Contrary to some recent research reports cited in the press I do not think we have seen any substantial rebalancing of the economy towards consumption in 2011. This is largely an argument being made by economists who did not see why Chinese consumption repression was all along at the heart of the growth model. These economists are now too quick, I think, to hail evidence of a surge in consumption, but I find the evidence very weak and more importantly I am convinced that there cannot be a sustainable surge in consumption as long as the investment-driven growth model is maintained and as long as debt continues to rise unsustainably.
And as for debt, it is still rising quickly. As regular readers know I have always argued that the rise in Chinese debt, as bad as it is, was not going to lead to a banking collapse or any other sort of financial collapse because of the way local and specific debt problems would be “resolved”. Debt would simply be rolled onto the government balance sheet.
Last Monday I was in Hong Kong visiting a few clients, and during my visit to Hong Kong the Financial Times gave me a nice gift – an opportunity to center my discussions – with this article:
China has instructed its banks to embark on a mammoth roll-over of loans to local governments, delaying the country’s reckoning with debts that have clouded its economic prospects. China’s stimulus response to the global financial crisis saddled its provinces and cities with Rmb10.7tn ($1.7tn) in debts – about a quarter of the country’s output – and more than half those loans are scheduled to come due over the next three years.
Since the principal on many of the loans is not repayable, banks have started extending maturities for local governments to avoid a wave of defaults, bankers and analysts familiar with the matter told the Financial Times. One person briefed on the plan said in some cases the maturities would be extended by as much as four years.
We are going to see a lot of stories like this. There is a growing amount of unrepayable debt in China and ultimately most if not all of it will end up on the government’s balance sheet. On that note I disagree with something Simon Rabinovich, in another article published in the FT on the same day, said on the topic:
China’s debt woes are very different from those of Europe or, for that matter, the US. In developed countries, the concern is the sheer amount of debt they have accumulated. The Chinese problem is less one of quantity and more one of structure: rather than issuing bonds, local governments have used opaque bank loans for funding.
“The problem is rooted in the national fiscal system,” said Huang Haizhou, chief strategist at China International Capital Corp, the country’s leading investment bank. “If a successful fiscal reform is implemented over the next three to five years by the new government, the problem will only be a temporary shock.”
Borrowing your way out of debt
This is almost certainly incorrect. The problem in China is as much the amount of debt as the structure – and by structure I don’t mean the distinction between bonds and loans (bonds end up mainly on the banks’ balance sheets anyway) but rather the unstable and self-reinforcing relationship between underlying conditions and debt servicing costs. The fact that much of the debt is being accumulated in an opaque fashion only explains why so many people did not see this coming, but it is not the fundamental problem.
As for the claim that successful fiscal reform can keep the impact limited, I am not sure what this means. Fiscal reform in China can only be successful, in this context, if it eliminates loss-making investment activities, and unfortunately I see it doing nothing of the sort. If the problem is that China is keeping growth high only or mainly by borrowing and misallocating the proceeds, then hidden losses are rising and one way or another the bad debt must be resolved. The only two ways to resolve the bad debt are by defaulting or by forcing someone else to make up the loss, and the former almost certainly won’t happen to any great extent.
That leaves the latter. The structure of the debt as this article defines it – transparent bonds versus opaque loan – is I think almost irrelevant. For example the article goes on to propose one solution:
“Five or ten years from now, local governments will borrow very, very little from banks. Their debt structure will be almost entirely bonds,” said Fan Jianping, chief economist of the State Information Centre.
There seems to be an almost touching faith in cosmetics here. If banks make foolish loans, stop calling them loans and start calling them bonds and the problem is immediately resolved – we’ll have no more bad loans.
True, we won’t, but we’ll have bad bonds, probably still on the bank balance sheets, and we’ll still be left with the problem of how to pay for them. Since household income is probably much too low to support another massive transfer to subsidize debt forgiveness, as happened after the last banking crisis of a decade of ago, the next debt crisis will have to be subsidized by government transfers.
But if households don’t clean up the next banking mess, how will it be resolved? My guess is that it will be resolved in the same way local government debt is being resolved – it will simply be directly or indirectly passed on to the government. And given the constraints that limit Beijing’s ability to push the household share of GDP down much further, Beijing, as I have argued before, basically has two ways to resolve another surge in bad debt.
Both involve transfers of assets from the government, but each has very, very different long-term implications. One way to resolve the bad debt is to privatize assets and use the proceeds to clean up the banks. The other way is to have the government absorb the debt. If debt rises faster than debt servicing capacity, there will have been a real transfer of assets from the government to the borrowers.
Which will Beijing choose? An article in Reuters this week reminds us of the consequence of the second way, which unfortunately way has the great advantage of being politically easier than the alternative. The article is about Japan and here is what it says:
Capital flight, soaring borrowing costs, tanking currency and stocks and a central bank forced to pump vast amounts of cash into local banks — that is what Japan may have to contend with if it fails to tackle its snowballing debt. Not long ago such doomsday scenarios would be dismissed in Tokyo as fantasies of ill-informed foreigners sitting on loss-making bets “shorting Japan.”
Today this is what is on bureaucrats’ minds in Japan’s centre of political and economic power. “It’s scary when you think what could happen if there’s triple-selling of bonds, stocks and the yen. The chance of this happening is bigger than markets think,” says a senior official. Leaning back in a leather sofa in his office, the official appears relaxed, but the way he wastes no time answering questions about a debt meltdown, suggests it is an all too familiar topic.
The official, like many others interviewed by Reuters, declined to be named because of the sensitivity of the subject and his alarm over Japan’s $10 trillion-plus debt overhang has yet to be reflected in public debate or action. But these officials would be the ones pulling the levers in the command center if Japan were to be hit by a debt crisis. The government borrows more than it raises in taxes, and its debt pile amounts to two years’ worth of Japan’s economic output, the highest debt-to-GDP ratio in the world.
This what I worry about most for China as it decides its adjustment process. Beijing could easily choose to absorb debt rather than pay it down through asset sales, and as debt rises it will be all the harder to raise interest rates. It will ultimately also create what is potentially a destabilizing debt overhang, although as Japan showed, it can take many years before the debt itself becomes unsustainable.
That is why although I don’t think it is a certainty, I am expecting that the most likely economic outcome for China for the rest of this decade is a combination of much slower growth and rapidly rising government debt. Privatizing assets and using the proceeds to shore up household wealth, directly or indirectly, is politically tough to do.
But that doesn’t mean it can’t happen. On Thursday the Wall Street Journal published a very interesting article on what is supposed to be an upcoming World Bank report – to be published this Monday. According to the article the report is already controversial but may gain traction within Beijing:
How much the report will help reshape the Chinese economy is unclear. Even ahead of its release, it has generated fierce resistance from bureaucrats who manage state enterprises, according to several individuals involved in the discussions. China’s political heir apparent, Xi Jinping, now vice president, has given few clues about his economic policies. Analysts expect the high-profile report will encourage Mr. Xi and his allies to discuss making changes to a state-led economic model that has alarmed Chinese private entrepreneurs while creating tension between China and its main trading partners, including the U.S.
The report’s authors argue that having the imprimatur of the World Bank and the Development Research Center, or DRC—a think tank that reports to China’s top executive body, the State Council—will add political heft to the proposals. The World Bank is widely admired in Chinese government circles, particularly for its advice in helping China design early market reforms.
They are also counting on the clout of the No. 2 official at the DRC, Liu He, who is also a senior adviser to the all-powerful Politburo Standing Committee, to help ensure that its findings are considered seriously by top leaders. Mr. Liu declined to comment.
Restructuring state involvement
The World Bank report will apparently warn that China is facing a very difficult economic transition:
An exclusive preview of an economic report on China, prepared by the World Bank and government insiders considered to have the ear of the nation’s leaders, offers a surprising prescription: China could face an economic crisis unless it implements deep reforms, including scaling back its vast state-owned enterprises and making them operate more like commercial firms.
“China 2030,” a report set to be released Monday by the bank and a Chinese government think tank, addresses some of China’s most politically sensitive economic issues, according to a half-dozen individuals involved in preparing and reviewing it.
It is unquestionably a good thing, in my opinion, that Beijing is made aware of how difficult, and urgent, the transition is likely to be, but it is also a little disheartening that it has taken so long to warn about what should have been deeply worrying us five or six years ago. China’s growth model was clearly unsustainable even back then, and was just as clearly heading to a debt crisis, and the longer it took to address the problems the more severe they were likely to get.
According to the WSJ:
The report warns that China’s growth is in danger of decelerating rapidly and without much warning. That is what has occurred with other highflying developing countries, such as Brazil and Mexico, once they reached a certain income level, a phenomenon that economists call the “middle-income trap.” A sharp slowdown could deepen problems in the Chinese banking sector and elsewhere, the report warns, and could prompt a crisis, according to those involved with the project.
It recommends that state-owned firms be overseen by asset-management firms, say those involved in the report. It also urges China to overhaul local government finances and promote competition and entrepreneurship.
…The World Bank and DRC argue that asset-management firms should oversee the state-owned companies, say those involved in the report. The asset managers would try to ensure that the firms are run along commercial lines, not for political purposes. They would sell off businesses that are judged extraneous, making it easier for privately owned firms to compete in areas that are spun off.
“China needs to restrict the roles of the state-owned enterprises, break up monopolies, diversify ownership and lower entry barriers to private firms,” said Mr. Zoellick in a talk to economists in Chicago last month.
Currently, many state-owned firms have real-estate subsidiaries, which tend to bid up prices for land, and have helped to create a housing bubble that the Chinese government is trying to deflate. The report also recommends a sharp increase in the dividends that state companies pay to their owner—the government. That would boost government revenue and pay for new social programs, said those involved with the report.
This is good as far as it goes, but it doesn’t go far enough. Of course increasing SOE dividends to the government for use in social programs will transfer wealth from the state sector to the household sector, but if the total profitability of the SOE sector is less than one-fifth to one-eighth of the direct and indirect subsidies transferred from the household sector, as I have argued many times, then even 100% dividends is not enough to slow the transfer significantly, and remember the transfers have to be reversed, not merely slowed. This proposal falls in the better-than-nothing category, but just.
What we really need are much more dramatic transfers, for example wholesale selling of assets, with the money used either to clean up bad loans or delivered directly to households. According to the article, however, “neither the World Bank nor the DRC proposed privatizing the state-owned firms, figuring that was politically unacceptable.”
This is the problem. The best solution for China, economically, seems to be off limits because it will be politically difficult. In that case the second best solution, a gradual build-up of government debt as growth slows for many years, is the most likely outcome.
And how much will growth slow? The World Bank report apparently doesn’t say, but the consensus has been slowly moving down towards 5-6% annual growth over the next few years. That’s better than the crazy numbers of 8-9% most analysts were predicting even two years ago (and some still are), but it is still too high. GDP growth rates will slow a lot more than that. I still maintain that average growth in this decade will barely break 3%. It will take, however, at least another two or three years before a number this low falls within the consensus range.
And by the way when it does, metal prices should fall sharply. Copper prices have done reasonably well in the past few months as Chinese buyers have restocked, as we suggested might happen to our clients last fall. With the recent easing we may see more strength in copper over the next month or so, but I have little doubt that within two or three years copper prices are going to be a whole lot lower than they are today. Chinese investment demand simply cannot hold up much longer.
Before ending I wanted to make one last, and totally unrelated, comment. There was a Financial Times podcast last Thursday in which David Bloom, global head of FX strategy at HSBC, worried that if the euro keeps strengthening, it will end up “harming the region’s competitiveness.” He is right of course that if the euro strengthens, this can hurt the region’s competitiveness and so slow growth, but if this is a problem, why are European government’s still asking China and the other BRICs to contribute to their bailout? Don’t they realize yet that importing foreign capital means strengthening the euro and exporting domestic growth? The more money they take from abroad, the harder it will be to pay back any of the debt.