by Michael Pettis, China Financial Markets
I have been arguing for several years that once China begins the adjustment process, which I expect to characterize the ten-year period of the current administration, growth rates must slow significantly. My expectation for long-term growth is that it shouldn’t average much above 3-4% annually. This is what it will take for household consumption to rise to roughly 50% of GDP in a decade if consumption growth can be maintained at its historic rates of around 8%.
But I always warn that this is likely to be an upper limit, not a lower limit, to growth. The key is whether or not it is possible to maintain current levels of consumption growth once investment growth is sharply reduced. A recent paper by the IMF on the topic is very interesting and not encouraging.
In the paper (“China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”) Il Houng Lee, Murtaza Syed, and Liu Xueyan team up again to examine the impact of investment in different regions and sectors of the economy. The abstract of the paper is:
This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.
If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.
Among the interesting findings of the paper, one is not (to me) at all unexpected. The authors find that investment is much less efficient in the poorer inland provinces than in the richer coastal provinces. This shouldn’t be a surprise. The inland provinces have much lower levels of worker productivity and lower social capital. This means that they should be much less capable of absorbing high levels of capital than the coastal regions.
But this argument – so logical, at least to me – flies in the face of the single most widely-used argument that China bulls have made in favor of additional investment. They argue that because capital stock per capita is much lower in China than in the US, the automatic conclusion is that China has a near-infinite ability usefully to expand investment – at least until it begins to approach the frontier of US levels. If this argument is true, investment should be much more productive in the inland provinces than in the coastal provinces because the inland provinces have much lower capital stock per capita than the coastal provinces and so are further from the “frontier”.
But it isn’t, according to the IMF paper. It is even more wasteful. Richer, more productive economies with higher levels of social capital (which include property rights, a clear legal framework, education, minimal regulatory distortions, minimal government intervention, limited corruption, etc.), in other words, are better able to absorb investment than poorer less productive economies. The appropriate level of investment for a country that is much poorer than the US is much lower than the appropriate level in the US. China does not have infinite ability to expand investment productively, and in fact, I would argue, has long ago passed the point where investment in the aggregate is wealth creating.
And this applies within China. It simply isn’t true that the poorer the province, the more investment should be poured into the province. The poorer inland provinces simply are incapable of absorbing investment, and before the authorities pour money into these regions they will need to make the difficult legal and social reforms that improve underlying productivity and social capital. Until then, additional investment is even more likely to result in negative wealth creation in the inland provinces than in the coastal areas.
The other very interesting finding of the IMF paper is that – surprise! surprise! – consumption growth is itself dependent on investment growth, and this is more true in the inland provinces than in the coastal provinces. The more money you pour into investments, no matter how unnecessary, the more local households consume. This shouldn’t have been unexpected because local household income is so dependent on consumption, especially in regions in which government-led infrastructure spending is the only real source of economic activity – such as the poor inland provinces.
The conclusion, I think, is that it is going to be very hard for China to maintain the current level of consumption growth if investment stops growing, and if consumption can only create 4.2 percentage points of GDP growth at current levels, why would we assume China’s long-term growth rate is much above that unless we assume that China can keep investment levels growing for a long time? Another conclusion of the IMF paper – very useful from a policy point of view – is that certain kinds of investment, in agriculture and services, for example, have a much more positive effect on consumption than others (it is probably not a coincidence that these are likely to be the least wasteful investment areas). In that case it suggests that the brunt of the adjustment in investment growth should not occur in the agricultural and service sectors.
Assets and Liabilities
On Friday Tom Orlik had an interesting article in the WSJ about Chinese debt, in which he cites analysts who argue that because the government has assets that exceed the liabilities, we should be less concerned about the size of the debt. It’s a short article worth citing in full because, I think, it demonstrates a number of popular misconceptions:
China’s debt is scary, but its assets are reassuring. Taken together with local government borrowing and other obligations, China’s gross government debt could be as much as 60% of gross domestic product, says UBS China economist Wang Tao. Corporate and household debt has also been on a tear, up to 201% of GDP at the end of the first quarter from 138% at the end of 2008 according to Bernstein Research.
Those are alarming trends. But debt is only half of the story. On the other side of China’s balance sheet, there are some significant assets. The net assets of state-owned enterprises reached 27.3 trillion yuan ($4.4 trillion) in 2011 equal to 58% of GDP in that year, says Dragonomics China analyst Andrew Batson. The state is also a major owner of land. China’s public sector is out of the red, even without taking account of massive foreign exchange reserves, which couldn’t easily be used to bail out domestic problems.
For the corporate sector, assets have grown in line with liabilities. Take the firms listed in Shanghai–China’s flagship equity market. The asset to liability ratio for this group has risen to 118% in 2012, up from 113% in 2007, according to Factset. Industrial overcapacity and reckless building by local governments mean some of China’s investment has not been valuable. A bridge to nowhere is not easy to bank. In a crisis, political paralysis and illiquid markets mean selling assets would be tough–Latin American countries discovered as much during debt crises in the 1980s and 1990s.
Still, China’s strong asset base points to a fundamental difference with the build-up of debt in the U.S. Borrowing to fund consumption–the U.S. model–does not create a stream of future income or an asset that can be used for repayment. Borrowing to fund investment–the China model – does.
One of the big problems with analysis of China is that most analysts seem to have little experience with other developing countries, and especially with debt problems in other developing countries. As a result they tend to repeat mistakes in a fairy predictable way. For one thing, they look at current debt levels without factoring in what I call balance sheet inversion in my 2001 book The Volatility Machine.
Basically what this means is that under certain kinds conditions or balance sheet structures, an adverse shock, or slowing growth, causes an explosion in contingent liabilities, most often through the banking system, and it is this explosion in contingent liabilities that creates the debt problem for the country. If growth slows in China, in other words, this should cause a sharp rise in NPLs, especially if borrowers are counting on rising prices to service the debt, which will itself cause slower GDP growth, and so on in a self-reinforcing way. If we want to understand the debt problems facing China we have to consider not just the current debt on the balance sheet but also what the balance sheet is likely to look like after an adverse shock.
In fact there is a regular pattern that we see when debt levels rise in a country to the point at which either we suffer from a debt crisis or from a lost decade of difficult adjustment. First, as sovereign debt levels and contingencies rise, we deny that they are rising. Then we acknowledge that they are rising but we argue that debt levels are very low. Then we acknowledge that they are high, but we point out that the sovereign has more assets than debt. Next we acknowledge that the excess of assets is irrelevant but the country is only suffering from a liquidity crisis. Finally we acknowledge that there is indeed a debt problem.
This seems to be what the WSJ article is describing. It is good that even analysts who used to be much more optimistic are finally recognizing that there is too much debt, but is it true that the Chinese government has more assets than debt? Of course it is. But this was also true in every single country in history that has ever had a debt crisis. Governments always have enough assets, or taxable authority, but since they enjoy sovereign immunity the question is not whether they have enough assets to cover the debt but rather whether they are willing to liquidate assets (and the power that comes with control) to cover debt. They almost never are.
In fact this whole issue is irrelevant. China is not going to default on its debt, and so whether or not lenders can seize government assets doesn’t matter. What matters is whether the returns on the assets are sufficient to pay the true unsubsidized cost of the debt. If they are not, then there must be a transfer from somewhere else to cover the difference, and this somewhere else is usually, and has been in the case of China, the household sector. It is the size of this transfer that causes growth to slow.
This is an abbreviated version of the newsletter that went out three weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at email@example.com, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.