Breaking China’s Investment Addiction

Zhang Monan

14 February 2013

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BEIJING China’s economic growth model is running out of steam. According to the World Bank, in the 30 years after Deng Xiaoping initiated economic reform, investment accounted for 6-8 percentage points of the country’s 9.8% average annual economic growth rate, while improved productivity contributed only 2-4 percentage points. Faced with sluggish external demand, weak domestic consumption, rising labor costs, and low productivity, China depends excessively on investment to drive economic growth.
Although this model is unsustainable, China’s over-reliance on investment is showing no signs of waning. In fact, as China undergoes a process of capital deepening (increasing capital per worker), even more investment is needed to contribute to higher output and technological advancement in various sectors.
In 1995-2010, when China’s average annual GDP growth rate was 9.9%, fixed-asset investment (investment in infrastructure and real-estate projects) increased by a factor of 11.2, rising at an average annual rate of 20%. Total fixed-asset investment amounted to 41.6% of GDP, on average, peaking at 67% of GDP in 2009, a level that would be unthinkable in most developed countries.
Also driving China’s high investment rate is the declining efficiency of investment capital, reflected in China’s high incremental capital-output ratio (annual investment divided by annual output growth).
In 1978-2008 – the age of economic reform and opening China’s average ICOR was a relatively low 2.6, reaching its peak between the mid-1980’s and the early 1990’s. Since then, China’s ICOR has more than doubled, demonstrating the need for significantly more investment to generate an additional unit of output.
As the accumulation and deepening of capital accelerate growth, they perpetuate the low-efficiency investment pattern and stimulate overproduction. When production exceeds domestic demand, producers are compelled to expand exports, creating an export-oriented, capital-intensive industrial structure that supports rapid economic growth. But if external demand lags, products accumulate, prices decline, and profits fall. While credit expansion can offset this to some degree, increased production based on credit expansion inevitably leads to large-scale financial risk.
Thus, a combination of investment, debt, and credit is forming a self-reinforcing risky cycle that encourages overproduction. In the wake of the global financial crisis, Chinese banks were instructed to extend credit and invest in large-scale infrastructure projects as part of the country’s massive monetary and fiscal stimulus. As a result, China’s credit/GDP ratio rose by 40 percentage points in 2008-2011, with most of the lending directed toward large-scale investment by state-owned enterprises (SOEs). In the last two years, bank credit has become the main source of capital in China – a risky situation, given the low quality and inadequacy of bank capital.
Meanwhile, strong currency demand has led China’s M2 (broad money supply) to increase to 180% of GDP – the highest level in the world. The massive wall of liquidity that has resulted has triggered inflation, sent real-estate prices soaring, and fueled a sharp rise in debt.
Given that it is in local governments’ interest to maintain high economic-growth rates, many are borrowing to fund large-scale investment in real estate and infrastructure projects. The active fiscal policy adopted during the financial crisis enabled the rapid expansion of local official financing platforms (state-backed investment companies through which local governments raise money for fixed-asset investment), from 2,000 in 2008 to more than 10,000 in 2012. But, as local-government debt grows, Chinese banks have begun to regard real estate and local financing platforms as a major credit risk.
Likewise, with key industries facing overproduction and slowing profit growth, firms’ deficits are growing – and their debts are becoming increasingly risky.

Indeed, the proportion of deficit spending among enterprises is on the rise, and the accounts-receivable turnover rate is falling. By the third quarter of 2012, industrial enterprises’ receivables totaled 8.2 trillion renminbi ($1.3 trillion), up 16.5% year on year, forcing many to borrow even more to fill the gap, which has driven up debt further.
According to GK Dragonomics, corporate debt amounted to 108% of GDP in 2011, and reached a 15-year high of 122% of GDP in 2012. Many heavily indebted companies are SOEs, and most of the new projects that they initiate are “super-projects,” with the return on investment taking longer than creditor banks expect. Indeed, some highly indebted firms’ capital chains may well rupture in the next two years, when they reach their peak period for debt repayment.
As a result, China’s financial system is becoming increasingly fragile. The expansion of infrastructure investment – which, according to some reports, exceeds 50 trillion renminbi, including highway and high-speed railway construction – will lead to the expansion of banks’ balance sheets. The investment loans and massive debts among local financing platforms, together with the off-record credit channeled through the “shadowbanking system, are increasing the risk that non-performing loans will soon shake the banking sector.
To reach the next stage of economic development, China needs a new growth model. Reliance on investment will not enable China to achieve stable, long-term growth and prosperity; on the contrary it may well inflict serious long-term damage on economic performance.
Zhang Monan is a fellow of the China Information Center and of the China Foundation for International Studies, and a researcher at the China Macroeconomic Research Platform

Markets Insight

February 12, 2013 8:23 pm
Give stocks a tax break to end bonds bias
Low level of yields reflects fiscal and regulatory imbalance
Cast an eye around the credit markets and it is hard not to conclude that risk is being mispriced. The compression of spreads and near zero policy rates of interest have contributed to a marked decline in yields. This has recently been especially sharp in corporate high yielding paper and junk bonds, reflecting the growing desperation of income-hungry financial institutions in a phenomenally low yielding world. The question is whether this manic buying, which smacks of the period before the credit crunch in 2007, constitutes a systemic threat.

At first glance there appears little cause for concern, given that developed world economies are aeons away from overheating and that the associated costs of any mispricing may merely amount to a misallocation of resources rather than a systemic crisis. Yet the Institute of International Finance, in its latest Capital Markets Monitor, argues that the question of mispricing is particularly applicable in the eurozone where economic divergence between stronger core countries and the periphery appears not to have gone away. Since economic divergence has been one of the main causes of tensions within the monetary union, its persistence despite improvements in current accounts and unit labour costs raises the question of whether the sovereign debt crisis is really over.

Note, too, that the mispricing of credit risk stores up trouble for later. An interest rate shock following a market reassessment of sovereign risk or an end to central banks’ asset buying programmes might wreak havoc among leveraged institutions. Looked at from a structural perspective, the extraordinarily low level of bond yields also reflects an unhealthy fiscal and regulatory bias against equity.

In most jurisdictions interest payments are tax-allowable, whereas dividends are not. Since the financial crisis regulators have strengthened the pro-bond bias by introducing risk-mitigation rules that favour low-risk, fixed interest bonds in banking, insurance and pension funds. In some countries financial stability has taken priority over making finance available to the real economy.

At the same time, global imbalances tilt the system in favour of low-risk investments because of the huge accumulation of official reserves in high-saving countries with big trade surpluses. These are traditionally invested in highly liquid government and agency paper.

Sovereign wealth funds are a potentially more benign recycling vehicle for these savings surpluses since they have a mandate to aim for higher returns. Yet their role in fiscal stabilisation since the onset of the financial crisis has forced them into lower risk mode. Most important of all, ageing constitutes a serious headwind for equity markets since older investors move funds out of equities into lower-risk fixed interest securities and bank deposits. This is already a reality in Japan and across much of the developed world.

A new report from the Group of Thirty, which represents the great and good of global finance, argues that this is one of several potential constraints on the long term investment that will be required to expand the productive capacity of modern economies.* On the basis of a range of growth forecasts and investment projections it estimates that nine leading economies that spent $11.7tn on long term investment in 2010 will need annual investment of $18.8tn in real terms by 2020 to achieve even moderate levels of economic growth. The economies concerned account collectively for 60 per cent of global gross domestic product.

The report provides an eloquent tour d’horizon of the factors that inhibit long-term financing in the public and private sectors, ranging from bank deleveraging to fiscal consolidation. It highlights, among a variety of policy recommendations, the scope for increasing the size of corporate bond markets in both the developed and developing world, while calling for the regulatory and fiscal handicaps on equity financing to be addressed.

This is not an easy agenda in the aftermath of the financial crisis. Yet the authors rightly say that it is important to review the regulatory framework to ensure that reforms aimed at increasing the safety of the financial system are fully supportive of economic growth, investment and job creation. In the advanced economies long-term investment is particularly important because it is one of the few ways of boosting economic growth during a time of deleveraging and necessary fiscal consolidation.

Addressing the anti-equity fiscal bias runs into the intractable difficulty that any change would create winners and losers. This could be overcome, the report suggests, by a revenue-neutral initiative to eliminate the tax deductibility of interest payments at the same time as lowering the marginal tax rate for companies.

Or tax deductibility could be applied to equity dividends while increasing the marginal tax rate. It calls for international discussion on the issue.

The logic of these proposals is compelling. The difficulty lies in the politics.

*Long-Term Finance and Economic Growth

The writer is a Financial Times columnist

Copyright The Financial Times Limited 2013

Is Japan About to Fire the First Shots in a 1930s Style Currency War?
By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning
February 12, 2013

Chances are you've heard about the so-called "race to the bottom" in which various industrialized nations are gradually allowing their currencies to depreciate in an attempt to maintain competitive parity.

Forget about it...the real risk right now is an all-out 1930s-style currency war. I know it's not front-page news yet, but I have a sneaking suspicion it will be shortly.

It's going to blindside Washington and most of Europe, where central bankers, politicians, and more than a few economists fail to recognize that events from nearly 100 years ago are now primed to repeat themselves.

Worse, it will devastate an entire class of investors who have put their faith in the current economic dogma of endless bailouts and money printing.

Ironically, this currency war won't start because of international problems. Instead, it will be touched off in earnest because of domestic concerns-- only they aren't ours. My guess is Japan fires the first shots.

Here's why:
1) Japan's newly elected Prime Minister, Shinzo Abe, is calling for unlimited stimulus and more aggressive financial intervention in an effort to boost Japan's flagging economic situation and eviscerated domestic economy.
2) The Bank of Japan has doubled its inflation target to 2% while also promising to buy unlimited assets using a page from Bernanke's playbook. Bear in mind that Japan's combined private, corporate and public debt is already nearly 500% of GDP, which is much larger than the 250% that's commonly bandied about in the media.

3) Japan has one of the strongest fiat currencies on the planet, which means it has the most to gain and everything to lose if somebody beats them to the punch. An expensive yen holds back Japan's exports by making them more expensive in global markets, while the debt I just mentioned hobbles future economic development by robbing the private sector of capital it needs for an actual recovery.

A Currency War Repeat

This is very similar to the situation in 1931 when the United Kingdom removed itself from the gold standard on September 19th of that year.

Not surprisingly, by December the pound sterling took a 30% nose dive against the U.S. dollar. It also set off a chain of "me-too" actions and reactions from the United States, France, Germany, Sweden, and Norway, among others.

Notes Roderick Floud in his book, The Economic History of Britain Since 1700: Volume 2: 1860-1939, there were "some 25 countries with close economic or imperial links to Britain" that had tied their currencies to the sterling.

If you remember your history, the lessons here are pretty clear: The nations that abandoned the then-prevailing international currency trading standard first benefited the most.

Conversely, those that hung on got slammed because their money suddenly commanded a premium versus the newly "inexpensive" sterling, U.S. dollar, French franc and German mark, which were the powerhouses of the day. By 1932, the sterling's depreciation had created a "rapid and forceful cyclical upswing" notes Floud, because the cheap money that stimulated investment following the UK's exit from the gold standard really was not so much a result of policy as a it was the by-product of "depressed world financial markets."

I agree. Right now, in a replay of events from that era, a stronger yen has crippled Japan's recovery by limiting its ability to engineer a brighter future by making its goods prohibitively expensive in global markets at a time when world markets are sluggish themselves.

Compounding the problem is the fact that Japan's overall market share of world export markets has declined much the way England's had.

Many leading Japanese companies are now struggling to remain even marginally competitive in markets that they once dominated like televisions, electronics and machinery. The most graphic examples include Sony, Sharp, and Panasonic, all of which once dominated the television markets and all of which are in deep trouble today.

A Full Blown Currency War

There's obviously no gold standard to come off of at the moment, which is why the "things will be different this time crowd" can't wrap their heads around the concept of a full-blown 1930s-style currency war.

Goosing the printing presses and moving aggressively to weaken the yen before other nations weaken their currencies further would allow Japan to capture additional market share from other exporters before they have a chance to react.

Obviously, such actions would not sit well with major regional trading partners, most notably South Korea and Taiwan. Nor would it be particularly well received in South America, where emerging markets are tied to a blend of U.S. dollars and, increasingly, the Chinese yuan.

So retaliation would likely be swift and significant in the form of capital controls and transaction-specific taxes, both of which are blunt force instruments capable of doing a lot of damage. That's another lesson from the 1930s that seems to go unheeded by today's leaders.

To some degree, a currency "skirmish of sorts" is already underway in that there's already been a lot of verbal intervention by various nations. However, I look at this as a largely wasted exercise by self-interested politicians and central bankers. They're all staring at each other across a sea of political niceties while all the while hoping nobody will be the first to blink.

Eventually, somebody will decide to do just that; it all depends on who has the right incentives and how much they have to lose.

The situation reminds me of something called the prisoner's dilemma, a theoretical exercise in game theory in which the optimal outcome for all participants results directly from mutual cooperation. The problem (and the reason why it's a dilemma) is that eventually the optimal outcome for one or more individuals is not to participate as a group.

That's significant because the psychology of our leaders has changed since this crisis began much the way it changed in the 1920s leading up the United Kingdom's departure from the gold standard in the 1930s. Specifically, when this crisis began, world leaders quickly realized that they had to work together in some capacity, so they gathered the G20 for discussion as opposed to the much smaller - some would say elite - G5.

Today, though, as conditions continue to deteriorate and each new round of fresh stimulative action brings less in the way of results, the attitude is becoming "every man for himself." Naturally, the breakdown in cooperation heightens the severity of any potential disruption or departure because the benefits of going it alone begin to be worth more than continued participation in the group.

It's no wonder that nations like Sweden, Hungary, and Germany are agitating for lower rates under the circumstances. Others are sure to follow.

As of February 5th, the euro was up 11% against the yen already this year, which greatly complicates the EU situation against a backdrop of 0.8% growth projections in 2013. A weaker euro currency would help them regain economic prowess...but only if the yen held still.

Who will be the winners?

That's an entirely different question. I think the winners will change as the battle progresses. Using the 1930s as an example, it's clear that the country that moves first gains the most, so that constitutes winning at least early on in the battle. That's probably Japan.

However, once a good old-fashioned currency war gets underway in earnest, I think the winners-- if you can call them that-- are those who have the wherewithal to withstand the deepest drop. In a world of interlocked finance and an estimated $1.5 quadrillion worth of unregulated derivatives tied to numerous asset classes including sovereign debt, that's not a pleasant thought, because some nations have a lot farther to "fall" than others.

I believe the U.S. will be the victor in the medium-term. While this country no longer has the deep manufacturing base it once did, the majority of commodities are still traded in dollars, which builds in a de facto advantage.

The looming downgrade everybody fears will actually strengthen things as long as Team Bernanke maintains an "accommodative" stance - boy, have I come to loathe that word.

Longer term, however, it's a very different story.

China, with its 1.3 billion consumers and growing global influence, will be the clear winner. Right now the yuan is a partially blocked currency, but that's changing very rapidly as the economic balance of power shifts east. And it will continue to shift for at least the next decade.

Currency War

As I have noted repeatedly, China's acutely aware of the yuan's potential, which is why that nation has very carefully and methodically engineered its emergence into global markets over the past decade.

Beginning with partial trading ranges, proceeding through bilateral yuan-based swaps that bypass traditional global currency trading pairs and the development of its own futures markets, China is taking action to ensure the yuan has the foundation it needs.

As part of that, China's also buying gold in record amounts - over 834.5 metric tonnes in 2012, which is 93.53% more than the 431.2 metric tonnes it purchased a year ago.


Because China wants to ensure that the yuan has stable, long-term value in global markets when it becomes fully convertible in 2015 and begins trading freely from an offshore hub in London.

viernes, febrero 15, 2013



Gold And The U.S. Dollar
February 13, 2013
by: Bob Kirtley

The printing of more paper money usually has the effect of debasing or diluting the strength of that particular currency. The lowering of interest rates also renders a currency less attractive to investors, as better returns might be available elsewhere. The demise of the U.S. dollar can be attributed, in part, to both of the above reasons. However, when this debasement is plotted against other currencies as per the U.S. Dollar Index, we can see that it is having some difficulty when it comes to heading lower, as the chart below depicts.

(click to enlarge)

The reason for this is that the U.S. Dollar Index is made up of a basket of currencies that in themselves are not static and indeed, are involved in various forms of debasement as nations have taken the view that a weaker currency will boost their exports. Japan, for instance, has recently elected a new government whose mandate is to avoid deflation by printing more paper money in order to boost their economy and increase exports via a cheaper yen. As we write, the European Union is meeting to discuss the strength of the euro and the effect that it is having on their ability to export goods. As each nation adopts similar policies, the result could be a kind of gridlock, as every action taken to weaken one's currency is neutralized by a similar action taken by the competing currencies. So we can see that despite Operation Twist and Quantitative Easing, the U.S. dollar is sitting at the "80" level on the Index.

Gold tends to have an inverse relationship with the dollar, and has increased when the value of the dollar has declined. Similarly, as the Japanese yen declined, gold prices reached a record high when purchased with the yen.

So if the actions of our political masters are copied across the board, we could find ourselves in a situation where the dollar trades within a limited range for some time to come, thus capping an advance in gold prices, at least in dollar terms.

One would think that with all this paper money swamping the world, we would experience a huge leap in inflation, which is contrary to what the "official" figures suggest, that inflation is under control.

This leads to us to conclude that, for now, the demise in the dollar is on hold and that inflation is having little effect on the price of gold. I have difficulty believing that inflation will not come roaring back, but for now, we have to deal with what we have. If gold prices are to head north, then it will be because of the fundamentals for gold; supply and demand. Consideration should be given to central bank purchases, the Russian and Chinese imports, the demand for physical gold as opposed to paper gold, various mints running out of products to sell, the reduction in available scrap metal, the ever-increasing difficulties in mining and the lack of new major discoveries. All of which suggests support for gold prices in the longer term, however, the short-term outlook is, as always, subject to volatile oscillations in both directions.

With this in mind, we need to proceed gently with our positioning in the precious metals market place, and also be prepared to weather the storm if and when it materializes.