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vendredi 11 mars 2011

Why China's economy may be in for tough times

I've always have mixed feelings about China's economy. Long term, I have no doubt that it has tremendous potential and that China will be capable of producing leading corporations and cutting edge business practices. Short term however I believe that China is due for a crisis.

Last year, I wrote an essay about China's economy. In it I exposed my general point of view about the middle kingdom’s economy: that it is a house of cards and that its model is unsustainable and inefficient. In this article, I will come back on what I wrote and try to see if the current situation corroborates the points I made back then (spoiler alert: it does).

Since 2004 china has devoted an average of 40% of its GDP to investment. This figure far exceeds that of South Korea or Taiwan at the height of their investment led development. These investments derive directly from China’s development strategy based on exports and manufacturing. All in all, industrial output accounts for nearly
half of china’s GDP and services for a mere 40%. As of today, if we look at the structure of its economy, China looks more like a communist country than a capitalist one. What’s mor
e, the stimulus plan is likely to raise the share of investment to over 50% of GDP in 2009, thus accentuating the imbalances the government was trying to correct before the crisis started.

(…)

It is troubling to see that household consumption represents a paltry 35% of GDP while this figure is 67% in India. If it is to join the club of advanced economies, China must go beyond industry and exports and evolve into a service-based economy
relying on its domestic market.

Today, consumption still represents barely 36% of China’s GDP! We see there the effects of a stimulus plan that basically consisted in showering large state owned industrial companies with money, launching boondoggle infrastructure projects (example there) and nationalizing entire swaths of the economy. China’s economy is still experiencing artificial short-term growth driven by massive over investment. It may look good on paper, but it will certainly not last.

The government has also addressed the crisis by ordering banks to lend virtually limitless amounts of money to SOEs. Analysts agree that co
nsidering the
number and size of the loans granted, banks cannot have conducted proper risk analysis an
d will most likely find themselves with an increasing share of Non Performing Loans in their portfolios.

Massive lending also fuels investment bubbles. The th
reat
is aggravated by the intrinsic volatility of China’s markets (the Shanghai stock market is often nicknames “the great lottery”). Lack of credible information from companies (especially state owned) and the government (many figures often differ whether you look at central government or local government figures) encourages blind speculation and makes man
y economists fret about the consequences of the investment boom.

I could write dozens of pages about Chinese banks. These things are time bombs and I wouldn’t touch them or their stock with a 10-foot long stick. Fitch Ratings recently put the probability of a Chinese banking crisis before 2013 at over 60%. According to Asianomics Ltd, bad loans could total more than 400 billion. Even more troubling is the fact that the PBOC (China’s central bank) is having a very hard time putting a lid on bank lending. Year after year it kept overshooting its lending quota by so much that it got rid of it altogether. The reason for all this is quite simple: Chinese banks are primarily political tools whose role it is to channel as much money as possible towards industrialists to ensure that whatever growth objective Beijing has set is achieved. When loans are granted based on political criteria, it is hard to have sound banking system and I believe that China will learn this lesson soon.


Furthermore, there is plenty of capital flying around but it’s not going to the right companies. Over regulated and over politicized financial markets make it very difficult for smaller companies to gain access to the capital they need to develop their activity. That’s one of the main reasons why it will be very hard (if not downright impossible) for China to produce the next Facebook or the next Google (please don’t tell me Baidu proves me wrong or I will hunt you down and hit you with a shoe Lybian style).

As of today, the burden of taxation is on consumption while many companies pay little taxes and thus over invest in new production capacities

Things have not changed since I wrote these lines. A fatal combination of generous tax laws, artificially cheap capital and crony capitalism is still leading companies to massively over invest in production capacities. In too many industries, capital expenditures are through the roof despite falling sales and margins. Many investors are starting to smell danger and things will not end well if nobody takes the punch bowl away (very good presentation about this here).

These are only some of the points I raised in the original paper I wrote. But on top of the problems I highlighted now comes that of inflation. Latest figures put year on year inflation at 4,9% but there a reasons to believe that the real figure is higher. Inflation is the logical result of artificially cheap capital, an ever-expanding monetary base (necessary to keep the Yuan for appreciating) and a lack of private property rights in the countryside that prevents the apparition of large, efficient farms capable of producing cheap foodstuff. I believe that stopgap measures such as price control schemes will only make the situation worst by creating shortages.

The real estate bubble is also a major cause for concern. Real estate investment now represents over 10% of Chinese GDP (vs only 6% and 9% for Japan and the US at the height of their investment cycles). There are more than 70 million apartments in China that are unoccupied. Large Chinese companies have poured billions in highly speculative real estate investments (a practice known as Zaiteku), which grossly inflates their balance sheets and increases market volatility. Moreover, with deposit rates so low (the spread between lending and deposit rates is at an astonishing 3,5 percentage points), real estate is also the only investment with a good enough pay-off for ordinary folks. With so many loans directly tied up to the housing market, there is no telling what will happen when the party stops…


So can China change? Yes but it will take some painful readjustments. Premier Wen Jiabao recently declared that the aim of the 12th five-year plan would be to rebalance the economy and “improve people’s livelihood”. That may sound lovely but that has been the government's stated goal for some time and was already at the center of the last 5-year plan. Top officials have been talking about re-balancing for years but so far have little to show for it. The truth is that the Chinese authorities are way too dependent on growth no matter of what kind or at what price. Even if the central government acknowledges the need to cool things down (which I think it does), local authorities still have growth objectives that are way too high to be sustainable on the long term. So this unstable, unsustainable and inefficient (it takes $7 of government spending to generate $1 of output) model stays alive. But beware, the longer China waits, the more painful the rebalancing will be and the more the wider world economy will suffer. One cause for hope is that many in the regime are aware of the dangers they face, the only question now is will they be able to match their words with actions? Only time can tell.








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