China waiting for a crisis: Andy Xie

Government must cut spending or wake up to a messy reckoning

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Feb. 19, 2013, 11:37 p.m. EST

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By Andy Xie

BEIJING (Caixin Online) — Bank loans and money supply rose sharply in January. The timing of the Spring Festival may have distorted the data. Still, there are signs that many local governments with new leaders want to try an old trick, pushing fixed-asset investment (FAI) to create gross domestic product and fiscal revenue. This would turn bank loans into GDP and fiscal revenue.

Local governments are already heavily in debt. Pushing FAI would keep them liquid through new loans. It is essentially a pyramid scheme and can go on as long as the banks are willing and able to lend. But constraints have appeared.

Joining the World Trade Organization (WTO) and demographic dividends have sustained China’s FAI push for so long.

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When an economy has underemployed factors of production like labor and natural resources, FAI, even though it isn’t profitable, can generate a positive return for the economy as a whole.

The increased income leads to more bank deposits that can sustain loans to loss-making FAI. Over the past two decades, this has been the case for China.

After China joined the World Trade Organization, foreign direct investment rushed in to take advantage of its labor surplus. It has built up the country’s export sector to the biggest in the world.

The export success has supported bank loans through increasing bank deposits within and supporting the exchange rate value without. The loans could support more FAI that would help expand export capacity. It is a virtuous cycle as long as the factors of production are still under-utilized and the export market healthy.

The virtuous cycle has come to a stop in the past few years.

Beijing’s property market is a symbol of China’s corruption income, as many recent corruption cases indicate. These cases reveal that even low-level officials can own tens of flats. Beijing has plenty of flats. They just remain empty. As the anti-corruption campaign spreads, it is likely that many worried property owners would sell. I believe that Beijing’s market would begin to decline this year, joining other cities. Indeed, as the gap between reality and perception is so wide in Beijing, the market may crash either this or next year.

The global financial crisis created a lasting barrier to China’s export growth. The country’s customers in developed countries literally went bust. Hence, there is no rising tide on the demand side for China’s exports anymore.

On the supply side, the labor shortage first appeared five years ago. Three decades of the one-child policy, the expansion of the college system and the beginning of the retirement of the baby boomer generation born between 1950 and 1975 have worked together to decrease the blue-collar labor force.

The National Bureau of Statistics (NBS) announced that the labor age population shrank for the first time last year. This is why the blue-collar wages aren’t rising faster than labor productivity.

Despite declining producer price index due to overcapacity in the past year, consumer price index has continued to rise and will likely continue to do so in 2013. The money supply continues to rise much faster than potential growth rate. The difference is working into inflation through labor and other costs.

Inflation tax maxed out

In the past five years, the FAI boom lived off the inflation tax on two fronts. First, the negative real interest rate taxed savers to sustain the negative return on FAI. Second, the property bubble, now 25% of FAI, taxed buyers to boost government income that in turn supported a negative return of FAI.

The inflation tax has serious side effects. It cuts into the country’s competitiveness and threatens exchange rate stability.

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Like other export-led economies in East Asia, China experienced a property bubble during the export and investment boom. The difference is that the government in China controls all the land and gets most sales proceeds as revenue. It has motivated the government to push the bubble as far as possible. This is why China has both a price and quantity bubble.

The quantity side is especially severe. NBS data showed that 10.6 billion square meters of properties were under construction at the end of last year, of which half were residential and the other half office and commercial.

An average price close to the market price now would put the value of this inventory at around 1.5 times GDP. Such a high level of inventory value has never occurred anywhere else. It is hard to imagine where the money would come from to absorb it.

The economic fundamentals require China to slow monetary growth to about 10%. The inventory digestion would demand 20% to 30$. This is why so many vested interests complain that today’s monetary condition is too tight.

Last year’s M2 growth rate of 13.8% is low relative to the average of 18.2% between 2000 and 2012. It is still too high for price stability. If the M2 growth rate rose to 20%, not only would inflation surge, the exchange rate would tumble.

These constraints may force the government to control the rate of monetary growth despite the pressure from vested interests that need to liquidate inventory.

The dead cat bounce

In the past three months, the property market has recovered in tier-one cities. It has led to spreading market optimism that the bubble is intact. I disagree. This is just a bounce in a multiyear slide.

My view is based on the constraints to money supply growth. Any acceleration in monetary growth, as is the case now, is short-lived. The inflation and devaluation pressure will trigger money to flow offshore.

Recent corruption cases exposed on the Internet suggest that the vast amount of corruption income is mainly in the property market. This explains the size of the bubble.

While the price-to-income ratio is similar to what Hong Kong experienced in the mid-1990s and Japan in the 1980s, China’s market volume is unprecedented. The bubble could be so big due to the tendency for money supply to become corruption income and the latter to become property demand.

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Corruption income is a tax on the whole population. Its concentration in the property market just recycles it in the government sector and supports the FAI boom far beyond what other East Asian economies reached.

During a bubble, some people, especially interested parties, cannot think straight. The best example is the surging optimism on Beijing property in the past three months. While the people were choking on poisonous air, so many so-called experts voiced the opinion that property prices in the capital would only go up, not down.

Beijing’s property market is a symbol of China’s corruption income, as many recent corruption cases indicate. These cases reveal that even low-level officials can own tens of flats. Beijing has plenty of flats. They just remain empty. As the anti-corruption campaign spreads, it is likely that many worried property owners would sell.

I believe that Beijing’s market would begin to decline this year, joining other cities. Indeed, as the gap between reality and perception is so wide in Beijing, the market may crash either this or next year.

More taxes will backfire

While the property market cools, the FAI push hasn’t. The search for new financing has led to unusual revenue-raising measures by local governments. Some resorted to prepaying last year. This is why the fiscal revenue rose much faster than the economy in a difficult 2012. More new measures to raise revenues may be invented this year.

The tax burden on consumers and businesses is already very high. This is why Chinese consumers prefer to shop offshore, even for necessities. The ongoing emigration wave is related to the tax burden in China.

Ultimately, businesses can shut down and liquidate if the taxes make them unviable. Their owners can take the cash and leave. Most private companies that I come across are barely surviving, even though they work much harder than their counterparts in other countries. More taxes will likely push them over the edge.

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When these businesses shut down, the government won’t get a dime from them anymore. This is why there are limits to increasing taxes to fund FAI.

Downsizing FAI

FAI-led growth, as analyzed above, works when the export market is strong and the domestic factors of production are underutilized. Both were not there five years ago. China has continued the FAI push on the excuse that growth per se would solve all problems and there is no other way to grow. Neither excuse is correct.

Growth has become the problem rather than the solution over the past five years. Inflation and a property bubble have cancelled income growth to keep living standards stagnant for most people. Pollution is making life difficult and sometimes dangerous.

The current growth model makes these problems worse every year, despite repeated promises by the relevant authorities to the contrary. When the government targets the total amount of money spent, would it care about others, especially when so many could take a slice of the FAI for themselves?

China’s growth potential is plentiful, just not through more FAI. In an economy with fully employed factors of production, growth comes from productivity.

China’s labor cost, though having risen substantially, is still one-sixth to one-seventh of the Organization for Economic Cooperation and Development level. As China loses unskilled labor-intensive industries to other developing economies, there is ample room for it to move into skilled labor-intensive industries. The demographic trend still gives the country an advantage in capital cost for another two decades. China has plentiful of room to realize $20,000 in per capita income before 2030.

When one closely studies industrial growth, the breakthrough often comes from someone or a company localizing the production of key equipment or a component. Some product then could be made in China at Chinese cost. Subsequently, export growth and import substitution happen.

China’s labor cost, though having risen substantially, is still one-sixth to one-seventh of the Organization for Economic Cooperation and Development level. As China loses unskilled labor-intensive industries to other developing economies, there is ample room for it to move into skilled labor-intensive industries.

The demographic trend still gives the country an advantage in capital cost for another two decades. China has plentiful of room to realize $20,000 in per capita income before 2030.

The transition from FAI to productivity-led growth requires a considerable period of consolidation. Many argue that a period of slow growth will lead to an employment crisis and social instability. Such worries are unfounded.

The economic reform and consolidation between 1997 and 2001 occurred under a background of tremendous labor surplus. Still, society was stable because the reforms gave people hope. The reforms made during this period laid the foundation for prosperity afterwards. The conditions for reform and consolidation are far better now, as labor shortage is widespread. There is no urgency to keep growth going for its own sake.

China’s FAI is so vast that sustaining rapid growth would surely bankrupt the country soon. FAI has tripled in five years to the current level of 70% of GDP in nominal value. If it triples again, the amount would become bigger than the economy of the United States. There wouldn’t be enough money in the whole world to fund it.

Limiting government’s size

Administrative power rules supreme in China. Without checks and balances, power interested in collecting and spending money will eventually become the whole economy. But, when spending, not making money, is the purpose, the economy would only become less and less efficient.

China’s property bubble must be understood in this context. It creates profits through asset inflation, which temporarily covers up the inefficiency of the real economy. But, asset inflation is followed by economy-wide inflation and eventually devaluation.

No matter how powerful and clever a government is, it cannot stretch a game of inefficiency forever. When devaluation happens, the whole system crashes.

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To stop a looming financial crisis and currency devaluation, China must make the transition now. The main argument against reform is that it is too difficult. There is no doubt that reforms would be very difficult. The problems have festered so much in the past decade that it is difficult to see where to start. I see one simple and effective way forward: capping government spending.

In 2012 government expenditures from fiscal revenue and government funds reached 31% of GDP. This doesn’t include spending from social funds. In developed economies, most spending is similar to the items in the social funds. Hence, China’s government spending is usually high by international comparison.

The central government should freeze total expenditure at the current level of 16.2 trillion yuan ($2.6 trillion) USDCNY -0.06% . Economic growth will gradually bring it down as a share of GDP. Such a simple measure frees up the fruits of economic growth to more efficient economic players who would use the resource to grow the economy further.

The other related item is the FAI by government and state-owned enterprises (SOEs). It reached 24% of GDP last year. China needs to bring total FAI to below 30% of GDP in ten years. Such a high level of government and SOE FAI isn’t sustainable. One simple way forward is to freeze this value, too, at 12.4 trillion yuan.

Unless the government chooses to limit its size through a spending freeze, the current trend is sending China towards financial crisis and currency devaluation. When that day comes, the economic adjustment would be chaotic and may throw the country into a vicious cycle.

Freezing government spending at today’s high level shouldn’t be too much of a hardship for all involved. If that much pain isn’t acceptable, we can only wait for the crisis.

Read this commentary on Caixin Online.

The China Investment ABCT ETF Fund

Tuesday, 19 February 2013