Some investors are bullish on China as they view that Chinese government is on a mega reforms path that may have short term negatives but long term positives. The most common reforms cited are – corruption removal drive, rate cut, and devaluation.
As described in previous articles, key Chinese problems are structural weaknesses, imbalanced economy, property bubble, debt spiral, and excess capacity. One has to evaluate the reforms with respect to the problems they are expected to solve.
Devaluation: It will make the Chinese exports more competitive and so manufacturing will also pick up. But can this advantage be sustained over a period of time? Devaluations only make your products cheaper compared to your trading partner countries; it doesn’t reduce their costs in reality. Historically, no country has ever been able to maintain sustainable competitive advantage based on devaluation. Additionally, it makes imports as well as debt costly. China is burdened with one of the world’s highest debt levels compared to its GDP. It is doubtful whether devaluation would help China in long run.
Rate cut and liquidity boosters: Lack of liquidity is not a root problem in China. The only use of a rate cut would be to prop up the real estate prices. Chinese households have huge exposure to real estate which may crumble any time, and this booster dose of government has given it a new lease of life. In absence of good investment opportunities in industries, this liquidity is bound to find its way into stocks and real estate. The property bubble will inflate more; its deflation has been delayed now. Government might have done it as an act of desperation as real estate is about 23% of GDP and a serious price correction will have a major impact on GDP and in turn on employment.
Recently, China scrapped a two decade limit on the percentage of funds banks can lend out relative to deposits. Again an act of desperation, one has to see that it is not the industries which are suffering from lack of liquidity – the government is desperate to prop up its real estate from crashing and to support its deep in debt government organizations from defaulting. In case there are cracks in economy, it will affect employment which is very sensitive matter for Chinese politicians. Right now there is no major issue of unemployment, but it is crucial that enough jobs are created for this world’s largest populated country. It is difficult to believe that by infusing liquidity China will be able to sustain its growth. It is following in the footsteps of Japan which is still reeling under the shadows of low growth for decades now.
Other than pumping the property bubble, easy credit will also increase the already high debt burden of households, government, as well as corporate sector. And deflationary pressures will make it even harder for the debtors.
Corruption removal drive: Its positive effects would be seen only in the longer run. Right now, it is causing rich Chinese to hide their money abroad or to invest in US property.
Previous article discussed the structural problems in China, now we will cover the major current issues with Chinese economy.
REAL ESTATE BUBBLE:
China’s real estate share of GDP is about 23% of its GDP, this is three times that of the US at its peak. It clearly highlights an abnormally lopsided investment in real estate. Any dent in real estate will cause a significant damage to the GDP, and that may have already started happening. Some relevant observations are –
Chinese ghost towns:
It is a shock to anyone who sees them for the first time. Just see yourself at the following links –
The Ghost Towns of China -
Videos online -
To respond to the 2008 crisis, China injected massive credit to offset the collapse of external demand. That held up the growth rate but also led to a scary spike in debt levels, excess capacity, and surge in property markets. These are the similar policies that Japan had followed in 1980s and is still suffering from them. China will not be an exception and is expected to be on a similar trajectory. We discuss below, why this debt is a serious threat.
China’s debt is at high risk levels. It’s debt as a proportion of GDP climbed to 282% in 2014 from 158% in 2007 (Chart below). That addition to debt is worth more than one entire Chinese economy’s GDP, added in just seven years. That’s huge and will put extreme pressure on its economy.
China’s total debt has risen to over $28 trillion by 2014, from $7 trillion in 2007, shooting four times in just seven years. Though, at 282 percent of GDP, China’s debt may be manageable, it is larger than that of the United States or Germany which have more balanced and stable economies.
Poor repayment possibilities:
A study by McKinsey shows three risks:
Debt exposed to real estate:
China's household and private-sector debt has accelerated sharply even when compared to its fast growing economy. Outstanding loans for companies and households was at record 228% of GDP in 2014, more than double the 116% of 2007. A great portion of the household debt is exposed to real estate which is in high danger zone – with falling property prices, repayments would be difficult, defaults would be on rise.
Debt explosion in shadow banking:
The shadow banking in China has grown at 37 per cent annually since 2007. Though the precise size of shadow banking is difficult to be estimated, there have been some figures. The Fung Institute puts shadow banking assets a little over 50 per cent of GDP, or less than one-third the size of bank credit. McKinsey estimates that the sector is a bit larger. This is much smaller than the American shadow-banking sector, and the Chinese institutions are much less complex.
In China, like most countries, the expansion of shadow banking is the result of controls on the core-banking which prevent banks from meeting the needs of savers and borrowers. Depositors are unsatisfied from core banking because government controls made the interest return unattractive. Borrowers are unsatisfied because banks would not give them loans, or offered only unattractive short-term funding. Though shadow banking system is a common phase in development, there are benefits as well as dangers. There are various forms of shadow banking like - trusts, leasing companies, credit-guarantee outfits and money-market funds.
Although bank lending is far bigger than the shadow variety but its rate of growth has now stabilised. Whereas the growth of the riskier forms of shadow lending, is accelerating (see chart). Shadow banks accounted for almost a third of the rise in lending last year, ballooning by over 50% in the process.
Trust loans are loans given by trusts. They are regulated by the same agency that supervises banks, the China Banking Regulatory Commission (CBRC). Regulators have recently strengthened oversight of trusts and money is now flowing to other forms of less regulated channels. One such fast growing option is entrusted loans involving cash-rich companies, well-connected state-owned enterprises (SOEs), lending to less well-connected firms.
The risk in these various forms of shadow banking arises because they want to get around regulations, exposing themselves to yet more risk. Since their clients are sub-prime, who could not get loans from core banking; they are exposed to significant high risk. Most of their lending is to real estate and steel, the probable bubbles. If there is a crisis in shadow banking, it could easily spillover to the core banking and the real economy. Or, a serious downturn in some sectors could cause problems for shadow banking. Many shadow loans are against property, but with cooling property prices, especially in smaller cities, there is a fear of a downward spiral. A pricking of this property bubble may lead to a panic in shadow banks, reducing access to credit, plummeting property prices and resulting in a falling economic growth.
Local governments unable to repay debt:
It is difficult to find the actual amount of local government debt in China. According to a survey by Beijing’s Tsinghua University, local-government debt was the worst-performing indicator in terms of public transparency among 294 major Chinese cities. Only six cities – Beijing, Shanghai, Guangzhou, Tianjin, Ningbo and Xiamen – disclosed their debt levels, the report said. “Among many city governments, even the most basic financial information is not disclosed,” the report said. It’s hard to tell. Official data are supposed to be released by China’s National Audit Office but it does not release regular reports. Occasionally it may disclose some small figures. Its recent data showed that local governments owed 17.89 trillion yuan at the end of June 2013. Analysts estimate the current figure is around 23 trillion yuan.
The local debt started zooming when four trillion yuan ($586 billion) stimulus was given in 2008 to offset the effects of the global sub-prime crisis. Like most of local-government debt in China, this was largely funded by bank loans. China’s local governments can’t borrow money directly they have created local financing vehicles to circumvent the rules.
There are serious problems with local government debt - officials do not use it prudently. The debt has been used for funding projects that may be creating excessive capacity or are infrastructures that are not needed. There are allegations that much of the money goes to official pockets.
The risk is that now with a cooling economy, local governments would find it increasingly difficult to repay. There are already several defaults. Though Chinese government has deep pockets to manage defaults but it is not a short term phenomena. The economy is in for a prolonged slowdown.
Rate cuts, deflation, devaluation
China has already gone for four rate cuts and three reserve-ratio requirement reductions and has implemented debt-swap facilities to reduce financing costs for local governments in the recent months. This stimulates more demand for debt, potentially increasing risks of instability in China's financial system. And risks have already started affecting results - nonperforming loans climbed by a record 140 billion yuan in the first quarter of 2015 as the GDP cooled down.
China’s inflation is at a five-year low and it makes the existing debt repayment costly for debtors.
Yuan devaluation is likely to hit local government financing vehicles and companies that have taken Dollar denominated loans.
Debt is a long term drag
McKinsey Global Institute (MGI) estimates that China’s government can bailout any property crisis. MGI thinks the risk is of future debt increases which may be necessary for economic growth. This may be an optimistic view as the possibilities of recovery and regaining normal growth would be difficult even after bailouts considering deteriorating economic structures, few sources of investment led growth, poor reforms for boosting domestic consumption, and moderate to low external demand scenario in future.
McKinsey views that high debt levels don't raise the risk of a dramatic crash rather they "have historically placed a drag on growth." One can validate this by considering how Japan did over the past two decades and the recent situations in Europe. There is enough empirical evidence that highly-indebted nations require increasingly larger stimulus to boost GDP.
China may not crash due to its debt, but double digit growth is now history for it. It enters a phase of slower growth with rising hurdles and higher probabilities of negative shocks.
An IMF study published in 2012 puts China’s average capacity utilization about 60% at the end of 2011, from 80% at end-2007. Capacity utilization is a proxy for assessing economic health. Lower utilization (meaning excess capacity) reflects a cooling down in economy.
This chart from SocGen draws on the IMF report to show the decline in capacity utilization:
This excess capacity is also weighing on prices of goods that are in deflationary mode and China is exporting this deflation globally. Root of the problem is blind and redundant investments aiming to raise GDP regardless of whether the means make any economic sense or not.
China is expected to reform its economy and move it from one based on investment to one based on domestic consumption. The problem is that domestic demand and purchasing power are not yet strong enough to drive the economy. China may not opt to raise wages as that would increase the cost of production, making exports more expensive.
China is plagued with inefficient and corrupt state owned organizations that managed to do away with their excess capacities, poor investments in redundant projects, and corruption as long as the economy was growing in double digits. But now they face the heat when economy is slowing and they have huge debt burdens to manage. Government has plans for privatization but little or almost no progress has been made on moving towards a market driven economy, and fair allocation of resources and funds. Rather, business environment is now more nationalistic and less open.
If there is a sharp slowdown in Chinese economy leading to a rise in significant unemployment, it will have serious socio-political repercussions. Masses are getting burdened with debt and have risky exposure to real estate. Rate cuts and easy money will further stimulate people to go for debt and when the property prices starts climbing down its impact will be very widespread.
Chinese government is well aware that it has to keep generating employment sources for its gigantic population, and it did so till now by pumping investments in manufacturing and infrastructure with main focus on exports. Now the tide has turned. Chinese face decades of unfavorable demographic dividend, losing the low labor cost advantage, burden of excess capacity, loss of any more productive investible options, falling external demand, looming risk of property bubble, poor domestic demand, and inefficient and corrupt SOEs – where is the light at the end of the tunnel?
China has huge reserves to manage capital flight and bailouts but there is a limit to that. It also has ability to control masses, but will it be able to do it in long run?
Recently, state planner said that China needs to ensure that risks presented by a slowing economy do not morph into social risks, acknowledging the problems the country faces should unemployment rise.
HIGH GLOBAL IMPACT:
China’s share for world growth was 23% in 2010 and by end of 2014 it had shot up to 38%. This single figure is sufficient to elucidate the impact on global growth if China slows down. This is the key reason many economists have stated that next global recession may come from China.
There are plenty of problems in Chinese economy but to understand its true state and its longer term future, one has to start with its structural issues as mentioned below.
• Demographics – growing proportion of aging people
• Imbalanced growth – roots of social unrest and economic woes
China has reached an important turning point this year in its demographics. Falling dependency ratio was one of the root reasons behind success of Chinese economic juggernaut that had been rolling on for about last 50 years. Simply put, it is a ratio of number of dependent people (below age of 15 years or above age of 64 years) to the number of working people (between age of 15 – 64) in a country. Lower ratio means fewer people need support from the working people. So a falling ratio can be a tremendous boost for an economy if accompanied by investments in education and job creation. In fact, historically almost all the major economies have made massive gains when they passed through this golden phase. China also fully capitalized by investing heavily in its economy during this phase. It has a simple logic, falling ratio means there are more young people available to work and less people that they have to support and if there are enough job opportunities, the economy has only one way to go – up.
Since this is a population trend, it can be fairly accurately forecasted. The trend for China is as shown below and it clearly shows that around this time the country’s dependency ratio is at turning point – from good to bad.
So from now onwards, China will face a rising burden of non working and old people. Fewer workers will be available to support them and government’s pension costs will start rising.
Traditionally in China, children, mostly sons, support their parents though it is changing now. Rapid aging also means that China faces 4-2-1 phenomena – each child supporting two parents and four grandparents. This setup is not sustainable and future generations are unlikely to take up this responsibility. It implies creating more social security measures by government.
Government unable to support aging population – may create severe social, political, economic troubles
China set up a pension fund in 2000, but it covers only about 365m and this setup is in deep crisis. The country's unfunded pension liability is roughly 150% of GDP and almost half the other pension funds run by provinces are in losses and some have skipped on payments.
But that is only tip of the iceberg – the main problem is a looming longer term crisis. Between 2010 and 2050 China's workforce will shrink as a share of the population by 11 percentage points, from 72% to 61%—a huge contraction. China's old-age dependency ratio will now escalate from 11 (It is 20 for USA) to nearly four times at 42 by 2050. Most damaging part is that by 2050, the number of older people will have risen by more than 10% whereas the number of working people will have halved.
This will be a paradigm shift – a catastrophe for the world’s manufacturing hub. Workforce will start to dwindle, and coupled with rising labor costs, China will lose its edge.
Though all rich countries are facing rising pension costs but China is at a disadvantage as it is not that economically strong on per capita basis. How Chinese authorities manage this particular issue will to a large extent decide the fate of China.
Chinese economy has focused more on investments as means of growth and job creation. It succeeded for a long time but there is a limitation to investment opportunities (mentioned earlier also in this article). China’s consumption as a share of GDP has declined steadily over the past decade to 35 percent, while its investment share rose to above 45 percent. No major country has as low a consumption share as that of the China’s and similarly none has as high as that of its.
A slowdown in investment will reduce jobs and it is one of the most feared scenarios for the leaders of world’s largest nation. They need to ensure enough jobs are being made available but their imbalanced economy may not generate more jobs on a sustainable basis from increasing investments any more. Unemployment has toppled many governments and though Chinese authorities are capable of handling social unrest, they may not be able to do it for long. Additionally, people don’t get what they want, the Graduates don’t want to work in factories; they have high ambitions and look for office jobs but most of the jobs are in factories. At present it is not a major problem but growing unavailability of jobs and suitable jobs is going to stir social unrest.
Economic impact – excessive investments in real estate:
China’s rising investment demand has been mainly for infrastructure, which will support long-term economic growth. But a large part of this investment is in residential property. Urban households have piled into property investment because of negative real interest rates on bank deposits, and also due to capital controls that prevent most households from investing abroad.
The real estate boom assumes that house prices will continue to rise and there may be only small price corrections. But when this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is derived from real estate, so if real estate slumps, whole of the economy may enter a long downturn. Excessive investment in real estate is a serious imbalance.
Hurdles in removing imbalances:
Removing imbalance means cutting on manufacturing but there are big banks, exporters and manufacturers who won’t easily let it happen. They are blocking reforms. Some even say that it is an effort by Americans and Europeans to get Chinese to import more goods and consume more. Though the Chinese premier has been trying for rebalancing but the necessary reforms have been blocked by vested interests.
Rebalancing may cause slower growth for a long period but in its absence there may be a larger, more gradual and deep decline. If Chinese leaders don’t act on needed reforms, imbalances may continue to rise. But this cannot go on indefinitely. At some point, the ticking time bomb will explode, and the growth rate will crash.