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China - the long road from perspiration to inspiration


Graeme Leach spoke at the Institutional Investor & Global Fixed Income Institute Annual Investment Roundtable in Amsterdam on 9th March. Below is a transcript of his speech.

There’s complacency in the West about the future of the Chinese economy, which, ironically, isn’t found nearly so much in China itself. At the end of last year, the Governor of the People’s Bank of China, Zhou Xiaochuan, described the debt threat to China as “hidden, complex, sudden, hazardous and contagious”. Other senior officials very recently warned that published figures for local government debt, of $2.6 trillion, may be excluding more than $3 trillion of additional debt that is hidden. The Chinese banking system is bigger than the US, and it is also bigger than all the euro-zone banking systems put together. But the world's largest 'official' banking system is smaller than its 'unofficial' one. In 2017 the China Banking Association reported that off-balance sheet assets - shadow banking - were 109 per cent of on-balance sheet assets (approximately $38 trillion). Off-balance sheet loans of China's banks dwarf those recorded on their balance sheets. 

In the West, we tend to look at the Chinese economy through the lens of a long-term economic growth model. As a result we make the mistake of believing you can see the road ahead through the rear view mirror. We tend to see continued strong growth due to the supply of labour and capital, together with a transition towards faster total factor productivity growth as the economy shifts towards an economic model based on innovation and consumption. This is the long march from perspiration (the mobilisation of resources) to inspiration (innovation, high value added output and an emphasis on quality not quantity), as China seeks to avoid an emerging market middle-income trap - when the supply of labour and capital slows, but productivity growth fails to take up the slack.

At present, our eyes are focussed on Chinese politics and the ending of term limits for the presidency, but we would do well to remember that the outlook for the Chinese economy is far less assured. We most definitely shouldn’t conflate political stability with economic stability. All the growth enablers of recent decades are now beginning to weaken significantly or go into reverse: growth in labour supply, low wages, rising investment rates, a competitive currency and negligible social welfare costs (the end of the iron rice bowl).

The key question is whether Chinese economic difficulties are, to use a medical analogy, chronic or acute. They are chronic if the economy experiences a sustained fall in the GDP growth rate over years and possibly decades – Japan today, China tomorrow? They are acute if the economy hits a brick wall and stops. As we will see, the chronic challenge is how to overcome a middle-income trap. The acute challenge is how to avoid a debt crisis. Let’s examine the chronic challenge first.

The ‘Old Model’ (OM) of Chinese growth is broken. The OM was based on investment, manufacturing and exports. Competitiveness was based on price and delivery - as global supply chains emerged in the 1980s and 1990s. Total investment peaked at 48 per cent of GDP 2011, but this over-reliance on investment came at a price. The incremental capital output ratio doubled as investment became less efficient. More and more investment was required to achieve a unit of GDP growth.

The Chinese investment orientated growth model has led to resource misallocation on an unprecedented scale. And we shouldn’t be surprised why. There has been: (1) An artificially low cost of capital, as a result of financial repression in the banking system, with household savings deposits receiving low interest rates so state owned enterprises (SOEs) can borrow cheaply. (2) Very high levels of corruption, which have perverted the borrowing and lending process on all sides. (3) A soft budget constraint on SOEs by the large state controlled banks, with a lack of enforcement of credit agreements and ‘extend and pretend’ on a huge scale. (4) Implicit guarantees by central and local government. (5) Subsidies for SOEs and their state ordained quasi monopoly power. (6) Visual reality e.g. so-called ‘ghost cities’ with recent unofficial reports of 64 million vacant properties!

A retrospective illustration from the response of the authorities to The Great Recession also speaks volumes as to their lack of confidence in “socialism with Chinese characteristics”. At the time of the financial crisis, the fastest growing economy in the world embarked on a massive monetary (bank lending expanded by $2.6 trillion) and fiscal stimulus (of around $0.6 trillion).

The good news is that a rebalancing of the economy is at least underway. Consumption is rising (to 39 per cent of GDP in the latest figures, and the headline share understates household consumption) and investment is falling as a proportion of GDP (to around 44 per cent of GDP at present). Consumption might also be expected to move upwards as a proportion of GDP due to an ageing population, and the shift in life-cycle expenditure as retirees run down their savings. It should be noted, however, that household consumption remains very low as a proportion of GDP, despite a burgeoning middle class (the global share of household consumption is 59 per cent of GDP).

There are umpteen examples of China beginning to shift towards an innovation and higher value -added economy. Technology sectors include cyber-tech, nano-technology, aerospace, genome mapping, supercomputers, space technology and the $200 billion State High-Tech Development Plan or 863 Program. But, and it’s a very big but, these examples don’t really reflect the reality of the Chinese economy. Governments are very poor at picking winners. Foreign investors keep their intellectual property outside China. Chinese R&D figures exaggerate the scale of activity. Chinese brands aren’t global.

Successful Chinese companies overseas, such as Huawei, are technically world class, but remain rooted in engineering, not global branding. Chinese companies are much better at process as opposed to product innovation. Dig below the surface and R&D, branding and innovation look far less impressive when examined across the whole economy (readers are recommended Timothy Beardson’s book, Stumbling Giant: The Threat to China’s Future).

There are also serious questions, yet to be answered, as to whether or not China has the cultural capacity to shift to an innovation based economy. Economic freedom hasn’t led to political freedom, powerfully illustrated by the ending of term limits for the presidency. It remains uncertain as to whether or not China can overcome the problem of innovation within a hierarchical society. There are also some pretty fundamental issues for the Chinese economy full stop, related to weak intellectual property rights and an absence of the rule of law, which also constrain the development of an innovation economy.

The Government will clearly not stand still and watch the economy weaken. It plans a whole series of reforms to state enterprises, to reduce overcapacity and the burden of zombie companies. Around a quarter of economy-wide investment is still in SOEs. Alongside the positive stimulus from reform – not withstanding the unemployment consequences which the CCP fears - there also has to be considered negative GDP growth influences such as the decline in working age population, which is likely to cancel out the positives.

The world’s largest population faces the world’s biggest population problem. China’s working age population is forecast to fall by a quarter between now and 2050. This is a problem further compounded by continued early retirement in China. Offsetting mechanisms are also limited by the already high labour force participation rate (China 69 per cent, World 62 per cent, East Asia & Pacific 68 per cent).

The chronic problem is serious, but manageable. It suggests an economy that will see further reductions in the trend growth rate to maybe half the current 6 to 7 per cent range.

Alongside excess capacity and diminishing returns to investment, there remain significant investment opportunities. SOE restructuring and wider total factor productivity gains in successful companies mean that the return to capital has stayed high for these enterprises. The One Belt and One Road initiative will also help push economic development further west in China. There is much scope for further investment with capital upgrading and deepening. But the bottom line is that the total investment rate still needs to fall significantly. The IMF projects it will fall from around 44 per cent now, to 41 per cent by 2022. This still looks too high to avoid excess capacity. It also acts as a blocking mechanism against rising consumption - and we shouldn’t forget that the ultimate aim of economic activity is to maximise sustainable consumption.

This, however, is far from the end of the story. The acute problem should make you afraid, very afraid. Over the past decade China has experienced a massive increase in debt, the potential consequences of which are grave. Total debt has quadrupled since the financial crisis. The debt threat is stark. And unlike before The Great Recession, we cannot claim we weren’t warned. Everybody from the Governor of the People’s Bank of China, to the IMF and the Bank for International Settlements (BIS) have issued warnings about the potential impact of a debt crisis in China.

BIS statistics show China has the largest credit to GDP gap in the world. The credit to GDP gap is the difference between the credit to GDP ratio and its long-term trend. Given the financial repression of households over a long period, an increase in the deviation was to be expected, but the excess created by the speed and magnitude of the credit created, surely not? China is not yet at a ‘Minsky Moment’ where asset values fall sharply in value, but the threat is undoubtedly there. Despite huge oversupply in many areas, the average price of new homes across 70 Chinese cities rose for the 28th straight month in January. The Government has taken steps to cool the market, but prices still rose 5 per cent (yr-on-yr) in January. There are dangerous potential links between the real estate market, debt default and the entire financial system. 

China’s GDP growth rate has slowed – to just below 7 per cent - despite it experiencing the largest credit boom in history. That growth has slowed at a time of debt-fuelled extravaganza, also strongly hints as to the presence of an underlying problem. There has been a truly staggering explosion in total debt (companies, government and households) to around 300 per cent of GDP with IMF projections that it is likely to top out at 325 per cent of GDP by 2022. There is no example in economic history of an economy burdening itself with such levels of debt, which has not crashed subsequently. Moreover, most high debt economies crashed way before they attained Chinese levels of debt.

Admittedly there are other economies at present with similarly high total debt to GDP ratios, but there is one key defining difference between them and China, exemplified by Japan. Japan’s 250 per cent public debt to GDP ratio comes in the wake of 2 decades of lost growth, where the state burden has exploded by 200 percentage points. China’s problem is ex-ante any crisis and not yet ex-poste.

The obvious retort to this argument is that China is different, because recent debt crises – for example in Greece – were the result of exposure to foreign held debt, whereas China’s problem is domestically sourced because it has operated a current account surplus. This is undoubtedly true, but should not mislead us. Throughout economic history financial crises have been as much domestically as externally sourced. And a bad debt is a bad debt, whether owed domestically or overseas. We simply do not know the true scale of non-performing loans (NPLs) in the banking system (ludicrous official figures suggest NPLs stand at a mere 1.7 per cent, unofficial estimates are 25 per cent or higher), but whatever they really are, if the economy were to slide, they would ramp up dramatically. A bad situation could very quickly become very ugly.

Readers may well argue that China has defied the odds time and again over the past 30 years. After all, every other communist country experienced deep and lasting pain in the shift from state to market. Pain, which China has managed to largely avoid - notwithstanding massive SOE restructuring in the 1990s – and go its own way. In other words, China has done it before and it can do it again. I’m not so sure. The justification for the staggering level of debt has all the hallmarks of “this time it’s different” when economic history teaches it never is.

Quite simply, if debt funded capital is being misallocated, debt must be rising faster than debt servicing capacity. Thus far the authorities have been able to kick this can down the road. But for how long?

SOE reform in the 1990s was helped by the state banks extending and pretending with regard to non-performing loans – which they are obviously still doing. Financial repression of households also helped to kick the can further down the road in the 21st century. And then when that process reached its limits, state controlled banks embarked on an investment surge in the wake of The Great Recession. Finally, of course, has been the explosion in wealth management products over the past 5 years, with households investing in securitised debt in order to yield a higher return than that received on traditional savings deposit accounts.

In the wake of the subsequent policy shift towards deleveraging there has also been recognition that financially sound companies will need capital and one way of providing this whilst also reducing the risk of resource misallocation, is to employ more foreign capital. Last year this led to the introduction of the Bond Connect facility, with the liberalisation of capital inflows for investment in the Chinese bond market. Remarkably, whilst the Chinese bond market is set to become the 2nd largest in the world by 2020, foreign holdings amount to just 1%.

Deleveraging is underway, but what we don’t know is how the story will unfold. Will it be like Japan, and evolve over years and decades? Or will it be much more abrupt? Herb Stein, an economic adviser to President Nixon, once quipped that: “if something cannot go on forever … it will stop.” That is the fear for the Chinese economy, that it will hit a brick wall and stop. If investment comprises 40% of GDP, and rises by 10 per cent per annum, then under a crash scenario of zero investment growth, this would take 4 percentage points off the overall GDP growth rate. Falling investment (as opposed to zero growth) could wipe out GDP growth completely, especially if it was accompanied by a surge in precautionary savings behaviour by households. The exposure of households to the growth of WMPs in recent years could also be expected to undermine consumption in a crash scenario. This is why the scale of debt, investment dependence, excess capacity and resource misallocation is so dangerous.

Under a crash scenario of falling investment and rising saving as a proportion of GDP, the current account surplus would increase, providing the added complication of the risk of some form of trade war with the US. This pressure might also be expected to constrain attempts to push down the value of the renminbi to boost export competitiveness.

All of this is not to suggest that the Chinese authorities are out of options in the event of a crisis. Business as usual projections from the IMF suggest that budget deficits of 4 per cent of GDP will result in a public debt to GDP ratio of 60 per cent of GDP by 2022 – thereby providing ample opportunity for largesse if the Government was to choose a gargantuan fiscal expansion.

Finally, of course, the central bank could be ordered to implement quantitative easing. Maybe the potential need for such a policy in future explains, albeit only in part, the introduction of the Bond Connect reform last year, in the hope that if the time comes, foreign buyers of Chinese bonds will be sucked in.

At the time of the financial crisis, Chinese officials displayed a degree of hubris in public statements, suggesting that their economic model was somehow superior – ignoring the massive stimulus they had themselves initiated – to that in the West and the US in particular. President Bush was quoted on the US economy at the time as saying “this sucker is going down”. Pride cometh before the fall - it may yet be the turn of the Chinese economy to go down.

A desire to maintain the existing CCP-population social contract – we’ll give you growth, you give us power – suggests the Chinese Government would throw everything but the kitchen sink at any future problem (remember what they did after The Great Recession started).

A little known fact about China shows how sensitive the CCP is to domestic unrest and the risk of higher unemployment. The Chinese authorities collate and publish incidents of social unrest. These instances of unrest are not on the scale of Tiananman Square or a fledgling Arab Spring, but they are large in number. In 2010, in the wake of economic weakening, the figure shot up to around 180,000. Labour disputes and strikes only form a very low proportion of the instances of unrest, but their potential to combine with other factors, if the economy turned south, has not been missed by the CCP. The CCP fears its own people more than anything, and will do whatever it takes to maintain its brutal hold and monopoly on power.

China has not discovered a new model of capitalism. Theirs is not a market model, more an abuse of market model. State capitalism in China is beset with fundamental problems, which are almost certain to ensure that China will indeed grow old long before it grows rich. Latest 2017 estimates from the IMF place China in 72nd place in the global GDP per capita rankings, at just $8,500.

Finally, of course, there is the assertion that China could somehow use the world's largest foreign exchange reserves to recapitalise its banks and rebuild its financial system. Sorry, there are no free lunches. Forex reserves are not rainy-day money for bust banks. Assets are matched by the liabilities attached to the forex reserves. If the central bank decides to deploy its forex reserves to pay for banking bail-outs it would still be on the hook for the money supply 'sterilisation' policy and the central bank bill liabilities associated with it.