China Model - A Momentous Challenge
The Chinese Economic system has become a topic of feverish discussion in academic circles as a result of the consistently high and stable rate of growth China has been able to manage over the last 3 decades. China Model as this economic governance system is labelled is said to be based on firstly high infrastructure investment based economic system fueled by credit and secondly an export-led manufacturing sector. Most of the large monopoly sectors including the infrastructure sector like railways, telecom, power, coal, oil and gas, roads, big airlines, etc are govt controlled. In addition the credit is directed by banks which also lie in the State sector. Apart from this all business lies in the private domain. This Model had built up two distortions over time - a world-record breaking Investment/ GDP ratio and unparalleled Trade Surplus figures. Since the global financial crisis as a result of the drop in demand by the Western nations, the Trade Surplus has been reined in. But the Investment/ GDP ratio has continued to escalate and now reached a ratio of 52% never reached for any nation earlier. While the overall Asset/ Infrastructure levels in China are still far low as compared to the west, the rates at which it is being increased has been made possible only by a rampant credit boom which has the potential to explode into a bubble. The Chinese economic administration has been aware of this dangerous distortion in the economy and has repeatedly emphasized its determination to change this state of things and move gradually from an infrastructure-based to a more consumption-based economy. But the move is fraught with danger and is likely to reduce the growth rates. So this has been constantly been postponed despite the stated Chinese resolve to make the necessary changes. But do we see signs that this long-delayed decision is being taken and that the China Model is now making a historic once in 30 year change to a more consumption based model?
China's Impressive Show in the post-Recession Period
All of us know that while the world economy went through a massive crisis in 2008, and yet the Chinese economy did impressively well. It dipped to 6.2% in Q1 -2009, and then bounced back to 11.9% by Q1-2010! In 2010, 2011 & Q1-2012 it has stayed above 8%. But since then it has stayed between 7.4 to 7.6%. Quarterly GDP rates can be seen here. This recovery was financed by a massive Fiscal Stimulus package launched by the Central government but in this credit boom the local governments have participated with enthusiasm. China indulged in this credit boom because it could. Its finances which had always been well balanced provided it the ample room to go in for this deficit financing. The LGFVs were at the were at the heart of the Stimulus implementation. The local government route with the hunger of local governments to invest in infrastructure were used by China to stimulate its economy during the global financial crisis. Moreover this was accompanied with continued investment push to the infrastructure sector. This tilt towards investment was further distorting the structure of the Chinese economy. But yes this infra investment push was temporarily rescuing the Chinese economy and maintaining the growth momentum. But all this credit cannot go on endlessly. More importantly the economy cannot be endlessly distorted. The managers of the Chinese economy (the NDRC and the other government economic think tanks) have known about this, but as this is going to be a relatively painful activity they have been reluctant to bite the bullet. But as recounted below, events are happening which force us to sit back and take notice. Finally maybe change is on the way?
Unusual Dry-Up of Liquidity
Short term interest rates in China have been zooming for the last one week. The short-term rates which are tracked as "Shibor" (Shanghai interbank borrowing rates -www.shibor.org) have reached 8 % from . A Chinese debt sale has failed after 2 years (Click here for Bloomberg report). Alongside this, in informal offshore currency markets the yuan has been declining. Which means that foreign funds are weak on China and money is leaving (as in the case of India and all Emerging Markets). The other great source of liquidity - the government & govt banks - too for the first time is keeping a lid on the liquidity flow. All this points to a Liquidity Crunch. China's Central Government debt seems to be in quite secure territory when compared to other Emerging Markets. So why is China reining in its expenditure? The Local Governments have a tendency to be profligate as they have the unchecked freedom to go in for large infrastructure investments. For some time now, the LGFVs have been rolling their interest payments - borrowing from the short-term market to pay their interest dues and then borrowing again when the short term obligations become due. With the current rise of short-term interest rates their outflows are going to increase and they are going to get badly hit.
The Chinese Economic system has become a topic of feverish discussion in academic circles as a result of the consistently high and stable rate of growth China has been able to manage over the last 3 decades. China Model as this economic governance system is labelled is said to be based on firstly high infrastructure investment based economic system fueled by credit and secondly an export-led manufacturing sector. Most of the large monopoly sectors including the infrastructure sector like railways, telecom, power, coal, oil and gas, roads, big airlines, etc are govt controlled. In addition the credit is directed by banks which also lie in the State sector. Apart from this all business lies in the private domain. This Model had built up two distortions over time - a world-record breaking Investment/ GDP ratio and unparalleled Trade Surplus figures. Since the global financial crisis as a result of the drop in demand by the Western nations, the Trade Surplus has been reined in. But the Investment/ GDP ratio has continued to escalate and now reached a ratio of 52% never reached for any nation earlier. While the overall Asset/ Infrastructure levels in China are still far low as compared to the west, the rates at which it is being increased has been made possible only by a rampant credit boom which has the potential to explode into a bubble. The Chinese economic administration has been aware of this dangerous distortion in the economy and has repeatedly emphasized its determination to change this state of things and move gradually from an infrastructure-based to a more consumption-based economy. But the move is fraught with danger and is likely to reduce the growth rates. So this has been constantly been postponed despite the stated Chinese resolve to make the necessary changes. But do we see signs that this long-delayed decision is being taken and that the China Model is now making a historic once in 30 year change to a more consumption based model?
China's Impressive Show in the post-Recession Period
All of us know that while the world economy went through a massive crisis in 2008, and yet the Chinese economy did impressively well. It dipped to 6.2% in Q1 -2009, and then bounced back to 11.9% by Q1-2010! In 2010, 2011 & Q1-2012 it has stayed above 8%. But since then it has stayed between 7.4 to 7.6%. Quarterly GDP rates can be seen here. This recovery was financed by a massive Fiscal Stimulus package launched by the Central government but in this credit boom the local governments have participated with enthusiasm. China indulged in this credit boom because it could. Its finances which had always been well balanced provided it the ample room to go in for this deficit financing. The LGFVs were at the were at the heart of the Stimulus implementation. The local government route with the hunger of local governments to invest in infrastructure were used by China to stimulate its economy during the global financial crisis. Moreover this was accompanied with continued investment push to the infrastructure sector. This tilt towards investment was further distorting the structure of the Chinese economy. But yes this infra investment push was temporarily rescuing the Chinese economy and maintaining the growth momentum. But all this credit cannot go on endlessly. More importantly the economy cannot be endlessly distorted. The managers of the Chinese economy (the NDRC and the other government economic think tanks) have known about this, but as this is going to be a relatively painful activity they have been reluctant to bite the bullet. But as recounted below, events are happening which force us to sit back and take notice. Finally maybe change is on the way?
Unusual Dry-Up of Liquidity
Short term interest rates in China have been zooming for the last one week. The short-term rates which are tracked as "Shibor" (Shanghai interbank borrowing rates -www.shibor.org) have reached 8 % from . A Chinese debt sale has failed after 2 years (Click here for Bloomberg report). Alongside this, in informal offshore currency markets the yuan has been declining. Which means that foreign funds are weak on China and money is leaving (as in the case of India and all Emerging Markets). The other great source of liquidity - the government & govt banks - too for the first time is keeping a lid on the liquidity flow. All this points to a Liquidity Crunch. China's Central Government debt seems to be in quite secure territory when compared to other Emerging Markets. So why is China reining in its expenditure? The Local Governments have a tendency to be profligate as they have the unchecked freedom to go in for large infrastructure investments. For some time now, the LGFVs have been rolling their interest payments - borrowing from the short-term market to pay their interest dues and then borrowing again when the short term obligations become due. With the current rise of short-term interest rates their outflows are going to increase and they are going to get badly hit.
Is it Deliberate
Amidst all this action the PBOC has remained firm and is not resorting to opening up the liquidity tap. Which is a huge break from the past. This is the amazing feature which stands out in these times. If the liquidity situation remains tight, the infrastructure investments will get badly squeezed. As a result of which the current investment/GDP rate of China should drop down from its dizzy globally unmatched heights of 50+%. This drop in investment/GDP rate entails a decline in infrastructure investments and a consequent decline in Growth Rate. Reuters had reported a few days back that China was Ok with 7% growth rate (Q1-2013 growth rate was 7.7%; Q3-2012 was 7.4%). The firmness China has shown in holding back on liquidity indicates that the Committee which rules China has now decided to begin the long promised and sincerely repeated goal of Rebalancing the Economy and Changing the Growth Model. This claim has been made for the last 5-6 years and was also repeated by both the incoming and outgoing Prime Ministers at last years 12th National People's Congress. However, now China seems to have decided that there was no alternative to taking the bull by its horns. It knew that it could not continue by just pumping more and more cash into infrastructure investments which were accumulating and a bubble was building up. Moreover, investments can become inefficient when they are not Demand Driven but are Supply Driven. For example if bridges were built based on anticipations of the future, one might end up building a Bridge to Nowhere - a wasted investment which nobody uses.
Changing the China Model
Changing the China Model
China seems to have begun the journey to change the China Model - shifting from an investment-led model to a model in which consumption plays an increasingly greater role. While curbing investments at one end this change seems to be encouraged by diverting more cash to the people through greater social security payments in the form of pensions, unemployment insurance, medical insurance, etc. Greater cash with the people should result in growth of retail consumption. And the safe Chinese fiscal deficit position should imply that China would not face much problem in triggering the consumption boom. As with all Chinese moves, one should expect that this change will also be executed gradually while being monitored and corrected for any negative consequences. China will also be watchful that this activity is not overdone and growth does not get choked off seriously.
So what will be the consequences and likely future scenarios? The Chinese Economy should get more rebalanced. If this transition takes place successfully, consumption by the Chinese people should increase successfully. This should herald a period in which the Chinese people who have worked tirelessly over the last three decades should improve their living standards considerably. One can then make a guess that the Chinese President was aware of this lifestyle improvement and that is why he has decided to present it to the Chinese people in the form of a "Chinese Dream"!
In the likely scenario, with this gradual rupture with the past, there could be a period when growth rates would drop and depending on the status of the world economy it could fall as low as 7% and maybe even 6.5%.
If and when the Chinese consumption engine gets activated the Chinese people would then start fuelling their own growth. Working, Earning, Building-Consuming - all parts of the cycle taking place in China.
If and when the Chinese consumption engine gets activated the Chinese people would then start fuelling their own growth. Working, Earning, Building-Consuming - all parts of the cycle taking place in China.
Pessimistic Possibilities
Concerns about the Chinese economy are now being reflected by larger sections of the financial industry. Wei Yao of Societe General is saying that China could be facing a Minsky moment. Zhiwei Zhang from Nomura says that H2 -2013 growth could fall below 7%. Charlene Chu of Fitch Ratings says that the Credit (total) to GDP is ~200%! While this ratio was only 40% 5 years ago. In the last 5 years the US securitization model has been replicated in the shadow banking system in China.
Once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4% annually. This is what it will take for household consumption to rise to roughly 50% of GDP in a decade if consumption growth can be maintained at its historic rates of around 8%. But I always warn that this is likely to be an upper limit, not a lower limit, to growth.
Although they might not be as negative as 3-4%, even the IMF has changed its growth forecasts about the Chinese economy from 8.8% to 7.75%. Click here to read report by Ryan Rutkowski of Peterson Institute of International Economics (PIIE).
Something has seriously changed over the last five years since the 2008 Western crisis. And this involves the huge expansion in credit, especially the hidden unofficial credit which is being termed as Shadow Banking by the financial experts.
A very recent phenomenon of Shadow Banking is afflicting the Chinese finance industry. Although the bad loans of Chinese banks are remarkably just 1percent, this hides the reality. In reality Trust Funds (Read a PIIE report by Nicholas Borst - "Role of Trust Funds in Amazing Rise of Chinese Credit", here ) and offshore investment companies team up in league with the second rung of banks. Loans are taken and then these are repackaged through innovative financial instruments to move these loans out of the banks balance sheet! It is almost as if there are two balance sheets. The loans are moved through a process of securitization the official balance sheet to an unofficial balance sheet. The official balance sheet shows low bad loans but the hidden balance sheet is accumulating the toxic assets. The Chinese government has been aware of this for some time and has continuously tried to stop these irregularities. But the financial wizards have kept one step ahead. Unregulatable Financial Innovation which resulted in the Great Recession seems to have China banking industry in its grip? It seems to be happening because the official bank rate is very low (as in India) and so investors come to bank with funds to invest but only if they get lucrative deposit rates. These banks then team up with LGFVs through unofficial methods to promise high deposit rates and the loans are given to local governments. But now the local government agencies are finding it even difficult to keep paying these high interest rates. Nicholas Borst of PIIE takes a different line. He says that most of these LGFV financed projects are viable and productive! But that they suffer from a wrong financing model. The financing of infrastructure investments should have long payment horizons as they fructify over long periods. Instead because of the hidden nature of the financing, they accepted short payment periods. The revenues on these projects will be earned many years later and so the LGFVs are in an extreme cash-flow crisis. Maybe the government needs to intervene and act as a bridge to resolve this time-period mismatch. But he says that while the government should crackdown on the Shadow Banking practices, it needs to provide a financing model for the local governments - otherwise growth rate could drop considerably.
Changing to Consumption Model - a Regional Perspective
Prof Pettis also quotes an IMF paper to take a regional perspective on the investment vs consumption debate. The coastal regions are having a relatively higher autonomous consumption based economy and the drop in investment could be shifted towards a rise in consumption. But the current low consumption in the western region is sustained by infra investments which have poured in (Western Development Strategy). And a drop in investments will not result in an automatic shift towards consumption as for the coast, but it could result in a dramatic fall in consumption. Investment can be used up productively only where requisite social capital exists to make productive use of it.
Conclusion
The pessimistic China Bear Lobby (Peter Chovanec, Gordon Chang etc.) has long been crying itself hoarse predicting China Collapse. As expected it has again gone into overdrive predicting a hard landing for China. Crying wolf they hope would dissuade investors and so by choking investment with their alarmist projections they hope to serve as a self-fulfilling prophecy.
But this time around their is a greater degree of skepticism and alarm that China might be in for a tougher time. One has to be more cautious as the new Shadow Banking phenomenon has spread like wildfire over the last five years. The true scale of Shadow Banking is not known. However, at one extreme it could bring down the Chinese Financial system and the economy. At the best, tackling it would seriously challenge the Chinese economy and slow it down considerably. On the other hand the steady discourse of 7-8% growth by the normally proactive Chinese leadership indicates that it is not considering the 4% growth rate projections to be a serious possibility. Once earlier, China has once cleared up its banking system in 2003 to rid it off bad loans. The year after the transition from Jiang Zemin-Zhu Rongji to Hu-Wen leadership. And now we have similar problems arising once again when the Hu-Wen leadership has been followed by the Xi-Li leadership. This raises the interesting thought that during its last years in office each generation of Chinese leaders tends to overspend in order to squeeze out every bit of growth out of the system. This is probably done to leave behind a legacy of exceptional economic leadership. But the problems which this loose credit policy creates have to be resolved by the next set of leaders during their initial years. Or to put it in another way it could reflect a desire of the new leadership to place the inherited problems upfront on the table and then to start with a fresh slate.
Related Documentation
Some of these issues especially the dangers to the Chinese economy especially the buildup of a threatening credit bubble are covered in the following articles.
1. Whatever Little Momentum China Had, It's Losing It by Kenneth Rapoza (Forbes). Click here to read.
2. China's economy stumbles in May, growth may fall in second quarter By Langi Chiang and Jonathan Standing Click here to read.
3. Is China’s Public Debt Level Sustainable? by Ryan Rutkowski (Peterson Institute of Intl Economics). Click here to read.
4. Economic Observer from China - Most Local Govt debt is becoming due next year and lending banks could bust - Click here
5. Bernanke signals end of Cheap Money - world in fear - Click here ;
6. The Economist - Chinese Credit is analysed. It say's that Chinese companies are taking credit for Nothing - no performance. Click here ;
7. NYT - Diminishing Job prospects in a slowing Chinese economy. Click here ;
8. Mamta Badkar of BusinessInsider - Fitch warns that China's Credit Bubble is unprecedented. Click here; The Telegraph says the same thing here ; Also here about the Credit Squeeze in China ;
9. On the other hand surprising news is pouring in (NYT) that the US economy is in for a huge rebound. In the short run (2013) it stays low but steady (1.5%). But 2014 is expected to see dramatic change (3 to 3.5%) and 2015 to 2018 could see growth in the range of 3.5 - 4%. This is expected due to huge Shale Gas reserves resulting in Cheap Energy and the attainment of marketization of a new cycle of technologies especially artificial intelligence. This is astonishing as most prominent US economists have been quite pessimistic about the middle term prospects of the US economy. Click here ;
10. Euromoney - Credit Fears grow in China. Click here ;
11. Gordon Chang here persisting with his extreme views as always in Forbes. Click here ;
12. Regarding the painful nature of transition to a Consumption led system for China. Prof Michael Pettis at Peking University is very pessimistic. Click here to read.
5. Bernanke signals end of Cheap Money - world in fear - Click here ;
6. The Economist - Chinese Credit is analysed. It say's that Chinese companies are taking credit for Nothing - no performance. Click here ;
7. NYT - Diminishing Job prospects in a slowing Chinese economy. Click here ;
8. Mamta Badkar of BusinessInsider - Fitch warns that China's Credit Bubble is unprecedented. Click here; The Telegraph says the same thing here ; Also here about the Credit Squeeze in China ;
9. On the other hand surprising news is pouring in (NYT) that the US economy is in for a huge rebound. In the short run (2013) it stays low but steady (1.5%). But 2014 is expected to see dramatic change (3 to 3.5%) and 2015 to 2018 could see growth in the range of 3.5 - 4%. This is expected due to huge Shale Gas reserves resulting in Cheap Energy and the attainment of marketization of a new cycle of technologies especially artificial intelligence. This is astonishing as most prominent US economists have been quite pessimistic about the middle term prospects of the US economy. Click here ;
10. Euromoney - Credit Fears grow in China. Click here ;
11. Gordon Chang here persisting with his extreme views as always in Forbes. Click here ;
12. Regarding the painful nature of transition to a Consumption led system for China. Prof Michael Pettis at Peking University is very pessimistic. Click here to read.
