously the “mandate of heaven” tradition, and they understand that the analysis by Marx of economic evolution is fairly reliable, and China needed a phase of primitive accumulation of capital, and that such a phase cannot be pretty, and the best bet was to make it as short as possible.

  5. Glen

    It will indeed be interesting to see how China navigates this part of the world depression. To all outward appearances, China is playing the role America had in the last great depression, a growing manufacturing export power, natural resources, a young population, and a government seemingly set on stimulus to grow their economy.

    There is also ample evidence that China is participating in a financial war against the US and the EU to ensure it’s place on top of the heap at the end of this depression. To this end, it’s one great advantage, that it is not within the grip of the Wall St and London financial firms which have assumed power, and thus free to act beyond the artificial constraints imposed by that seriously corrupted and failing power of the kleptocracy This would, on it’s face seem to be a significant and compelling advantage in this contest.

    It’ll be interesting to see how it all plays out.

    1. Jim

      Glen, good comment, with one quibble.

      In 1930, the US median age was 26.5.

      Today, it’s 37. China’s is 36.

      1. Glen

        China has more young men in the 25 to 34 age group than the TOTAL US population. Of course, this could be as much of a problem as an advantage.

        China also seems to be making a more serious attempt at pushing technology such as here:

        Everybody is aware of the “empty cities” built in China, well, at least they have buildings, America is spending it’s future to buy “toxic waste” and prop up the people and firms that created it. Given a choice, I’d rather build real infrastructure which can be a real benefit for the next ten, twenty, thirty years.

  6. Barry Gantz

    It annoys me *greatly* when a collection of intelligent, bright people, posting well-written, insightful posts aren’t bright enough TO INCLUDE A LINK TO THE FIRST PART OF THIS ARTICLE.
    And before I get someone jumping down my throat offering that I should use the “search” feature; I have – and it’s even more useless than posting two-part articles with no links to the first one. Give it a try – educate yourself.
    Seriously people – this is just basic common sense.

      1. Barry Gantz

        Beg your pardon.
        My slathers of effusia were drenched in efflusia. Bad I.
        Apologies and thanks.

  7. Schofield

    Hey. China does MMT. So did Hitler and Germany went from pushing virtually worthless pieces of paper around in a wheelbarrow to coming within an ace of taking over most of Europe.

  8. Schofield

    Of course ya’ll have noticed China didn’t opt for Western hyper-inflating private banks when it went Deng Xiaoping.

  9. Godfree

    This is shaping up to be a real test of the ‘managed economy’ model. One that will instruct us all, whichever way it goes.
    On one side is the (unstated) Western/Indian wish that China fail.
    On the other side is the Chinese government, the smartest and most honest government on earth, supported and trusted by 85% of Chinese people.
    I’m betting that smart and honest wins out, and that China emerges as the clear global leader when the dust settles in, say, 5 years. If so, it will define the 21st. Century.

  10. different clue

    “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.”

    I have read ( or heard?) a theory that the China government decided long ago to write off these reserves years ago once building them up had accomplished the mission of exterminating every trace of every industry in America (and perhaps elsewhere) and replaced all that industry in China. Buying the dollar securities is the price the China government pays to manipulate the RMB downward and keep it downward to help in underpricing American industry in order to exterminate that industry.

    And the Klepton Occupation Front Government in America collaborates with this China government plan by stringing the American public along with “lectures” and “admonishments” about that currency manipulation in order to delay action against that currency manipulation . . . in order to buy time for China to get the planned extermination of American industry completed.

  11. Blissex

    «I have read ( or heard?) a theory that the China government decided long ago to write off these reserves years ago once building them up had accomplished the mission of exterminating every trace of every industry in America (and perhaps elsewhere) and replaced all that industry in China.»

    That was likely me in these columns and I was writing in less strident terms. The Chinese want to import jobs to China, and they know how corporate USA works:

    * Various managers on the make champion various alternatives, like a plant in Ohio vs. a plan in Chonqqing.

    * Each produces a spreadsheet with a best-case scenario to make the alternative they champion look the winning one.

    * Upper management has to choose the one with the best numbers, even a 5% difference wins.

    * The manager who championed the winning alternative gets the promotion and bonus.

    * China’s jobs depend on ensuring that the manager championing the Chongqing plant gets promoted and gets the bonus, because this will ensure that everybidy takes notice that championing offshoring makes them winners.

    * To support the manager championing the Chongqing plant, China “tricks” the spreadsheet in three ways: cost suppression via lot exchange rate, advertising that independent trade unions are a crime in China, and creating massive amounts of infrastructure.

    * The goal of the Chinese is to ensure that foreigners have the incentive to create massive amounts of physical production capital in China, and the jobs that come with it.

    The latter has worked very well: there are now many reports saying that USA companies are reluctant to move production out of China into cheaper places like Cambodia because while Chinese workers are more expensive, economies of location (the whole supply chain is there) trump that.

    In the story above of course the China govenrment plans to eventually get rid of the foreigners: the Chinese are not stupid, and if foreigners put a plant to make stuff there, they will learn everything about it quickly, and build their own eventually, and bye-bye. Which is what the Japanese, Koreans and Taiwanese have done in the past, in much the same way, but not quite as quickly and determinedly.

    The goals of China are aligned with those the USA upper classes, especially the Republican-voting ones, which are to offshore as many union jobs as possible in order to destroy the unions and increase unemployment in the USA to decrease the leverage of the lower classes and redistribute income from lower to upper classes and from workers to rentiers.

    The Chinese understand this very well, and support these policies with massive lending to the USA to support the Republicans.

    «Buying the dollar securities is the price the China government pays to manipulate the RMB downward and keep it downward to help in underpricing American industry in order to exterminate that industry.»

    Chinese lending to the USA has enabled several policies that have made Republican election victories possible:

    * Massive chinese purchases of USA debt have allowed Republicans to cut taxes to the upper classes and fund the cuts with debt.

    * Lending at very very low interest rates has allowed Republicans to fund the Iraq and Afghanistan occupations with what in effect are war bonds issued to the Chinese (and Saudi and Japanese) governments.

    * Massive chinese purchases of mortgage based securities have allowed the USA upper classes to create a huge capital gains bubble in real estate rewarding Republican voters and donors.

    To a very large extent China is providing the funding to enable Republican voters and donors to asset strip America, with the considerable help of the Fed (and the Bank of Japan).

    At the end of the game what matters to China is not some pieces of paper that will be repaid in much devalued dollars; it is to have a strong productive capital base in productive plants and research centres, designed and built in China by foreigners, but ultimately under Chinese sovereignty. That’s what makes countries prosperous.

    It is not a new game, the Japanese were doing it too, to the point that after the Plaza Accord economist David Hale joked that Japan was acting as the Republican reelction comittee (30 years ago most USA voters were against unemployment).

    Now the game has changed. This is how Frum describes the current state of USA politics, financed by China:
    «It’s fine to be unconcerned that the rich are getting richer, but blind to deny that middle-class wages have stagnated or worse over the past dozen years. In the aftershock of 2008, large numbers of Americans feel exploited and abused.

    Rather than workable solutions, my party is offering low taxes for the currently rich and high spending for the currently old, to be followed by who-knows-what and who-the-hell-cares.

    This isn’t conservatism; it’s a going-out-of-business sale for the baby-boom generation.»

    One of my favourite quotes from Landes “The wealth and poverty of nations” on the same plan:

    «The annals of competition show entire national branches dragging and withering — not this and that enterprise, but the whole industry. Sometimes, having learned their lesson, the last members of the branch move away, generally to cheaper labor; that is smart, but also easy, and evidence more of rationality than enterprise. An sometimes, as in Britain and Holland earlier, enterpreneurs retire to a life of interest, dividends, rents, and ease.»

    «So on Holland two centuries ago. The United Provinces pared and trimmed to meet the competition, but the best they could do was run in place. Many businessmen gave up the fight and retired to the country and to a life of passive investment. Incomes polarized between the rich few and the poor many, with a diminishing middle between them. Tax returns show that by the late 1700s, most wealthy Dutch were big landowners, high state officials, or rentiers. Gone were the prosperous enterprises of the “golden age”: employers were not confined to the middle and lower ranks.
    In the process, the United Provinces abdicated as world leader in trade and went into a postindustrial mode. Italy had gone that way before.

  12. subu

    1. Thanks for the article

    2. people have been writing this epitah for long … but china has been thriving

    3. ….so …. IS THERE one central reason why china will fail in the next 1 to 3 years ? ..ONE ? if so which one ?


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