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Falling Star


The Chinese economy is slowing and is likely to slow a lot more. Get ready for a hard landing.

After three decades of annual growth averaging 10%, China's bullet-train economy is slowing markedly. Economic problems in Europe and the U.S. are stunting export growth, long the primary driver of China's economic miracle. Growth in industrial production has likewise been decelerating for months. This year growth in gross domestic product could slip to 8%—and it may get a lot worse from there. Though recently announced interest-rate cuts and a ramp-up in the government's already massive infrastructure spending could postpone the day of reckoning, to us it looks like the Great China Growth Story may be falling apart.

A comprehensive report by Nomura Global Economics issued late last year entitled "China Risks" paints at least one scenario in which China's growth would fall in half to under 4%.

Already cracks are becoming more and more apparent in the seemingly adamantine façade of the Great China Growth Story that may well deter China from surpassing the U.S. in the near future—or ever. One can only remember the triumphalism extant about Japan's prospects 25 years ago just before its economy went into a two-decade funk.

The most outspoken Sino-Skeptic is Wall Street short-seller Jim Chanos, who over the past several years has placed negative bets on the stocks of major Chinese banks, real-estate developers, and mining concerns, like Australia's Rio Tinto (ticker: RIO) and Brazil's Vale (VALE), which are major suppliers to the Chinese fixed-asset orgy. Never one to mince words, Chanos contends that China is headed for a hard landing of epic proportions because of its shaky financial system and an imminent collapse in its property market, which undergirds the entire economy. "I'm being conservative when I say that the coming bust in China's real-estate market will be a thousand times that of Dubai," he told Barron's.

Of course, Chanos has been singing this tune for years, and such apocalyptic pronouncements have so far proved a mug's game.

Edward Chancellor, a global strategist for the Boston-based GMO, is of a similar mind to Chanos on the subject of China's future. "I hear all the time from China bulls that there've been eight economic slowdowns there over the past 20 years and yet each time China has come roaring back," he says. But he is steadfast in his belief. "I can't tell you precisely when the downturn will hit," he says. "No one can. All I know is that China has all the earmarks of a classic mania that will end badly—a compelling growth story that seduces investors into ill-starred speculation, blind faith in the competence of Chinese authorities to manage through any cycle, and over-investment in fixed assets with inadequate returns facilitated by an explosion in credit."

It's also of note that even some of the longtime bulls are growing concerned on the nation's future. One is William Overholt, a respected Asian scholar who has moved smoothly between Asian investment-banking posts, think tanks, including the Rand Corp., and academia; he's now a senior research fellow at Harvard's Kennedy School.


Troubling Trends

Increased government spending on infrastructure is, for now, offsetting a slowdown in household consumption. A property bubble, should it burst, would thrash China's economy.


As Overholt sees it, the economic and political reform movement of the Jiang Zemin/Zhu Rongji era (1993-2002) has flagged badly over the past 10 years. As a result, the giant state-owned enterprises—outfits like energy colossus Sinopec (0386.HongKong), telecom giant China Mobile (CHL), conglomerate Norinco and integrated steel maker Baosteel—have become overly dominant in the economy, thanks to their oligopoly positions, implicit government guarantees, cheap credit, tax breaks, and subsidized access to cheap raw materials. In the process, these national champions have been squeezing out small and medium-size companies in the more innovative private economy catering to the export market.

The so-called SOEs boast close family and financial ties to China's ruling party clique. Power and wealth have become one in the same—a kleptocracy of insiders skimming off part of the prodigious money flows sluicing through the Chinese economy through relatives strategically placed in state companies, consulting firms, and various financial institutions.

Unless this blatant favoritism is curbed by the incoming administration of Xi Jinping, says Overholt, China faces the prospect of long-term stagnation—a prospect potentially far worse than that of Japan some 20 years ago.

Japan entered the economic dead zone at a time of broad and robust affluence, with per-capita annual income some eight times that of China's $5,000 and far more technological sophistication. "The bulk of Chinese high-tech products and indeed exports that come from foreign companies with plants domiciled in China, and they don't have to stay there," says Overholt.

"I've been championing the China growth story in various academic papers and publications for 30 years," he continues, "including a book called The Rise of China in 1993, but I don't want to be a permabull when a great historic trend may or may not be changing."

Could China be nearing the point at which so many high-octane growth economies suddenly decelerate or even contract? Back in 1994, economist Paul Krugman wrote a prophetic essay entitled "The Myth of Asia's Miracle," which among other things took a close look at both Japan, then in decline, and China, then leaving Earth's atmosphere and blasting off into space. A Nobel Prize winner (and an often polarizing pundit from his perch on the op-ed page of the New York Times), Krugman maintained that the extraordinary economic growth rates in places like China largely reflected the brute mobilization of surplus farm labor into vastly more productive manufacturing jobs and huge spending on capital equipment and infrastructure—"expansion of inputs," as he put it—rather than a focus on efficiency, innovation, and ultimate economic return, or "growth in output per unit of input."

Such state- or party-directed human wave attacks work for a time, yielding large increases in outputthink of the Soviet Union in the 1950s or Japan in the '50s and '60s. But eventually those economies hit the wall of diminishing returns and never quite caught up to developed economies grounded more in free-market principles and less dominated by selfish special-interest groups.

China has been on a ferocious ascent in investment spending on industrial capacity and infrastructure, flying higher, faster, and longer than any Asian economy in the past. The nation's labor and capital input to GDP has been above 40% for the past decade, even topping 50% over the past two years, according to the Nomura report. By contrast, Japan, Korea, Singapore, and Thailand had lower ratios than that during their periods of rapid economic takeoffs and hit the wall in terms of investment growth after seven to eight years.

Of course, consumption is the yin to investment spending's yang. And here the Chinese consumer has suffered mightily, accounting for just 35% or so of total spending, while U.S. consumers' spending comes to nearly 70% of GDP. Consumption in China is hobbled by myriad factors. Chinese are heavy savers because of the necessity of paying for the bulk of their own medical costs and retirements.

Meanwhile, interest rates on bank savings deposits are kept artificially low by the government, well below the actual inflation rate.


Despite increasing lip service given in the latest five-year plan to rebalance the economy by making the transition to consumption-led growth, powerful special-interest groups stand in the way of such a change. The state-owned enterprises and other state-dominated joint stock companies, which have enormous sway in the Communist Party, account for more than half of employment and fixed-asset investment in the nonfarm economy.

Those businesses don't make especially good use of their resources, either. Based on what economists call total factor productivity, which takes into account managerial skill and technological innovation in addition to labor and capital investments, the state companies measure far below the private sector in efficiency. That's despite such special advantages as low tax rates, government-mandated low costs of capital, access to underpriced resources like water, energy, and land, and light enforcement of environmental protection and workplace safety rules. In all, it's an increasingly weak use of labor and equipment.

Infrastructure, the other major area of China's investment boom, may similarly be running into the wall of diminishing returns. GMO's Chancellor talks of a highway system with sparse traffic, local airports running at half-capacity and the rapidly expanding national high-speed railroad system, a technical marvel that can't charge ticket prices sufficient to pay for itself. He terms China a "Field of Dreams" economy built on the shaky premise of build and they will eventually come.

There are other signs of a serious misallocation of resources during the recent infrastructure building frenzy. Kenneth Lieberthal, a political scientist at the Brookings Institution and a longtime China expert at the University of Michigan, points out that much of the investment funds pass through local government fronts or investment vehicles that in turn spend the money on all manner of facilities from fancy government buildings and roads and bridges to special development zones and high-end shopping centers. There is no overall regional planning, rendering many of the facilities redundant.

Even worse, says Lieberthal, most of the building was financed with three-year bank loans on projects with insufficient cash flow to service the interest, let alone principal repayment. "The mismatch means that these loans are going to have to be rolled over for years," he avers.

Nowhere is the overcapacity controversy more pitched than in the urban real-estate market, where mountain ranges of large apartment buildings sit empty in cities all over China. To hear Chanos tell it, this is the bubble of all bubbles. He and other skeptics love to talk about "ghost cities," like Ordos in Inner Mongolia with its virtually empty streets, shopping centers, and unoccupied apartments for more than one million residents. Satellite images of other cities tell a similar tale of vast new unoccupied developments. Developers in Shanghai and Beijing regularly put curtains up on new luxury high-rises to mask their sad see-through state. (For more on China's housing woes, see "A House of Straw?".)

THIS ALL HAS OLD CHINA hands like Peterson Institute economist Nicholas Lardy concerned. He points out that last year residential construction accounted for 9.2% of Chinese GDP. Compare that with 6% in the U.S. at the peak of its housing boom in 2006. Among major countries, only Spain has hit that levelright before the housing collapse in that country.

Lardy and others fear that a major decline in residential real estate and underlying property prices could severely damage the Chinese economy. (Average new-home prices in some 70 major Chinese cities fell monthly in the eight months through May.) A falloff in demand for steel, cement, and copper would lead to heavy layoffs. He reckons that some 25% of all Chinese steel consumption goes into residential real estate.

According to Lardy, nearly 20% of Beijing residents own two apartments or more in the city. Thus any precipitous slide in the property market would have a tremendous negative wealth-effect in an economy whose consumption spending needs to be nurtured, not impaired.

And, of course, the financial system could suffer mightily from a real-estate slide, even with the conservative loan-to-value ratios of most mortgages. Local governments typically raise 30% to 40% of their annual revenues from land sales—the state technically owns all land—to finance their operations and capital improvements.

Property also constitutes the collateral that underlies the local government funding vehicles that borrow from state banks to finance infrastructure projects. State-owned enterprises and, indeed, the state-dominated banking system have all been drawn to real-estate speculation like catnip. Fitch estimates that some 35% of all bank loans in China are exposed to the vagaries of the Chinese property market. And that number doesn't capture all the commercial and industrial loans that companies borrowed ostensibly for corporate purposes and then diverted into real-estate development.

IF DEMOGRAPHICS ARE destiny, as some social scientists assert, then China has reasons for concern. Because of more than 30 years of its one-child-per-family policy, its population is rapidly aging. In fact, its working-age population is projected to begin a long-term decline in 2015, with the all-important entry-level cohort of 15-to 24-year-olds falling the fastest. Already, average wage levels in urban areas have been rising by double-digit rates (a 13.3% increase alone in 2010), a sure indication that the flow of cheap migrant labor from the hinterlands to the cities is slowing.

Just as problematic is the widening disparity between male and female births. Last year the gender gap was 120 boys to every 100 girl babies. So, according to the Nomura report, not only does China face the likelihood of a "quite sharp" slowing in economic output in the next five to 10 years because of an aging population but also perhaps higher crime rates from a growing male population without marriage prospects.

IF THERE IS ANYTHING that inspires confidence in China's prospects, it's the supposed strength of its financial system. The banking system, which controls some 90% of all financial assets, is mostly state-owned with a dollop of American and other foreign investment. Chinese banks report a negligible amount of nonperforming loans.

And even if they were to get into trouble, the central bank, the People's Bank of China, is sitting on $3.2 trillion in foreign reserves (mostly earned from China's positive trade balance with the U.S.) that could be deployed to head off any bank run or other financial emergency. Chinese national debt, as officially reported, sits at around 50% of its 2011 GDP of $7.3 trillion, compared with a U.S. debt-to-GDP ratio of more than 80%.

But appearances can be deceiving, says Victor Shih, a political scientist at Northwestern University who has a host of sources inside and outside government in China and has burrowed deeper than most other Western observers in all manner of government reports, corporate financial statements, bank filings, and bond prospectuses.

His conclusions are several. First, when one tallies up all the liabilities direct and contingent of the Chinese central government, indebtedness of the state-controlled banking system, various government entities like the Ministry of Railroads, state-owned enterprises, local government loan investment vehicles, and considerable cross-holdings of bond debt by SOEs, China's government debt-to-GDP triples to about 150% and is rapidly rising.


Secondly, nonperforming loans in the financial system are dramatically higher than officially reported, because the banking system, under orders from authorities, masks that total by sedulously rolling over bad loans. For example, even the $500 billion of bad loans hived off by authorities to facilitate the initial public offerings of the giant state banks Bank of China (601988.China), China Construction Bank (601939.China), Industrial & Commercial Bank of China (601398.China), and Agricultural Bank of China (601288.China) now sit chastely in various asset-management companies, mostly bereft of any write-downs or of substantial recoveries.

Peril for China's banking system lies, ironically enough, in a liquidity crisis that might ultimately expose many of the rotten loans like so many stinking, beached whales. Any faltering in the China growth story could cause corporations and investors both on the mainland and offshore to run down their renminbi balances through simple balance transfers and clever invoicing to move funds offshore.

There was such an outflow in the latest monthly figures for April, when some $11 billion worth of renminbi left China in excess of the sums flowing in from overseas as a result of the nation's continuing positive current-account balance and foreign direct investment.

Capital flight by corrupt party members and other wealthy Chinese could also shred China's vaunted safety net of $3.2 trillion in foreign-currency reserves. Northwestern's Shih estimates that the top 1% of Chinese households have amassed liquid and real-estate wealth of as much as $5 trillion. The gambling mecca of Macau and leaks in the banking systems afford plenty of ways to get money out of the country.

Only a major political upheaval would likely trigger massive capital flight. Yet the authorities seem to be running scared, spending more on internal security than national defense in the past two years.

RESENTMENT CONTINUES to grow over widening income inequality, Internet censorship, and the state's thuggish suppression of dissent. To many, including the Chinese middle class, the system is rigged in the favor of a new hereditary aristocracy, the "princeling" descendents of leading party figures, and other insiders.

And even Chinese research and development consists more of theft of intellectual property, industrial espionage, and cyber attacks on Western companies than genuine collaboration with foreign concerns.

Fatefully, the Chinese government has tied its very legitimacy to its ability to deliver unending, hyperthyroid GDP growth, a task that figures to be far more difficult in the years ahead. Indeed, many say that anything less than 7% could create unrest if the economy fails to produce enough jobs to accommodate the millions of citizens migrating to cities and industrial areas every year.

Perhaps the new administration of Xi Jinping, which will take over late this year, can make many of the structural reforms to rein in powerful special-interest groups and introduce more fairness in the functioning of the nation's political economy.

To that point, the saga of Bo Xilai, the disgraced party boss of Chongqing Province, may be revealing. One way to read it is that Bo was vanquished from his post and membership in the Politburo as a signal that epic corruption—and his wife's apparent complicity in the murder of a European associate—will not be tolerated. Another is that it was out of fear of his inordinate political ambitions; his late father was a close associate of Mao and a veteran of the Long March.

All things considered, the odds in favor of fixing China seem long indeed.

More questions than answers after the summit

June 29, 2012 4:55 pm

by Gavyn Davies

This blog contains Gavyn’s initial response to the eurozone summit. As more news emerges, he may add further comments below if his assessment changes during the weekend.

In the wake of yet another summit, we need to ask our usual question: is this the eurozone’s game changer, or in football parlance the “Balotelli moment”? Clearly, there have been some late night concessions from Germany, which could turn out to be very significant in the long term. Spanish and Irish debt ratios will markedly benefit as the costs of their bank bail-outs are removed from the sovereign balance sheets and absorbed by the eurozone.

The markets have welcomed these developments, and rightly so. In particular, the opening sentence of the statement, which says boldly and simply that “we affirm that it is imperative to break the vicious circle between banks and sovereigns”, could prove to be a major breakthrough. Some think it might be the beginning of a Euro-tarp.

But my fear is that, as so often in the past, the devil will prove to be in the detail. The more carefully one examines the text of the statement, the more questions are raised about how the proposed measures will actually work.

In particular, it is debatable whether there are any terms for direct eurozone recapitalisation of Spanish banks which will be acceptable both to the Spanish government and to the German Bundestag. (The latter will be empowered to “monitor” the new arrangement, according to Mrs Merkel’s spokesman.) And the shortage of remaining funds in the EFSF/ESM, which I discussed here last week, has certainly not been solved.

I would like to discuss each of the key points raised by the summit separately.

1. Direct bank recapitalisation by the ESM

This is clearly the critical new development which potentially allows the costs of recapitalising troubled banks to fall on the eurozone as a whole, rather than on an individual sovereign country. It could therefore represent a very large step towards debt mutualisation, and it directly addresses the point which the markets so disliked in the Spanish bank deal two weeks ago. The statement says that this can only be done after the eurozone’s new bank supervisor isestablished”, and that this should only beconsidered” by the Council before the end of the year. In view of the disputes which could arise over this thorny issue, the risks of slippage are considerable.

The ESM will need to negotiate precise terms for each of the bank injections, and these terms will in effect determine the extent of any transfer of funds across national boundaries. As James Mackintosh argues in an important piece, Germany will have an incentive to wipe out existing shareholders and bondholders in Spanish banks so that they will obtain greater ownership for each euro of rescue money expended. The incentives on Spain will be the exact opposite. So this could prove very contentious indeed.

Furthermore, the statement says that conditions will be set for these bank injections, including “economy wideconditions. This is mysterious but could mean that conditions will be required from the sovereign, for example that the ESM would be compensated if there are any losses on the capital injected into the Spanish banks. That would seem to meet Mrs Merkel’s pre-summit demand that sovereigns can only deal with sovereigns, not with foreign banks.

I understand that such conditions would obviously eliminate the whole principle of breaking the link between the sovereign debt crisis and the banking crisis, but I suspect that Germany will be quite demanding is setting these terms. Otherwise, there could be great problems with the constitutional court in Karlsruhe.

2. Seniority of debt

The markets initially became excited by this, but should not have done. There is very little change here. The statement reaffirms” (a word which in effect impliesthis is not new”) that the Spanish bank injection, made by the EFSF and then transferred to the ESM, will not gain seniority status over private debt holders. Careful observers knew that already, since it has always been the intention, stated in the preamble to the ESM treaty. The key point is that there is no general change intended for the seniority of ESM debt, so this problem is not alleviated.

3. ESM support for the Spanish and Italian bond markets

The final paragraph of the statement gives the strong impression that the ESM will in future be able to stabilise these bond markets in a “flexible and efficient manner. This appears to be a major victory for Mario Monti, but actually it does not contain anything really different from the status quo. Ever since last year, the EFSF/ESM has been empowered to buy both primary and secondary market debt, on a request from a member state, which then has to sign a Memorandum of Understanding. This memorandum involves less onerous conditions than a full Troika programme.

There is also an emergency procedure available, which can be triggered by the ECB. It has always been a bit obscure whether this requires a formal request from a member state. Today’s statement reminds everyone that there should be conditions written into a Memorandum, so the basic principle appears to be unchanged.

Another point to bear in mind is that any bond buying by the ESM may result in less bond purchases by the ECB under the Securities Markets Programme. This is a key objective of the ECB, and it means that net support for the bond markets may not increase very much.

4. The availability of funds for the ESM

German Finance Minister Schauble emphatically said yesterday to the Wall Street Journal that there would be no increase in the size of the ESM, and that position has been maintained by Germany at the summit. Furthermore, Mrs Merkel has repeatedly stated that there will be no joint financing” of eurozone debt (ie eurobonds, or eurobills) before full fiscal union has taken effect. Again, there is no change in that position. Indeed, that is the basis for the German government’s insistence that they have not taken on any extrajoint liabilities” as a result of this summit.

In summary, the summit has given the ESM some new tasks, but no new money with which to discharge these tasks. And many details are obscure. To quote the lyrics of the great Johnny Nash:

There are more questions than answers

Pictures in my mind that will not show

There are more questions than answers

And the more I find out the less I know

Yeah, the more I find out the less I know.