Thursday, February 9, 2012

Beyond the bubble

February 7, 2012 / Andy Xie

Andy Xie urges the Chinese government to embrace the restructuring that is needed to sustain economic growth, instead of using its financial muscle merely to delay the inevitable - a painful transition

China's obsession with stability may lead to greater instability. A skilful person can keep a ball on a bigger ball only for so long. China's economy faces serious structural problems. Reshuffling liquidity to keep everything afloat for now will lead to a collapse later. The right way forward is to accept restructuring, deal with the pain, and be reborn into a more dynamic economy. This way, China could become the world's largest economy in 10 years.

China has experienced a tremendous economic boom, the result of it joining the World Trade Organisation, its demographic dividends, and its building of infrastructural networks. China's nominal gross domestic product has almost quadrupled over the past decade to an estimated 47 trillion yuan (HK$58 trillion) last year, with exports up more than seven times in US dollar terms, while electricity consumption, the best proxy for real growth, is up by over 200 per cent. Prosperity on such a vast scale has never occurred before. China should be proud of its achievement.

Amid the prosperity, two related forces have been sapping China's dynamism: the rise of the state sector and a vast financial bubble. Fixed-asset investment, dominated by government and state enterprises, rose from 2.8 trillion yuan to 31 trillion yuan, or from 30 per cent to 65 per cent of GDP, over the past decade. It is a symbol of the nationalisation of demand during the boom. Its two consequences are rising corruption and declining efficiency. The bubble, especially in property, has diverted the energy of businesses and households towards speculation to chase quick profits. Amid rising costs, China's businesses have tried to stay alive through speculation rather than by increasing efficiency and upgrading products.

China's bubble isn't a result of investors overreaching. In this system, every bubble-making opportunity is seized upon because it benefits the government and the people with influence. The productivity gains from joining the WTO, the demographic dividend and infrastructural build-up should go into raising profits and real wages. But, through rampant monetary expansion and government manipulation of the land market, the productivity gains have gone into supporting a giant credit-cum-land bubble.

The bubble has begun to deflate. Many blame the government's tightening measures, but they have merely brought forward the inevitable, because the bubble was already unsustainable. The WTO dividend is gone. The depressed global economy is turning China's export dependence into a weakness. Population ageing is causing labour shortages, shifting money from asset inflation to price inflation. And, the quantum benefits from building infrastructure have mostly been absorbed.

The right way forward is to: first, quickly deal with the bad debts from the bubble bursting; second, rebalance demand from the government to the people through tax cuts; and, third, to boost supply-side efficiency through industrial consolidation.

China's banking system has 110 trillion yuan in total assets or 234 per cent of GDP. While the reported loans are about half of those assets, a majority of the assets are loans to local governments and businesses, directly and indirectly. Much of the lending to businesses is also outside the banking system. And we know that most loans in mainland China go into property. China's property and land prices are likely to plummet from the peaks. Yet many more properties are under construction. China's bad debts could easily go into trillions of yuan.

China reported fiscal revenue at 22 per cent of GDP and industrial profit at 12 per cent of GDP in 2011. The household disposable income survey suggests household income was 40 per cent of GDP. Suffice it to say that China's income distribution is heavily skewed towards the government and state-owned enterprises; household disposable income is low, and this is why China's consumption is low.

On the supply side, China suffers extreme fragmentation and overcapacity. When labour and capital were cheap and supply was endless, such an industrial structure could survive. But, as China's demographic headwind pushes up wages and inflation pushes up capital costs, most businesses in China are having trouble. To survive, numerous companies have turned their core businesses into a fund-raising platform for property speculation. This strategy is backfiring as the property market heads south.

China's bubble has covered up many structural problems. The bubble worked when the benefits from other sources were available to sustain it. As the latter vanish, the bubble deflates. Obviously, it is painful to deal with all the problems at the same time.

The obsession with stability may be pushing China towards a stalling strategy. China's vast foreign-exchange reserves give it the freedom to maintain domestic liquidity regardless of the quality of the banking assets or hot-money outflows. The lack of liquidity pressure means China doesn't have to press bankrupt developers and inefficient businesses to sell out or liquidate. But that could lead to a Japan-style equilibrium with zombie banks, zombie companies, and zombie local governments.

Unlike Japan two decades ago, China's labour costs are still low. It is possible that, through multinational corporations and new companies at home, Chinese workers will become more productive, for example, by competing against their German and Japanese counterparts. The resulting rising tide could solve China's problems. But this strategy needs luck, and time, to work.

It would be far better to control one's own destiny through restructuring to become more productive on the supply side and more balanced on the demand side. But the prospect of that seems low for now. China's economy may take a long pause.

Andy Xie is an independent economist


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