by Michael Pettis, China Financial Markets
In China, I have argued many times, high growth is no longer compatible with a strengthening balance sheet. If China is growing at a rate that approaches or exceeds five or six percent, it is probably a safe bet that debt is rising faster than debt servicing capacity.
The good news is that the current leadership seems very clear about the need to implement reforms, and also understands that this is going to be politically a difficult process. Last week Xinhua had this article:
China must maintain economic growth and persevere with market-oriented reforms in the face of multiple risks in the economy, the new helmsman of China’s ruling party has said. The government should continue its proactive fiscal and prudent monetary policies next year and improve the economy’s internal vigor and dynamic, said Xi Jinping, general secretary of the Communist Party of China (CPC) Central Committee, at a symposium held with non-Party figures here last week.
“The growth that we achieve must be tangible, not exaggerated growth, and should be efficient, of good quality and sustainable,” Xi said. He urged adherence to market-oriented reforms and well-conceived top-level reform designs.
Two weeks earlier the South China Morning Post had a similar, if less politically worded, message:
The man who will become premier next year has made a strong case for reform just days after the unveiling of the Communist Party’s new leadership, saying reform is the biggest dividend. Li Keqiang, speaking at a seminar with selected local officials on Wednesday, organised by the State Council, said China would still be able to see the completion of a “moderately prosperous society” by 2020 even with a lower economic growth rate of about 7 per cent a year, China News Service reported.
“We do not blindly pursue gross domestic product growth and it is very likely that our future development will go through a period of moderate growth rate that can hardly stay in double digits,” he said. “To achieve the goal [of building a moderately prosperous society], we’ll have to rely on reform, which still has enormous scope and potential to be explored.” Analysts said the remarks by Li, 57, who was elevated to No 2 in the party hierarchy last week and will succeed Premier Wen Jiabao in March, could be viewed as a strong political message calling for bolder reform.
Last week Xi Jinping, the newly elected general secretary of the CPC Central Committee, toured Guangdong Province in a self-conscious reference to Deng Xiaoping’s famous 1992 tour supporting reform. Xi’s tour was widely interpreted as a similar signal about Beijing’s intentions. As an article in the People’s Daily put it:
During his recent tour of Guangdong Province, Xi Jinping, general secretary of the CPC Central Committee, stressed the need to accelerate economic restructuring, describing the task as imperative. Xi’s latest southern tour is widely seen as a signal of the new leadership’s determination to firmly deepen reform. Xi met with business leaders in Guangdong on Sunday. This is in accordance with widespread concerns and anxiety over the nation’s economic future.
Economic reform directly decides the growth and distribution of wealth, people’s living standards and social confidence. It is in line with the trend of placing emphasis on adjusting the nation’s economic development model. After three decades of speedy development, the nation should take another look at the advantages it once relied upon. The era in which prosperity can be realized through labor-intensive industries and extensive production is becoming a thing of the past.
Restructuring the economy is a real challenge in the context of China’s rise. It is during this process that China will begin a decisive competition with developed countries.
More interestingly to me, in what is probably the most authoritative newspaper in the country, was that the article pointed very specifically to the kinds of problems Beijing expects to encounter and seemed to be warning everyone that reform is going to be tough and divisive:
In recent years, it’s been shown that the rhetoric of reform is widely welcomed, but practically carrying it out can meet with unexpected setbacks. This is natural. Only very few fortunate reformers implement reform measures with the public applauding all the way.
The Chinese have various demands, and some conflict with each other. For instance, public awareness of environmental protection is rising, and the worship of GDP is being opposed. However, public panic arises as soon as economic growth begins to slow down.
…Reform is exciting, but it is also full of difficulties and challenges. Xi said in Guangdong that China must squarely face difficulties and challenges, strive for the best results and firmly seize the initiative. This deserves consideration by the entire Party and society.
These expected, and exciting, “difficulties and challenges” are, I suspect, the things we should be most concerned about in our attempts to understand the pace of reform. The history of developing countries suggests that most countries fail in the reform and adjustment process precisely because the sectors of the economy that have benefitted from the distortions are powerful enough to block any attempt to eliminate those distortions.
I have written several times that this reform process may have already begun in earnest, and that in 2012 we have seen, for the first time, some real economic rebalancing, but not everyone agrees. The current issue of Caixin has an article that argues that the imbalances may have gotten worse, not better:
One of China’s top government think tanks warns that the nation’s economic imbalance has worsened alarmingly with investment growth overshadowing consumption. In a report published on December 12, the China Academy of Social Sciences (CASS) said the structural imbalance in the country’s growth model, measured by its self-devised index, has significantly worsened over the past decade and more.
CASS is a ministry-level research institute that advises the State Council. Its index gauges economic imbalance on a scale of 0 to 1. The higher the index, the worse the imbalance. China managed to bring the index down from 0.5644 in 1991 to 0.4513 in 2000, the report said. But the figured climbed to 0.6173 in 2012, as investment surged relative to consumption.
From 2000 to 2009, investment as a share of GDP rose from 35.3 percent to 47.2 percent, while private consumption declined from 62.3 percent to 48.2 percent, the report said. Income distribution inequality and an imbalance in the international payment account, which resulted mainly because of a long-running trade surplus, were also factored in when calculating the economic imbalance, the report said.
CASS’ recommendation to encourage domestic consumption echoes that of many other academic and business researches, and the new central leadership has vowed to address imbalances by exploring domestic consumer market.
I have no idea how the index is constructed, but it seems that CASS believes that even in 2012 we have not seen a reversal of the growing imbalances in the Chinese economy. This puts all the more pressure on Beijing to change the growth model quickly.
But will everyone cooperate?
But certainly not every one in China is confident that Beijing will be able to force through the reforms that are widely accepted as necessary without a serious fight. There were two interesting and related articles in this week’s South China Morning Post that may indicate the degree of worry. They also show that it is not just the economic policymaking elite in beijing that recognizes the urgent need for economic adjustment and reform.
The first article tells you much of what you need to know in the title (“China’s rich and skilled leave in record numbers”). It goes on to say:
More than 150,000 Chinese became permanent citizens in major immigrant countries including the United States, Canada, Australia and New Zealand last year, topping the world’s list of overseas migration in absolute numbers, a recent report revealed. The Centre for China and Globalisation (CCD) and Beijing Institute of Technology (BIT) School of Law jointly released their findings in the Chinese International Talents Annual Blue Book’s International Migration Report (2012) on Monday, according to media reports.
…Another report by Hurun Research Institute and Bank of China in 2011 found that 14 per cent of China’s high-net-worth individuals had either emigrated or were in the process of doing so. In addition, 46 per cent were considering permanently moving overseas through various immigrant investor programmes with real estate, foreign currency deposits and stocks being the primary areas of investment.
US Citizenship and Immigration Services (USCIS) declared that 41 per cent of total EB-5 Immigration Investor Programme applicants were Chinese while the Australian Department of Immigration and Citizenship reported that 61.5 per cent of applicants for the Business Skilled Migration Programme were Chinese.
We have known for a while that Chinese with the means to do so are increasingly opting to move abroad. There are many reason for this, of course, but China is still growing much faster than the rest of the world, even if some of us don’t fully accept the official numbers, and so for people to look for opportunities abroad suggests at the very least that either some of these people seriously doubt the sustainability of China’s current growth and expect it to come crashing down, or that they are worried about political uncertainty and the possibility of difficulty ahead. Or both.
The second article, also by the South China Morning Post, involves data from a completely different source and for completely different purposes, but it may broadly be telling the same story. The article is based on a very interesting study conducted by Global Financial Integrity on illicit capital flows around the world. The article summarizes their study as:
Some 150 developing countries, led by China, have been the source of flows of tainted money totalling US$5.9 trillion over 10 years through 2010, Global Financial Integrity, a research and advocacy group in Washington, DC, said.
Flows of illicit money from tax evasion, crime and corruption in the developing world have roared back to pre-financial crisis levels, topping nearly US$859 billion in 2010, near the all-time high of US$871 billion in 2008, it said. In 2009, following the global financial crisis, the figure dropped to US$776 billion.
China tops the list of developing countries sending illicit money abroad, either to offshore havens or to financial institutions in developed countries, GFI said in a study. In 2010, illicit money out of China totalled US$420 billion, the report said, and exceeded US$2.7 trillion for the decade ending in 2010 – nearly half that period’s total for all developing countries.
For comparison’s sake, Malaysia came second, with over $64 billion in 2010 and $285 billion for the decade. Mexico was in 2010, with over $51 billion in illicit flows, and $476 billion for the decade. The study acknowledges that it does not include cash transactions, so actual illicit flows are probably higher, maybe even significantly higher.
You can find the full ranking of 71 countries here, and it shows, among other things, that illicit capital flows from China are roughly equal to the sum of illicit capital flows from the next fifty countries. I haven’t been able to adjust the numbers for GDP size (larger economies should on average have larger illicit outflows), but when you consider that the next fifty countries include Mexico, Malaysia, Russia, India, Indonesia, Poland, Brazil, Turkey, Argentina, Hungary and forty others, I think it is pretty safe to say that China’s ranking as number 1 is not just a function of its being the largest developing economy in the world.
As a share of GDP, in other words, Chinese illicit outflows seem easily to exceed the average for all developing countries. Mexico’s GDP, for example, is roughly one-seventh the size of China’s, and yet for all its drug money, its illicit flows were only one-eight those of China. This means that the Chinese business and political elite export illicitly a larger share of the Chinese economy than the combination of the Mexican business and political elite and their drug cartels.
One of the most interesting paragraphs in the study, for me, concerned trade invoicing:
Trade misinvoicing is the preferred method of transferring illicit capital from all regions except the MENA region where it accounts for only 37 percent of total outflows for the decade ending 2010 (Chart 6). In declining order of dominance, the share of trade misinvoicing in total outflows by region is Asia (94.0 percent), Western Hemisphere (84.0 percent), Africa (65.0 percent), and developing Europe (53.0 percent). Large current account surpluses of countries in the MENA region driven by crude oil exports entail larger outflows through the balance of payments. In the case of Europe, the relatively large unrecorded outflows from the Russia’s balance of payments dominate regional outflows.
This creates, for me, a real and very obvious problem with understanding China’s trade figures. According to the study, illicit money out of China totaled US$420 billion in 2010. The study also claims that in Asia nearly all of the illicit money flows (94%) occur through mis-invoiced trade, which suggests, of course, that the trade numbers can be seriously distorted. If capital is being secretly taken out of the country through trade, exports are likely to be under-reported, imports are likely to be over-reported, and the real trade surplus is almost certainly larger than the reported trade surplus.
How much does this illicit capital flow impact China’s real trade account? Here is a January 2011 Xinhua article on China’s 2010 trade account:
China’s foreign trade last year jumped 34.7percent year on year to more than 2.97 trillion U.S. dollars while its trade surplus fell 6.4 percent to 183.1 billion U.S. dollars, the General Administration of Customs (GAC) said Monday.
The country’s exports grew 31.3 percent year on year last year to 1.58 trillion U.S. dollars while imports surged 38.7 percent to 1.39 trillion U.S. dollars, said the GAC. “China’s foreign trade is, in general, heading towards a balanced structure,” said the GAC in a statement on its website. The trade surplus accounted for 6.2 percent of all foreign trade last year, down from 8.9 percent in 2009 and 11.6 percent in 2008.
It is clear that these illicit capital flow numbers are pretty significant in relation to the trade numbers. China’s trade surplus in 2010 was reported to be $183 billion, but GFI claims that Chinese illicit capital flows (I assume that most if not all represents outflows, or even net outflows) for the year were $420 billion, most of which may have been recorded as higher exports or lower imports.
Even if these numbers are way off, they still suggest that China’s real trade surplus may have been substantially higher than reported, with much if not most of the money parked offshore for safekeeping. Among other things these numbers also suggest that the sluggish import growth of the past year, which smart people like Andy Xie insist are among the many numbers that are not compatible with the high official growth rates claimed by the government, may be even lower than reported.
Obviously I am not the first person to complain about the opacity of Chinese economic data and the difficulties we often have in reconciling one set of numbers with another, but I think it is important to note that while opacity may not be a terrible problem during the optimistic up-cycle (in fact hazy data give us more leeway to daydream pleasant things), it can suddenly become a huge problem during the pessimistic down-cycle, when they don’t even constrain our nightmares. What is worse, an increase in opacity, which we are clearly seeing in the financial system, is usually a herald of bad tidings. When the economy starts to get bad, often the first impulse for many is to massage or hide the data.