CHINA, GROWTH, DEBT, STABILITY AND THE GLOBAL ECONOMY

GROWTH AND SOCIAL STABILITY IN CHINA

Maintaining high growth is one of the Chinese Communist party’s main political goals. It wants to raise living standards and absorb the migration of rural immigrants to the cities by using growth to generate jobs. In this way growth, prosperity and economic might are viewed as a way to promote domestic stability.

In a speech in March 2010, Premier Wen Jibao said, “the biggest problem with China’s economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable.” Many economists feel that anything less than 8 percent growth is like a recession in China because of the need to create jobs and support the growing labor market. Eight percent growth is regarded as the minimum for maintaining social stability.

Growth has to produce 24 million jobs a year to sustain the pace of migration. Before the economic downturns in the 2008 that appeared implausible. After that it seemed impossible.

The Chinese economy has been able to expand rapidly and post extraordinary high growth figures while boasting huge trade surpluses, Ths has been made possible by the high volume of exports, the use of Chinese labor by foreign companies and the large amount of direct foreign investment into China.

High growth also has allowed workers to receive double digit pay increases each year and attracts foreign investment, which in turn brings modern technology and management skills.

In an effort to increase consumption and spending in the countryside China has built supermarkets and even malls in what would regarded as the boonies to get farmers and rural workers to spend their money and generate local economic activity.

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Maintaining Growth in China and Problems Associated With it

Experts warn China's growth has become too reliant on investment. "If you look at infrastructure projects, it is very clear that the banks have looked at them as risk-free lending because they're guaranteed by the government," said Patrick Chovanec, associate professor at Beijing's Tsinghua University. "It does create growth but it also creates big problems down the road in terms of bad debt." [Source: Boris Cambreleng, AFP, July 23, 2011]

The old game has started collapsing, says Xu Xiaonian, a professor of economics at the China Europe International Business School in Shanghai, referring to China’s inefficient export-oriented economic model, which can be prone to overheat. We are now in a transition period. We need to find new ways to do things. Many economists feel that China may be reaching the “Lewisian turning point” named after the late Nobel-Prize-winning economist Arthur Lewis who described how developing countries eventually exhaust their pool of cheap labor and have to evolve into a more developed economy.

Michael Spence, a professor emeritus at Stanford Universit and the winner of Nobel Prize for economics in 2001, told Global Viewpoint, China “is capable of sustained growth if it can properly manage structural change in several dimensions. First, China is going through a “middle-income transition” in parts of the country as earlier “growth drivers” in the export sector, notably low-wage manufacturing along the coast, die off and must be replaced with other drivers such as services. The domestic consumer will have to become more important so there is a better match between the productive potential of the economy and domestic demand.” [Source: Christian Science Monitor, August 23, 2010]

“Second, China is going to have to get quite a bit more income into the hands of the household sector in order to drive growth from within the domestic market. That means getting away from the very high levels of investment in the corporate and public sector where the marginal return on investment is declining. Disposable income as a percent of GDP is low, and the savings rate is high, around 40 percent of GDP. Third, they have to get their current account surplus down in the global economy or they will get a bad reaction from outside, for example protectionism. If they can get the surplus down, that will help the global economy, but it will also help build domestic demand and household income.” [Ibid]

“This is a complicated set of changes to navigate, but I believe the Chinese leadership is up to it. I’ve been able to listen in and participate in some of their internal discussions, and I think they are going in the right direction. Certainly there are interests that want to block these changes. But the same qualities that have enabled China’s resilience so far---a long-term horizon, decisive policymaking, and consistent follow-through by a generally competent government---bode well for the future. Because of their long time horizon there is a high level of understanding by the leadership that the economy has to evolve. Looking out at where they want China to be in 10 or 20 years, they know that an advanced economy cannot be based, as China is today, on labor-intensive process manufacturing for export. They have seen how South Korea has managed the middle-income transition. I’m sure they are intensively studying that experience.” [Ibid]

Slowing Growth in China

According to the I.M.F. that despite the nation’s spectacular growth, the quality of that growth had become increasingly inefficient. It now takes about $5 worth of investment to create $1 of gross domestic product---about 40 percent more than it takes in Japan or South Korea, an IMF report said. [Source: New York Times]

Researchers expect China's rapid growth to slow from 9 percent a year to about 5 to 6 percent by 2015. Vikram Nehru, a former World Bank chief economist for East Asia, told AP: "In the next 20 years, even with reforms, China's growth is expected to slow," Nehru said. "But managing the smooth slowdown to a sustainable path in the medium-term will be challenging, and a key risk could be if growth suddenly slows."

On the belief that China’s rapid economic growth shows no signs of slowing, Minxin Pei wrote in the Washington Post:. The pace of growth is already cooling somewhat---from above 10.3 percent in 2010 to 9.2 percent last year---and the downward shift will accelerate in future years.[Source: Minxin Pei, Washington Post, January 26, 2011;Minxin Pei, director of the Keck Center for International and Strategic Studies at Claremont McKenna College, is the author of “China’s Trapped Transition: The Limits of Developmental Autocracy.”]

Like South Korea and Taiwan, which achieved stellar growth for three decades but have slowed gradually since the 1990s, the Chinese economy will encounter strong headwinds. The population is aging; citizens 60 and older accounted for 12.5 percent of the population in 2010 and are projected to reach 17 percent in 2020. This will reduce savings and the supply of workers, and raise the costs of pensions and health care. If China wants to keep its high growth rate, it must graduate to making Chinese-designed high-tech and high-value-added products. It will need more innovation, which demands less government control and more intellectual freedom.

Most critically, the investment-driven and state-led economic model responsible for China’s rapid growth must give way to a more efficient, consumption-driven, market-oriented model. Such a shift will not be possible without downsizing the state and making the party accountable to the Chinese people.

Bad Debts and Bad Loans in China

In June 2011, Credit Suisse said data recently released by the Chinese central bank showed that credit in China had expanded at “alarming levels,” far more than previous government estimates suggested. Credit Suisse downgraded its profit forecasts for Chinese companies and state-owned banks, as it warned of slowing growth for the overall economy. [Source: David Barboza, New York Times June 20, 2011] Credit Suisse’s new figures also indicate that off-balance-sheet lending, much of which took place outside the banking system, pumped a large amount of additional credit into the financial system last year. As a result, Credit Suisse downgraded its ratings of Chinese companies and the big state-controlled banks, and warned of a possible rise in bad loans.

Although Beijing used state-run banks to bolster growth after the financial crisis hit in late 2008, the central government is ordering them to help rein in growth. Wang Tao, the chief economist in China at UBS, warned that over the next few years, loans to local government investment companies could result in as much as $460 billion in nonperforming loans.

Asked whether nonperforming loans---or N.P.L.’s---are set to rise, Vincent Chan, the head of China research at Credit Suisse, told the New York Times: “A rise in N.P.L.’s is a must. The question is, how much will they rise?”

In July 2011, global ratings agency Moody's said: "The potential scale of the problem loans at Chinese banks may be closer to its stress case than its base case." In view of that, the non-performing loan ratio for Chinese banks could be as high as 8-12 percent, compared with 5-8 percent in the base case and 10-18 percent in the stress case. Unless China comes up with a "clear master plan" to clean up its pile of local government debt, the credit outlook for Chinese banks could turn negative, the ratings agency said.

Chinese Debt

Different Chinese authorities including the state auditor, the bank regulator and the central bank assess China’s debt. All three agencies have used different definitions and accounting methods to review the debt, resulting in a hodgepodge of official forecasts.

China's state auditor said in June 2011 that local governments held a massive 10.7 trillion yuan ($1.65 trillion) in debt at the end of 2010, warning there was a risk some might default. [Source: Boris Cambreleng, AFP, July 23, 2011]

Many investors have long eyed China's mountain of local government debt as a major risk. The worry is that slower growth in the world's second-biggest economy could set off a wave of loan defaults and hobble its banking system. About half of the debt dates back to the 2008 financial crisis when Beijing unveiled a 4 trillion yuan fiscal stimulus package that compelled local authorities to spend their way back to economic health. But the legacy of the massive spending is now catching up with China as maturity dates for the loans, many of which are due in 2013, draw closer. [Source: Reuters, July 5, 2011]

In July 2011, global ratings agency Moody's said authorities may have understated that debt burden by as much as $541.6 billion (3.5 trillion yuan), adding the proportion of bad loans could be higher than previously forecast. Moody's said it derived the additional 3.5 trillion yuan of debt after comparing the estimates of China's state auditor with that of the bank regulator's. The ratings agency said the Chinese state auditor likely omitted the 3.5 trillion yuan of debt from its assessment because they were not considered as real claims on local governments. "This indicates that these loans are most likely poorly documented and may pose the greatest risk of delinquency," said Yvonne Zhang, a Moody's analyst.

Unless China comes up with a "clear master plan" to clean up the problem, the credit outlook for Chinese banks could turn negative, Moody's said. Moody's outlined three scenarios for resolving the debt problem. Most likely, Beijing would work on a case-by-case basis, helping local governments to get funding. China may ask banks to absorb losses on loans for which local governments are not liable. Moody's said this scenario would probably involve a fair amount of debt restructuring by banks.

Moody's said it expects Beijing to "implement gradual discipline" over the stock of government debt, and that would involve the Chinese government leaving banks to manage a part of the problem loans on their own. In the worst-case scenario, Beijing would leave banks and local governments to thrash out the issue on their own. This could hurt investor confidence in China as there would be no clarity around China's debt problems and loan disputes could drag on, thereby worsening losses. The best case would involve Beijing stepping in to supply local governments with funding or take on some of their debt, although Moody's acknowledged that this would raise "moral hazard" issues of banks assuming excessive risk knowing the government would always come to their rescue.

Wen Jiabao: Government Debt Risk "Controllable"

In January 2012, Reuters reported: “China's Premier Wen Jiabao said the nation's government debt is at an "overall safe and controllable" level, that funding for key projects would be ensured and that applying the brakes to the problem would be done in a way to avoid systemic risks. Investors have been worried by the scale of the debts built up by China's local governments, which some fear could threaten the stability of the banking system. Wen's comments, reported in the official People's Daily, were made in a speech at the government's flagship financial work conference. [Source: Aileen Wang and Chris Buckley, Reuters, January 29, 2011]

Wen pledged to contain and defuse local government debt risks and avoid the spread of financial risks. "Currently, our government debt is overall safe and controllable," he said. "We are taking the issue of managing local government debt very seriously. Through clean-ups and regulation, the trend of expanding investment vehicles has been effectively contained."

China's state audit office said earlier this month it had uncovered 530 billion yuan ($84 billion) worth of irregularities involving local government debt. But the figure is a fraction of the 2 trillion-3 trillion yuan of sour loans economists believe are buried in the 10.7 trillion yuan of debt local governments had at the end of 2010.

Wen said China "must both actively and appropriately ease financial and fiscal risks, and also ensure the funding needs of key construction projects approved by the government." But he warned against a simplistic approach to local government investment. "We cannot simplistically hit the brakes and use a one-size-fits-all approach, and must avoid turning localized risks into comprehensive, systemic risks," he said.

Wen also urged greater attention and controls on systemically important financial institutions. "We must study standards for determination and a framework for assessing our country's systemically important financial institutions, and we must adopt more stringent oversight standards towards these institutions, enhancing external constraints on them," he said.

Wen also vowed to "break monopolies" against private capital participation in the financial sector, promising broad reforms to ownership and capital structures in banking, equities, insurance and other financial institutions that would encourage more private capital to flow into the financial services sector. "Improving financial services for small businesses requires the reform, innovation and regulated development of financial institutions that come in different types and different sizes," he said, making clear there was a role for private credit in the economy, providing it was properly regulated.

In addition, Wen made the case for more market-based reforms to interest rates and credit pricing to enhance their roles, along with exchange rates, as price levers.Wen said China should "accelerate nurturing of a market system for benchmark interest rates, guide financial institutions towards enhancing their risk price-setting capacities, and steadily advance marketizing reform of interest rates." And he repeated the long-standing commitment to "further improve the renminbi exchange rate formation mechanism, strengthen the flexibility of the renminbi exchange rate in both directions, maintaining a basically stable renminbi exchange rate at a reasonable and balanced level."

BRICS

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China is one of the BRIC nations. BRIC stands for Brazil, Russia, India, China. The term was coined by Goldman Sachs economists in 2003 to describe a new category of emerging market powerhouses that were regarded as good places to invest money because they had stable political leadership and relative international stability.

The four BRIC nations embrace nearly half the world’s population, 20 percent of its land area and are rich in natural resources. It is estimated that the BRIC nations will produce 60 percent of the world’s growth between 2010 and 2014. Some want to South Africa to be included as a member.

In 2000, the BRICs accounted for 16 percent of the local GDP. In 2009 that number rose to 22 percent and is expected to keep getting bigger. There is a key difference between the four nations. Russia and Brazil rely chiefly on commodities export to spur their economies while China and India rely more on trade and are large consumers of commodities rather than producers of them.

In July 2009, the leaders of the four countries held their first meeting, in Yekaterinbrug, Russia, in part to work together and increase their leverage. During their second summit meeting in Brasilia in April 2010 the BRICs discussed ways they could start using local currency for trades instead of relying on the American dollar. In 2011 the BRICs talked about coordination and handling of commodity price fluctuations. In a blow to the dollar they have worked out ways to settle accounts using their own currencies.

China and India and Economics

For much of world history up until around 1800 or so, China and India made up half the world’s economy and many see that situation returning in the 21st century as the influence of the United States and Europe decline and China and India rise.

According to the Economist, “This is uncharted territory that should be seen in terms of decades, not years...Countries as huge and complicated as China can underachieve or collapse under its own contradictions...Caveats abound...As recently as the early 1900s, India was rich, in terms of national income per head. China then hurtled so far ahead that it seemed India would never catch up. But India’s long-term prospects now look stronger. While China is about to see its working age population shrink, India is enjoying a bulge in manpower which brought sustained booms elsewhere in Asia. It is no longer inconceivable that its growth could outpace China’s for a considerable time.”

China Can Soften Impact of Global Economic Woes, IMF Says

China has the scope to shield its economy from global risks and Beijing’s response would help soften the impact if Europe's debt woes and faltering U.S. growth escalated into a global crisis, a senior International Monetary Fund official said according to Reuters. Anoop Singh, head of the IMF's Asia and Pacific department, suggested it was also the responsibility of the world's No. 2 economy and other export-reliant economies to help rebalance the global economy by strengthening domestic sources of growth. He said China "has the scope to respond" should downside risks to the global economy materialise. "What's important to notice is that even China's response would only offset a part of the shock. It could not offset the entire shock.” [Source: Rie Ishiguro, Reuters, October 13 2011]

"China would be more affected by trade than financial channels. That is clear. That is because China has been highly depending on external demand," Singh said. "What it underscores.. is that the time has come for China and other countries of Asia that rely on exports to accelerate steps to build domestic engines of growth."

The IMF report also highlighted the threat of capital outflows from the region, saying foreign investors from advanced economies could reverse the large positions they have built in Asian markets since 2009."The sell-off in Asian financial markets in August and September 2011 underscores that an escalation of euro area financial turbulence and a renewed slowdown in the United States could have severe macroeconomic and financial spillovers to Asia," it said. Singh said though, that over time capital was likely to flow back to Asia attracted by the region's high economic growth.

The IMF report said heightened economic risks amid persistent overheating pressures confront Asian policymakers with "a delicate balancing act." "They need to guard against risks to growth but also limit the adverse impact of prolonged easy financial conditions on inflation." Many of the region's countries needed to continue normalising easy macroeconomic policies to address inflation risks, both through higher interest rates and more flexible exchange rates, the IMF said.

Be Very Afraid of The China Bubble

Ken Miller wrote in Time: “The frothiness of the real estate market in major Chinese citiesmakes the U.S. housing peaks of 2007 look positively staid. Inflation is growing, as are unemployment--particularly among the middle classes, for whom,as in the U.S., there aren't enough high-level jobs--and social unrest. China'sown Premier, Wen Jiabao, calls his nation's economy "unbalanced, uncoordinated and unsustainable." [Source: Ken Miller, Time October 31, 2011

While very few economists doubt that China's growth is going to slow eventually, it's a question of how much and how soon. Will the landing be hard or soft? So far, the signs are mixed. GDP growth has moderated slowly in the past few quarters rather than falling off a cliff (though it's worth noting that Chinese economicfigures, as released by the government, are a notorious black box). Yet in many parts of the economy, the bubble continues to expand. Local-government debt grew about 30 percent in 2010 from the previous year. In the first six months of this year, Chinese investment in real estate was up 33 percent from the same period in 2010.

In order to understand the potential fallout from a China bubble, it's important to understand how the bubble began. The popular narrative is that China's rise from nowhere in 1978 to its position today has been fueled mainly by an inexpensive and massive labor force. That's part of it, but equally important have been low-cost capital and land. Most Chinese, who are huge savers, have little choice but to put their money in bank accounts that pay interest rates lower than inflation; in a country with a relatively undeveloped financial sector, there are few other options. These funds are then channeled into state-owned enterprises whose capital expenditures create the factories and skyscrapers on which the Chinese miracle has been built.

But the Chinese are pretty smart about money. They see the fortunes the elites have made by buying land at bargain prices and developing it. Ordinary individuals cannot get in on the ground floor to reap the obscene profits made by well-connected officials who broker--often by force--these purchases from the properties' historical owners, but they are permitted to invest in real estate at later stages of development. And so housing is where much of the wealth in the Middle Kingdom ends up. Anyone who's spent more than a day or two in China knows that real estate is a popular preoccupation. Apartment flipping is all the rage; real estate prices have tripled in the past five years.

The question is whether the bubble--not only in housing but in commercial property as well--is about to pop. Everywhere you go in China, you see new airports and high-speed-train lines under construction; glass-fronted apartment buildingswhose empty units loom unilluminated in the night; underutilized roads, bridges and tunnels; and entire towns waiting for occupants. One such town, Kangbashiin Inner Mongolia, has everything a city needs, including investors who have bought apartments on spec. Yet it remains largely vacant.

Why does China keep building? Because building creates jobs and wealth for those who are associated with all that development. Right after Mao Zedong came to power in 1949, the party dedicated the country to a massive social-industrial complex under direct control of the government. Many of the early government-controlled institutions were dismantled in the post-1978 DengXiaoping era, and the focus for the past 30 years has been on production and exports fueled by state capital expenditure--something the party could control. Eventually, those investments created factories that churned out made-in-Chinagoods, an infrastructure that supported the factories and a building boom that has culminated in a glut of high-rises all over the country.

The problem today is that this model, which has worked so well for over three decades, is showing signs of fatigue. Chinese factories are aging, and their counterparts across Asia are now poised to compete. Returns on investment have been declining. At the same time, wages are slowly rising, which is one reason manufacturing jobs are trickling back to the U.S., as the labor costs between the two countries narrow.

If the party's attempt to rein in the easy money flowing to state-owned enterprises results in a dramatic decline in property values, the outcome could be an earthquake in the Chinese financial system that would be felt in the U.S. In the past, loans made by state banks to big government-related businesses created a significant amount of bad debt that had to be written off. In 1998 and 2004--05, loans totaling about $500 billion were classified as nonperforming, and state officials transferred them to special investment vehicles in an attempt to create the appearance of containing the problem. But because the state, which owns the biggest banks--and thus the people's savings--ultimately pays the price of any write-off, households bear the costof the cleanup. Chinese banks are the original too-big-to-fail financial institutions.

There are rumors across the country that another big round of write-offs is imminent. The amount might be equal to or greater than the sum of the two previous write-offs. If Beijing is serious about moving its economy to a consumption model, imposing the cost of these bad loans on citizens again will be a serious impediment to its goal. Household income as a percentage of GDP has been declining in China for almost a decade, and it's hard to see what the people are going to use to buy stuff, even if wages rise, if they have to keep paying for bailouts and can't earn anything on their savings. It is one thing for the government to lower taxes on consumer goods, as it recently did, but unless itcan reverse the decline in household income as a percentage of GDP, the people won't spend.

Another problem Beijing has in moving to a new growth model is local and provincial governments' addiction to revenue from land sales. According to the Ministry of Finance, land sales totaled $500 billion in 2010, more than double the amount in the previous year. Because provincial officials are promoted on the basis of their GDP-growth figures and because land sales are an important part of local revenue, it's difficult to curb the enthusiasm of local officials for project development.

Being a Bear on China Gains Favor

David Pierson wrote in the Los Angeles Times, “Not long ago, those who predicted that China's economy was headed for a fall were in a lonely place. U.S. economist Nouriel Roubini, widely praised for calling the U.S. housing meltdown, was dismissed as a serial contrarian when it came to his pessimistic China views. So was well-known hedge fund manager Jim Chanos. Lawyer and author Gordon Chang was derided as a Chicken Little for his 2006 book "The Coming Collapse of China."[Source: David Pierson, Los Angeles Times, November 28, 2011]

Suddenly they're all Nostradamus. Backed by data showing a slowdown in the world's second-largest economy, doomsayers have taken center stage. Unbridled optimism has given way to fears over widening cracks in the Chinese economic miracle. The gloomy sentiment has spilled into financial markets, whose investors have been running for the exits. The Hang Seng China Enterprises index, which tracks the stock performance of major mainland companies listed in Hong Kong, is down 26 percent this year , making it the worst-performing market gauge in Asia.

The practice of short-selling -- betting that a stock will fall in value -- has become so pervasive among traders of Chinese equities that analysts at French banking firm Societe Generale deemed China the "world's most crowded short." For instance, nearly a third of the shares of China Overseas Land & Investment Ltd. were shorted in August and September, signaling doubts about the prospects of China's largest property developer. "There's growing sentiment that the Chinese story doesn't make sense," said Chang, who is now invited to investor conferences and remains convinced of a looming crash. Bears like Chang see slowing GDP growth, rising public debt and stubbornly high inflation as evidence China's problems are about to get bigger.

Image Sources: Posters: Landsberger Posters http://www.iisg.nl/~landsberger/; 3) bank note pictures, China Today

Text Sources: New York Times, Washington Post, Los Angeles Times, Times of London, National Geographic, The New Yorker, Time, Newsweek, Reuters, AP, Lonely Planet Guides, Compton’s Encyclopedia and various books and other publications.

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© 2008 Jeffrey Hays

Last updated April 2012

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