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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.


China's investment boom may also be exacerbating industrial overcapacity. The greater portion of investment has been in infrastructure, rather than manufacturing. But demand from projects has increased production capacity for basic raw materials, both within China and overseas suppliers of raw materials, such as Australia, South Africa and Canada.

A 2009 report prepared for the European Chamber of Commerce outlines the over-capacity. In its analysis of six major sectors, the report identified the following capacity utilization rates: steel 72%; aluminum 67%; cement 78%; chemicals 80%; refining 85%; and, wind power 70%.

In 2008, China's steel capacity was 660 million tons against demand of 470 million tons but the difference is similar to the European Union's total steel output or the combined output of Japan and Korea. China's excess in cement is larger than the total consumption of the US, Japan, and India. Yet China continues to add capacity.

If China is unable to absorb this new capacity domestically, then it might seek to increase exports in order to maintain production and growth, increasing a global supply glut.

To the extent that Chinese growth is driven by such spending on unproductive investments, it is both wasteful and ultimately economically destructive.

"Botox Economics"

China's recovery from the initial effects of the GFC was no miracle. Like the rest of the world, it was the result of "Botox economics." Taking advantage of a centrally controlled, command economy, Beijing boosted output through government spending and directed bank lending to maintain growth.

Unfortunately, China now faces significant problems. The weakness of its two major trading partners (US and Europe) means export demand is likely to remain subdued. Domestically, the side effects of debt driven investment are now emerging.

China's ability to sustain high growth levels is questionable. Specifically, its capacity for further stimulus is uncertain. The ability to adjust the economy to the new economic environment poses unprecedented challenges in rebalancing consumption and investment within China. Slowing growth also poses social and political challenges. In 2009, Premier Wen Jiabao admitted that the "stabilization and recovery of the Chinese economy are not yet steady, solid and balanced."

Lack of Stimulation

The conventional view is China will be able to continue to stimulate demand using its large foreign exchange reserves, large domestic savings and low levels of debt.

China's $3.2 trillion in foreign exchange reserves are invested in predominately in US dollars, Euro and Yen, primarily in the form of government bonds and other high quality securities. These assets have lost value, through increasing default risk (as the issuer's ratings are downgraded) and falls in the value of the foreign currency against the Renminbi.

Attempts by the Chinese to liquidate reserve assets would result in sharp falls in the value of the securities and a rise in the Renminbi against the relevant currencies with large losses. The reserves also force China to buy more US dollar, Euro and yen securities to defend the value of the existing portfolio, increasing both the size of the problem and risks.

In reality, China will ultimately have to write-off these reserves, recognising its losses. It can do so of its own volition or have the value of its investment reduced over time through falls in the value of the currency in which the security is denominated. This equates to a real loss of wealth as China has issued Renminbi or government bonds against the value of these investments.

Hidden Debts

China also has far greater levels of debt than commonly acknowledged, although the bulk is held domestically. The central government has a low level of debt – around $1 trillion (17% of GDP). In addition, state owned and supported entities have debt totaling $2.6 trillion (42%); local governments about $1.2 trillion (19%), policy banks $800 billion (13%); Ministry of Railways $280 billion (5%), and government-backed asset managements companies set up to hold non-performing bank loans $300 billion (5%). The total debt, around $3.6 trillion, is 59% of GDP.

China's real debt level may be even higher. Victor Shih, an academic at Northwestern University of the US, calculated that local government debt may be $1.7 trillion or higher based on analysis of local government documents and ratings agency filings. In addition, local governments have secured further lending commitments that have not been drawn down. The analysis does not take into account significant off balance sheet and unofficial lending activity.

The debt levels are exacerbated by what Michael Pettis in his book The Volatility Machine describes as an inverted debt structure – where borrowing levels increase when the economy has problems. Irrespective of current moderate debt levels, when the economy slows China's debt levels, both direct and contingent, will increase rapidly.


China also has limited flexibility in managing its currency. The renminbi has risen 30% since Beijing adopted a policy of managed appreciation and revalued its dollar peg in July 2005.

As growth and exports slow (the trade surplus has fallen to 2% and foreign exchange reserves are falling), China needs to let the renminbi fall to cushion the adjustment. But developed countries are all seeking to increase their share of limited global growth by lowering the value of the currency.

While economists disagree about the correct valuation of the renminbi, developed nations, led by the US, argue that it is "substantially undervalued." An increase in the remminbi, they argue, would increase consumers' purchasing power, discourage excessive investment and reduce the trade deficit further. In an US election year, the risk of trade protectionism and the prospect of being referred to the World Trade Organization for currency manipulation limit China's policy flexibility.

The End of the Meal

The country's strong growth, increasing importance, and foreign praise has led to hubris. The July 30, 2009 editorial in the English language People's Daily, an official publication, boasted that China, under the leadership of the Chinese Communist Party ("CCP"), had coped successfully with the financial crisis, earning worldwide attention: "High-level figures from the Western political and economic spheres ... envy China's superb performance ... as well as 'China's spirit'– the kind of solid, unbreakable 'Great Wall' at heart to ward off the financial crisis."

The reality is that since 2007/ 2008, a part of China's growth has been an illusion. Since 2008, China's headline growth of 8-10% has been driven by new lending averaging around 30-40% of GDP. Given that (up to) 20-25% of these loans may prove to be non-performing, amounting to losses of 6-10% of GDP. If these losses are deducted, Chinese growth is much lower.

The China economic debate is focused on the alternatives of a soft or hard landing. Both scenarios assume a slowdown in growth and transition to a troubled maturity.

The case for the soft landing assumes that the investment and property bubbles are less serious than thought. Beijing has sufficient financial capacity to boost growth by loosening monetary policy and bank lending, while adjusting specific policies, such as lifting restrictions on housing sales to prop up prices. China is able to boost domestic consumption, replacing investment as the key driver of its economy. Excess capacity is gradually absorbed as the world economy recovers.

Growth comes down gradually, without causing social and political disruptions.

The case for the hard landing assumes the rapid and destructive unwinding of asset price bubbles and problems within the Chinese banking system. A poor external environment and losses on foreign investment exacerbate the problem. Growth collapses triggering massive social unrest and political tensions.

The end of a cycle of debt and investment-driven growth is typically disruptive. Japan's experience, which China has drawn on in shaping its economic model, is salutary. Japan grew by 10% in the 1960s, 5% in the 1970s, 4% in the 1980s, and has remained stagnant since, adjusting to the deflation of its debt fuelled bubble.

As an old Chinese proverb, probably apocryphal, holds: "There is no feast that does not come to an end."

No positions in stocks mentioned.

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