January 16, 2012 / Andy Xie
China's economy is slowing down due to export weakness and a bursting property bubble. Unless painful structural reforms are undertaken, the slow growth may be here to stay.
China has excessive debt in the corporate sector due to property speculation, excessive fragmentation of the supply side due to local government subsidies, and unsustainable dependency on investment on the demand side. Export slowdown and property bubble bursting expose their drag on growth. Unless structural reforms deal with these problems, China is entering an era of slow growth-GDP growth rate down by one third or more compared to the record in the last decade.
The structural problems are unlikely to be cured in the foreseeable future. China is likely to avoid widespread business bankruptcies, which is necessary for balance sheet cleansing and supply side consolidation, by forcing banks to prop up unprofitable businesses. This dynamic will suppress economic growth rate.
Fiscal or monetary stimulus couldn't revive growth. The stimulus money would go into government fixed investment, already excessive, inefficient, and inflationary.
China's per capita income reached $5,000 in 2011. It is less than half of the global average and one tenth of the OECD level. China has the potential to continue high growth rate until $15,000 per capita income. However, the will to embrace painful reforms, necessary to realize China's full potential, isn't here.
Too much debt
China's debt is concentrated in the business sector and local governments. It appears that both are excessively in debt and will have trouble expanding through more debt. At a glance China's economy isn't excessively levered. The domestic credit at Rmb 65 trillion reported in October 2011 is about 145% of GDP. It is not alarmingly high by itself. But, the off-balance assets in the banking system and the lending activities outside of the formal financial system may add considerably to the country's indebtedness. The financial institutions have total assets of two times GDP. And the country's officially recognized financial assets are about 2.6 times GDP. These two numbers indicate that the lendings outside of the officially recognized financial system are considerable. China's total indebtedness of its non-financial sector is probably above 200% of GDP.
The concentration of China's debt in local governments and businesses is a big problem. Local governments usually have debts over three times revenue. There are examples of over ten times. Corporate debts in many coastal townships are above two times the local GDP. Such high leverage is difficult to sustain. It is quite likely that both sectors are having trouble paying off their debts.
Corporate debts usually go into property investments that in turn become revenues for local governments. As the property bubble bursts, the revenues for local governments will come under pressure. That increases the difficulties for local governments to pay off their debts.
The inability to pay off debts is not likely to lead to bankruptcy. The recent trend suggests that the banks will roll over the loans to governments or businesses despite their inability to repay.
Fragmentation of the supply side
Most businesses in China seem to have a large number of companies, while similar industries in the rest of the world are consolidated into a few players. Low entry costs are the reason for China's fragmented industrial structure.
Local governments keep entry costs low to promote investment. Land is commonly free for industrial use. The environment protection cost is usually low. Until recently, credit and labor were cheap and plentiful. In an environment of low entry costs, market growth leads to more entries. Hundreds or even thousands of companies are doing the same thing across most industries.
The fragmented industrial structure is running into trouble due to rising labor and credit costs. A fragmented industry has no pricing power. When costs rise, only bankruptcies could shrink output, increase prices, and restore profitability. The logical ending in this process is the emergence of large players that develop brand, quality, intellectual properties, and economies of scale as entry barriers.
However, the consolidation process led by market force is unlikely to proceed normally. The lenders are under pressure not to pull the credit lines on struggling businesses. That means that the industrial sector couldn't improve efficiency to deal with rising costs.
Excessive investment, led by local governments and state-owned enterprises, has become the central pillar for demand management in China. As debts pile up, more investment with new debt has become the only option to keep liquidity positive. This dynamic of riding the tiger is leading the Chinese economy to become more and more skewered towards investment.
In 2001 the reported urban fixed asset investment ('FAI') was 25% of GDP. It surged to 43% in 2006, 60% in 2010, and an estimated 65% in 2011. The increase in the FAI over the past decade exceeded three quarters of GDP increase. The trend is simply crazy.
China's FAI is supply-driven, i.e., it starts with a government project. The government concerned then tries to raise revenues in whatever way at its disposal. As government power is unchecked, such dynamic inevitably leads to squeezing the household sector through whatever channels. High property price, inflation, taxes, or fees all lead to the same end: funding government projects.
The reported FAI could be exaggerated due to leakages in the expenditures. China's gray income could be one tenth of GDP. Much of it comes out of FAI. Such redistribution of income from the masses to a privileged few is not good for social stability. That is one reason that the FAI trend is bad for the country.
Leakages aside, some of the massive investment is just waste. The image projects are visible everywhere. China's per capita income is less than half of the global average. It doesn't make sense to waste money on such a scale.
Stimulus could backfire
China's economy is slowing significantly since the summer of 2011. The eurozone debt crisis was the trigger. It appears that Europe is experiencing a deeper recession. It is the largest trading partner for China. The bursting property bubble at home is adding to the slowdown. The property bubble has been the liquidity machine turning bank loans to property developers and buyers into revenues for local governments that leverage up the receipts further with bank loans to fund FAI. The breakdown in this liquidity machine has forced many governments to stop FAI projects.
As the slowdown continues, there will be calls for monetary and fiscal stimulus. Such stimulus will merely go into FAI again, prolonging the problems in the economy. Inflation will follow such stimulus. It is just taxing the currency holders to finance inefficient FAI. While stimulus for propping up FAI isn't a good idea, it may happen anyway in 2012. The resulting inflation will cause public outcry and pullback of such stimulus.
China's current slowdown isn't just a cyclical phenomenon. The country's investment-and export growth model is running into a wall. Global trade isn't likely to return to high growth. Without export boom, there is no income to afford the inefficient FAI. Pure cyclical thinking in policy prescription isn't likely to get the economy out of the doldrums.
Structural reforms can revive high growth
If China wants to revive growth, it should allow market force to function fully. Unviable businesses should shut down or be sold. China's cost structure will continue to rise due to labor and energy shortage and rising cost for environmental protection. Fragmented industrial structure is just not viable. Consolidation into the right hands could increase efficiency to offset the cost rise.
Further, China has to move up the value chain to deal with the rising costs. While China's exports are the biggest in the world, Germany and the US are not so far behind. Their labor cost is ten times China's. They are sustaining their exports by doing what China cannot. It is a big market out if China can upgrade and move into the same markets that Germany, Japan, and the US occupy now. The current industrial structure couldn't get China into the high value added market, as companies are too small and profits are too low to fund R&D. Consolidating the current fragmented industrial structure is a must if the country is to move its industrial base up the value chain.
The concentration of resources in the government sector has become a drag on the economy. This political force is the root cause for most of China's problems. The trend needs to be reversed if the economy is to move up the value chain. China should consider to decrease the government's stakes in the state-owned enterprises and to open up the industries that the SoEs now monopolize to private companies.
Demand support is worthwhile if it coincides with structural reforms. Otherwise, it would be just for propping up an inefficient and unsustainable economic structure. And, any stimulus should support consumption rather than investment to ease structural imbalance.
As I wrote in this page last time, cutting taxes is the best way to support demand. Monetary stimulus or increasing fiscal spending would only support inefficient FAI, making the situation worse down the road.
Stagnation for stability?
The micro evidences suggest that China is trying to prop up the existing structure rather than to restructure the economy. Local governments are putting pressure on banks to support failing companies. The local government debts are likely to be rolled over too. While such actions preempt disruptive bankruptcies, businesses, banks, and local governments could all become zombies for a long time to come. Stability will be paid with stagnation.
China's attitude to the current economic challenges seems to be similar to Japan's two decades ago, emphasizing stability above all else. Japan essentially buried the consequences ot the bubble in the financial system. Businesses, banks, and local governments all became zombies. Of course, China is entering the phase at much lower per capita income. Stagflation will trap hundreds of millions of people in low income.
It is possible that China will emerge from the low growth phase on its own as businesses eventually learn to use China's labor for higher value-added activities. Import substitution and export expansion may follow, which would bring a rising tide again. But, it would be years away. Unless we see a coherent and comprehensive restructuring program soon, China may be stuck in low growth for years.
It doesn't have to be that way
China's per capita income is only USD 5,000. The household consumption is merely one third of that due to over investment. China's living standard is still relatively low. It would be a trajedy for China to be stuck at such a low level.
Two decades ago, Japan was already enjoying per capita income similar to other developed economies'. Stagnation wasn't a bad prospect. Also, due to high cost, Japan wasn't in a position to revive high growth rate. One may argue that Japan made a rational choice to digest the consequences of the bubble over a long time.
The tradeoffs for China today are totally different from Japan's then. The country still has low cost. Through upgrading, high growth rate could be revived. The current per capita income is too low for most people.
Avoiding bankruptcies is very bad for the stock market. Failing businesses that are propped up by the banks will suppress profits for healthy companies. The banks will suffer terribly. Hence, the stock market will remain depressed due to low profitability. The government may try liquidity support for the stock market sometime this year. Its effect will be short-lived. Without a good environment for business profit, the stock market cannot perform.
As I wrote before, soft landing may not be good, hard landing may not be bad. Indeed, if China goes into a hard landing now, it will most likely push the country towards painful reforms. The economy will prosper for a long time afterwards. But, it doesn't look likely now. China's economy is slowing down in an orderly fashion, as the banks are not permitted to pull the plug on failing companies. When we celebrate the soft landing, we should remember the cost.
Monday, January 16, 2012
January 16, 2012 / Andy Xie