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Growth in China: an overview of viewpoints on the main issues [ClearOnMoney]
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Commentary

Growth in China: an overview of viewpoints on the main issues

29 Mar 2010 by Jim Fickett.

Chanos' widely quoted statement that China is like “Dubai times a thousand” triggered a number of thoughtful overview articles, providing the average investor with the opportunity for considerable insight into China. We provide a brief overview of a few of the key issues, giving a synopsis of viewpoints on either side of each one. My own overall conclusion is that a slowdown is quite likely, but not a nationwide crisis or collapse.

Last November Jim Chanos, the famous short seller, made it known he thought the China property market (and perhaps China more generally; stories differ) was in a bubble (one account in Politico). The statement provoked many responses, both for and against.

In this article we list half a dozen of the main issues raised, and quote from the arguments on either side. Hopefully by aligning the positive and negative arguments around each issue it is a little easier to get a balanced view.

Foreign exchange reserves are large, but they are not savings that can be spent

In a prominent 12 Jan 2010 piece in the New York Times, the columnist Thomas Friedman voiced a common feeling when he pointed (with some envy) to China's vast foreign exchange reserves, as a resource with which problems could be fixed:

First, a simple rule of investing that has always served me well: Never short a country with $2 trillion in foreign currency reserves. …

I am reluctant to sell China short, not because I think it has no problems or corruption or bubbles, but because I think it has all those problems in spades — and some will blow up along the way (the most dangerous being pollution). But it also has a political class focused on addressing its real problems, as well as a mountain of savings with which to do so (unlike us).

Michael Pettis, a finance professor at Peking University and a senior associate at the Carnegie Endowment, explains the basic nature of foreign exchange reserves:

[in managing the exchange rate, the People's Bank of China buys dollars, and] must fund the purchase of these dollars. It does so primarily by borrowing in the domestic money markets …

This means, to simplify, that the PBoC has a balance sheet consisting on one side of dollar assets (and here “dollar” is short-hand for all foreign assets). Against this and on the other side it has a roughly equivalent amount of RMB liabilities …

China’s reserves are often thought of as if they were a treasure trove available for spending. They are not. They are simply the asset side of the mismatched balance sheet.

And in a 2 Feb 2010 article, Pettis specifically responded to Friedman:

Twice before in history a country has, under similar circumstances, run up foreign reserves of the same magnitude.

The first time occurred in the late 1920s when, after a decade of record-beating trade and capital account surpluses, the United States had accumulated what John Maynard Keynes worriedly described as “all the bullion in the world”. …

The second time occurred in the late 1980s, when it was Japan’s turn to combine huge trade surpluses, along with more moderate surpluses on the capital account, to accumulate a stockpile of foreign reserves …

Needless to say, and in sharp rebuttal to Friedman, both previous cases turned out badly for long investors and brilliantly for anyone dumb enough to have gone short.

Clearly, then, a large accumulation of foreign exchange reserves is no magic protection against the dire effects of collapsing bubbles.

Advances have been made in infrastructure, but some projects were wasteful

In the Financial Times, on 21 Jan 2010, David Pilling made the case that stimulus spending on infrastructure would provide long-term value:

With an urban population of just 47 per cent, China is at roughly the stage of development Japan reached in the 1950s when it was building as if cement were running out. Many Chinese residents heat their homes with gas canisters because there are no pipelines. Some have no sewerage or running water. Much else, beyond such basic needs, can be built. Take the high-speed railway now strung across the nation. Within a few years, it will connect 70-80 per cent of Chinese cities with a population over 500,000. In terms of travel times, the entire country will shrink by three-quarters. Shanghai and Beijing will be five hours apart. There will be potentially enormous productivity gains.

Edward Chancellor of GMO, in a March 2010 white paper entitled China's Red Flags counters that,

China already possesses a highly developed infrastructure, given its current state of economic development. Last year, highway usage in China was estimated at 12% of the OECD average. Many smaller airports were running at half capacity. Plans for a national high-speed railway may appear impressive on paper, but the investment returns are questionable. A transport researcher at China’s own National Development and Reform Commission has recently warned that the proposed 18,000 kilometres of high-speed railroads would face problems in recouping costs and “might not be able to achieve its minimum passenger loads to break even.”

(The 12 page report from Chancellor is probably the most carefully documented bear case available; free registration is required to read it)

It is pretty clear that much of the infrastructure spending is useful and that much of it is wasteful (the example of Ordos is now infamous). I doubt anyone, even inside China, will know for some time what the proportion is in each category. What is clear is that there will be a significant increase in non-performing loans from the recent burst of projects.

There is clearly a property bubble, fortunately not as leveraged as those in the west

Chancellor again, on residential property:

Last year, sales of residential properties in the People’s Republic climbed to RMB 3.8 trillion, up 87% on 2008. Average home prices rose by 8% in 2009. Several local markets saw stronger gains, rising by 20% or more. Residential construction has also taken off. New housing starts (as measured by floor space) climbed 16% in the year to November. In 2010 housing construction is expected to rise another 20%. This raises a question about potential oversupply. The consensus view is that new supply will be gobbled up as the economy continues expanding and the rural population flocks to the cities.

Migrant workers, however, can’t afford the prices that prevail in the major cities. Ownership ratios in the cities have already climbed to 70%. Residential completions in Beijing have grown faster than the population. Much of this excess supply is being held off the market by property “investors.” A recent survey found that nearly a fifth of all recently sold properties were kept vacant.

And a 12 Feb 2010 article from Bloomberg, on commercial property:

Jack Rodman, who has made a career of selling soured property loans from Los Angeles to Tokyo, sees a crash looming in China. He keeps a slide show on his computer of empty office buildings in Beijing, his home since 2002. The tally: 55, with another dozen candidates.

“I took these pictures to try to impress upon these people the massive amount of oversupply,” said Rodman, 63, president of Global Distressed Solutions LLC, which advises private equity and hedge funds on Chinese property and banking. Rodman figures about half of the city’s commercial space is vacant

The Economist does not dispute that prices may have risen too far, but in a 16 Jan 2010 article, (subscription required), points out that, unlike in the worst bubbles, leverage is not overwhelming, at least on the residential side:

Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash. The average mortgage covers only about half of a property’s value. Owner-occupiers must make a minimum deposit of 20%, investors one of 40%. Chinese households’ total debt stands at only 35% of their disposable income

(This Economist article is probably the most comprehensive one on the positive side.)

It does seem likely that there will be fairly serious dislocations as a deflating property bubble causes significant losses. It is probably true that it will not be as bad as America's housing crisis and, in particular, is less likely to cause a financial crisis. But it is still likely to cause a significant slowdown in demand, and hence negative pressure on the economy.

Growth in industrial capacity has been excessive; at some point it will slow

On 29 Nov, the Financial Times made an apparently damning case concerning excess capacity:

China has responded to the world financial crisis with what seems to be great success. But this is an illusion. …

In a disturbing new report, the European Chamber of Commerce in China lays out the challenge in six sectors: aluminium, where the capacity utilisation rate is forecast to be 67 per cent in 2009; wind power, on 70 per cent; steel, on 72 per cent; cement, on 78 per cent; chemicals, on 80 per cent; and refining, on 85 per cent. Yet vast additional capacity is on the way.

The scale of the excess capacity is breathtaking. At the end of 2008, China’s steel capacity was 660m tons against demand of 470m tons. This difference is much the same as the European Union’s total output. Yet, notes the report, “there are currently 58m tonnes of new capacity under construction in China”.

Note that the European Chamber of Commerce is perhaps not the most objective source on the matter. The Economist wrote in rebuttal:

China does have excess capacity in some industries, such as steel and cement. But across the economy as a whole, concerns about overinvestment tend to be exaggerated. …

China’s critics overstate their case. A recent report by the European Union Chamber of Commerce in China estimates that in early 2009 the steel industry was operating at only 72% of capacity. That was at the depth of the global downturn. Demand has picked up strongly since then. …

Many commentators complain that China’s capital-spending spree last year has merely exacerbated its industrial overcapacity. However, the boom was driven mainly by infrastructure investment, whereas investment in manufacturing slowed quite sharply

Unfortunately the Economist does not back up “Demand has picked up strongly” with any quantitative data. And although they say “investment in manufacturing slowed quite sharply”, the accompanying chart shows investment in manufacturing to be still growing at a pace of 25% year-over-year. Though this is down from 45% year-over-year, 25% is still very rapid growth. Further, in earlier articles, before all the controversy raised by Chanos, it was reported that the government of China itself was worried about industrial overcapacity. According to a 30 Sep 2009 article in the China Daily:

China's cabinet has laid out detailed plans to curb overcapacity in industries such as steel, aluminum, cement and wind power …

the State Council said meeting the government's long-standing goal of reducing overcapacity was urgent because the result of inaction would be factory closures, job losses and rising bad bank loans. …

“There is 58 million tonnes of crude steel capacity under construction, most of which is illegitimate. Crude steel capacity could exceed 700 million tonnes and overcapacity will intensify if curbs are not implemented in time,” it said. …

On aluminum smelters, the Cabinet repeated pledges announced in May to ban for three years new capacity and to remove small plants scaled at 800,000 metric tons per year or below.

It seems fairly clear that (1) there is, in fact, significant overcapacity, and (2) the government is, at least to some extent, addressing the problem. Whether the growth in capacity is slowed from above or by business failure, it seems that here, too, current economic activity is at an unsustainable level.

Everyone agrees that irresponsible lending is a major problem

Even the most positive reviews admit the recent growth in lending has been extreme. The Economist, for example, writes

The biggest cause for worry about China is the third point of similarity to Japan: the recent tidal wave of bank lending. Total credit jumped by more than 30% last year. Even assuming that this slows to less than 20% this year, as the government has hinted, total credit outstanding could hit 135% of GDP by December. The authorities are perturbed. This week they increased banks’ reserve requirement ratio by half a percentage point. They have also raised the yield on central-bank bills. …

recent lending has been excessive; combined with overcapacity in some industries, it is likely to cause an increase in banks’ non-performing loans. …

Much of the past year’s bank lending should really be viewed as a form of fiscal stimulus. Infrastructure projects that have little hope of repaying loans will end up back on the government’s books. It would have been much better if such projects had been financed more transparently through the government’s budget, but the important question is whether the state can afford to cover the losses. …

Total government debt could be 50% of GDP. But that is well below the average ratio in rich countries, of around 90%. Moreover, the Chinese government owns lots of assets, for example shares of listed companies which are worth 35% of GDP.

Most commentators predict the same outcome – a large increase in non-performing loans, and a government rescue. The resulting slowdown in lending is likely to be a significant drag on the economy.

Central planning has its advantages and disadvantages

Those of us dependent on the tortuous processes of the US Congress find it easy to admire the efficiency of central decision making. The decision is made for a high speed railroad from Beijing to Shanghai, and voila, work begins. Many commentators have extended this to a virtually unlimited faith in what the central government of China can accomplish. Pilling writes

Intellectually, there is much to suggest that China's economy can't go on like this. But one's gut tells you it can, not least because the Communist party needs it to.

But central planning has its limitations, most obviously in that real results are not always what is rewarded. The communist party retains the power to review any hiring decision in the country, and perhaps competence is not always the top criterion for approval. The crisis has also been used to strengthen central control and weaken the limited free markets that have driven much of recent growth:

There is another way in which the crisis has exacerbated the trend known as guojinmintui, literally the state advances as the private sector retreats. State-led companies that have received massive stimulus related loans now have the wherewithal to buy private enterprises, some of which are struggling in the downturn. In one example, a consortium led by state-owned China National Oils, Foodstuffs, and Cereals Group, the country's largest importer and exporter of food, grabbed 20 per cent of Mengniu Dairy, China's largest milk producer. That gave the state a majority share and, sure enough, a few months later, Mengniu's founder was replaced by a state-appointed executive. Some China-watchers were never really convinced the state was on the retreat. Few can doubt that, for now at least, it is advancing.

Chancellor refers to the historical record:

One of the wonders of modern China is that it has turned some of the world’s most ardent capitalists into fervent admirers of an economy managed by communists.

Both economic theory and history, however, argue against the notion that central planning is the optimal mode of economic development.

Summing up: positive and negative forces on growth

There are many more issues, but perhaps the biggest ones we have not addressed, pollution and demographics, are somewhat less immediate.

The best summing up of all this comes from another article by Michael Pettis:

[China] may have a painful financial contraction, but this will not necessarily lead to a collapse in growth. Instead it will grind away at its overinvestment and excess capacity, which, with a reversal of the favourable demographics enjoyed since the mid-1970s, will slow growth sharply, but this will coincide with three more favourable circumstances.

First, China will continue to urbanise rapidly, which will raise household income and create new sources of growth. Second, even as the workforce declines, increased education and infrastructure spending will raise worker productivity. Third, a sharp contraction will force Beijing finally to liberalise the financial system and transfer resources from the inefficient state sector to small and medium enterprises, increasing productivity. …

No successful emerging country has experienced unbroken growth and, contrary to inane claims by bulls, even China has had at least three economic crises in recent decades. Denying the possibility of difficult adjustment periods makes no historical sense. But adjustment is not collapse.

One can question many particulars of this analysis, but I think overall it fits the facts: the rapid growth based on exports is not currently viable, and the stimulus-led growth is, in fact, unsustainable, so a slowdown in growth is likely. But neither a crisis/collapse, nor a long period of stagnation looks like the most likely outcome on current data.