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Satyajit Das on China's Economic Miracle of Mirage


The Chinese growth story may be ending. The ability of the country to support the seriously compromised global economic and financial system is overestimated.


China's economic structure is deeply flawed and fragile. The Chinese growth story may be ending. The ability of China to support the seriously compromised global economic and financial system is overestimated.

Good Times, Desperate Times

In the first phase of the global financial crisis ("GFC"), China was badly hit, with growth slowing and layoffs of 20-25 million migrant workers in the export-based Guangdong province alone. In response to a large external demand shock stemming from rare synchronous recessions in the developed world, Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.

In late 2008, China announced a fiscal stimulus package of renminbi 4 trillion (about $600 billion) over two years, equal to a budget deficit around 2.2% of Gross Domestic Product ("GDP"). But the major response was via the large policy banks, which are majority government owned and controlled. The banks were directed to extend credit and finance infrastructure projects on a large scale.

New lending by Chinese banks in 2009 and 2010 was around 40% of GDP. New bank loans in 2009 and 2010 totaled around $1.1-1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50% over the past two years.

If additional credit growth over and above normal lending is taken into account, then the Chinese government's stimulus totaled around 15% of GDP, amongst the largest in the world.

According to the World Bank, almost all of China's growth since 2008 has come from "government influenced expenditure." In fact, the Chinese growth story since 2008 is reminiscent of the debt-fueled US economy after the recession of the 2001/2002.

The unsound foundations of Chinese economic and financial strength have been largely ignored. But then all food tastes good to the starving man.

The Short of It

In the short run, China's use of rapid growth in credit to restart growth will result in a rise in bad debt problems for the banking sector.

The volume of credit outstanding increased to 130-140% of GDP and as much as 160-170% when off-balance-sheet lending is included. In the 1990s, a similar increase in the growth of lending resulted in sharp increase in bad debts. The biggest state-owned Chinese banks required government bailouts that cost around 40% of GDP, only ending in 2004.

Increased lending created asset bubbles in property and shares (both now unwinding). It is doubtful whether the cash flows from the investments will be sufficient to cover all the debt, increasing non-performing loans in the banking system. Governor of the central bank People's Bank of China ("PBOC"), Zhou Xiaochuan observed candidly that the large credit flows "pose bank lending quality risks." As much as 25% of new loans may not be repaid.

With characteristic hyperbole and an eye for a media headline, James Chanos, a hedge-fund investor argues that China is "Dubai times 1,000 or worse." But predictions of a financial and banking collapse are overstated. Property loans are conservatively structured and also the government has a variety of policy tools to manage problems.

Predictably, in February 2012, the Chinese government instructed it banks to roll over $1.7 trillion of loans to local governments, to avoid the risk of default. It was tacit recognition that the loans were at risk and may not be able to be repaid on schedule. There was lip service to the fact that Chinese banking regulators would check to ensure that the loans were capable of being repaid. Having already borrowed from the playbook of Western governments to resuscitate the Chinese economy from the GFC, Beijing now adopted "extend and pretend" strategies, deferring the day of reckoning on the loans.

As China analysts, such as Michael Pettis, a professor of finance at Guanghua School of Management at Peking University, have observed, the bad debts will absorb significant financial resources and restrict domestic consumption.

The government will recapitalize the banking system by lowering deposit costs and ensuring a wide spread between their borrowing and lending rates. Just like the Japanese after the collapse of the bubble, Chinese householders will be forced to pay for the restitutions of their insolvent banks. Savers will pay a disguised tax – low deposit interest rates and high borrowing rates. In effect, the bailout will entail a large transfer of wealth and income from households to other parts of the economy, amounting to several percentage points of GDP.

This will reduce wealth but also slow consumption growth at a time when external demand for Chinese products and Chinese trade surpluses is decreasing.

The Long of It

The long-term effects of this debt-fund investment boom are more complex. Revenues from many projects will be insufficient to cover the borrowing or generate adequate financial returns.

The efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio ("ICOR"), calculated as annual investment divided by the annual increase in GDP. China's ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University's Dwight Perkins of Harvard argues that China's ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. It now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago, well above the $4-5 debt needed to create $1 of GDP just before the GFC in the US.

Sinophiles dismiss the lack of efficiency arguing that the decline was because of falls in the growth rate due to the collapse of global demand. Sinophiles also argue that the investment in infrastructure will produce long-term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made financial return with many going bankrupt.

The real issue is whether the specific projects are appropriate. High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low. While trophy projects are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety, and more flexible pricing structures may yield higher economic benefits.

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