Dr. Doom and the Chinese Economy

China’s Ministry of Railways recently announced its high-speed trains will run slower in order to cope with problems of high operating costs and low passenger figures. This was promptly seized upon as a matter of important symbolism … for the United States.

Charles Lane, an irregular contributor to the Washington Post’s famously right-wing op-ed page, echoed the view of many conservative pundits when he wrote that the Chinese move vindicated Republican opposition to President Barack Obama’s plans for high-speed rail in the United States.

Lane wrote:

Meanwhile, in the United States, Obama’s high-speed rail plan, originally set at $53 billion over six years, has gotten a thorough democratic vetting. Three freshly elected Republican governors spurned federal dollars for high-speed rail, fearing a long-term burden on their budgets; homeowners in liberal Northern California are fighting construction through their neighborhoods; and the president agreed with Congress to trim current-year spending as part of a budget deal.

On the whole, I’d say China should envy us. [1]

In Lane’s view, partisan gridlock will allow the United States to avoid the perils of socialist big-government planning and enjoy the enviable economic trifecta of decaying infrastructure, sluggish growth, and high employment.

By way of instructive contrast, the financial year 2011 cost of US military operations in Iraq and Afghanistan is expected to exceed US$171 billion (for a cumulative total of over $1.2 trillion to date). Fortunately this exercise in financially irresponsible big-government paternalism is discretely piling up corpses and blasting holes overseas, instead of affronting the eyes of value-conscious American taxpayers with the infuriating spectacle of shiny new high speed trains in their backyards. [2]

Nouriel Roubini observed the same Chinese trains and was able to extract some useful lessons for the Chinese economy.

China has grown for the last few decades on the back of export-led industrialization and a weak currency, which have resulted in high corporate and household savings rates and reliance on net exports and fixed investment (infrastructure, real estate, and industrial capacity for import-competing and export sectors). When net exports collapsed in 2008-2009 from 11% of GDP [gross domestic product] to 5%, China’s leader reacted by further increasing the fixed-investment share of GDP from 42% to 47%.

Thus, China did not suffer a severe recession – as occurred in Japan, Germany, and elsewhere in emerging Asia in 2009 – only because fixed investment exploded. And the fixed-investment share of GDP has increased further in 2010-2011, to almost 50%.

The problem, of course, is that no country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. China is rife with overinvestment in physical capital, infrastructure, and property. To a visitor, this is evident in sleek but empty airports and bullet trains (which will reduce the need for the 45 planned airports), highways to nowhere, thousands of colossal new central and provincial government buildings, ghost towns, and brand-new aluminum smelters kept closed to prevent global prices from plunging further. In the short run, the investment boom will fuel inflation, owing to the highly resource-intensive character of growth. But overcapacity will lead inevitably to serious deflationary pressures, starting with the manufacturing and real-estate sectors.

Eventually, most likely after 2013, China will suffer a hard landing. All historical episodes of excessive investment – including East Asia in the 1990s – have ended with a financial crisis and/or a long period of slow growth. [3]

The views of Dr Roubini, a professor at New York University and lord of an extensive econometrics and punditry empire, carry significant weight in China because of his reputation as “Dr Doom” – the economist who, as early as 2005-6 and virtually alone among his peers, predicted the catastrophic popping of the US real estate bubble and the subsequent unraveling of the world financial system.

Dr Doom’s diagnosis of the problem is widely accepted. China engaged in an orgy of infrastructure building to stimulate industrial – as opposed to consumer – demand in order to dodge the 2008 recessionary bullet.

China’s extravagances, most notably in the area of high-speed rail, do need some paring back.

As for the prognosis – that China will finally, in 2013, experience the hard landing that economists have continually predicted since the economy of the People’s Republic kicked into high gear – views are considerably more mixed.

Morgan Stanley’s analysts weighed in with an optimistic prediction that the Chinese consumer will, at long last, step up and drive the restructuring of the Chinese economy away from export-oriented industries and immense infrastructure projects that generate much more prestige than cash flow:

Most controversially perhaps, the analysts predict what they call “a golden age of consumption”. China’s consumption as percentage of GDP is currently among the lowest in the world, which many analysts attribute to cautious Chinese families saving money for their retirements or to pay for healthcare bills. But Mr Wang says Chinese consumers aren’t waiting for the government to build a new social safety net before they spend more. They’re waiting to make more money, which they’ll do as labor demand boosts wages over the coming decade. Consumer spending zoomed in [South] Korea and Japan after those countries reached the $7,000 mark. [4]

Shaun Rein of the China Marketing Group put some factual – or at least statistical – meat on the rhetorical bones in an an op-ed for CNBC:

My firm interviewed 5,000 Chinese in 15 cities last year. It is true consumers over the age of 60 reported savings rates near 60% because they feared soaring medical and housing costs. After living through decades of upheaval and missing out on the recent economic boom, they remain thrifty. Little can be done to change decades of ingrained habits.

Our research suggests the key metric Roubini misses is shifts in how younger Chinese spend. Respondents under 32 years old had effective savings rates of zero. They remain confident about their money-making potential. Secretaries earning $600 a month commonly save two month’s salary to buy the latest Apple iPhone or Estee Lauder cosmetics.

Consumer finance reforms are also spurring more consumption for younger Chinese. Total credit cards in circulation rose from 13.5 million in 2005 to 240 million in 2010 and will rise 22% annually for five years. More than 80% of the 18 million auto sales there last year were paid 100% up front. Brands like Toyota and General Motors are starting to push financing options, which will further unlock consumption. The data dispels the myth that Chinese are culturally high savers. [5]

Xinhua took note of Roubini’s arguments and the rebuttals in a Chinese-language article.

The basic theme was polite skepticism, pointing out that China’s growing economy had in the past defied predictions of overbuilding by catching up to the infrastructure and productive capacity poured into the economy.

But as for the future…

However, Roubini is perhaps quite correct in one respect. He believes that China’s infatuation with excessive investment will lead to enormous waste and a significant decrease in the growth rate in the future. This view of his is very persuasive. [6]

A Caixin article picked up on the “future” theme, pointing out that the 2008 infrastructure investment bulge was a temporary measure to counteract the global economic slump.

An academic at Beijing Normal University, Li Shi, was interviewed by Caixin. He also pinned his hopes on the Chinese consumer. According to Li:

In the past, increases in individual incomes have lagged behind GDP growth. However, the 12th Five Year Plan intends to change this. It should be said it can be changed, because in the coming years there will be a major change in China’s entire economic structure. If the economic structure can change, urbanization will accelerate, excess labor capacity in the villages will be mopped. It is possible that within three to five years, if the labor market experiences conditions of demand exceeding supply, worker’s wage growth will accelerate. This would change the problem of excessively low personal incomes.

Also, China has been continually upgrading the social safety net … which will, to a certain extent, contribute to an increase in individual consumption..

Maintaining 7% growth and maintaining relatively full employment while at the same time the government structurally adjusts its outlays and use a greater proportion to meet the demands for improved people’s well-being, all can increase personal consumption.

Lot of conditionals, ifs, cans, coulds, and shoulds in Mr Li’s observations. [7]

Roubini identifies some deeply embedded structural issues for the Chinese economy that he defines as critical and fears will take “two decades” to reform, rendering moot hopes of a soft landing in the next couple years:
To ease the constraints on household income, China needs more rapid exchange-rate appreciation, liberalization of interest rates, and a much sharper increase in wage growth. More importantly, China needs either to privatize its SOEs [state-owned enterprises], so that their profits become income for households, or to tax their profits at a far higher rate and transfer the fiscal gains to households. Instead, on top of household savings, the savings – or retained earnings – of the corporate sector, mostly SOEs, tie up another 25% of GDP.

But boosting the share of income that goes to the household sector could be hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented firms, and provincial governments, all of which are politically powerful. As a result, China will invest even more under the current Five-Year Plan.

Continuing down the investment-led growth path will exacerbate the visible glut of capacity in manufacturing, real estate, and infrastructure, and thus will intensify the coming economic slowdown once further fixed-investment growth becomes impossible. Until the change of political leadership in 2012-2013, China’s policymakers may be able to maintain high growth rates, but at a very high foreseeable cost.

Dr Roubini has a point. The 12th Five-Year Plan is not a glorious political and economic document. Its apparent priority is to kick the can down the road rather than risk the big reforms that might upset the applecart prior to the leadership handover.

Instead of moving openly and aggressively on the issue of the real estate bubble – thereby gutting the finances of the SOEs and local governments that rely on the real estate boom for significant revenues – the Five-Year Plan puts a political band-aid on the problem by mandating the construction of low-income housing for citizens priced out of the private sector residential market.

The perpetual lure of the bubble, combined with access to virtually cost-free money courtesy of China’s inflation-beleaguered individual depositors, continues to drive runaway bank lending, despite government efforts to cool things down by raising interest rates, boosting reserve requirements, limiting the leverage available to buyers of first and second homes – and trying to reduce local government dependence on revenues from real estate boondoggles by introducing a property tax.

As Reuters reported:

“Net interest margins for the quarter were higher, and that’s the most important factor for Chinese banks,” said James Antos, a banking analyst with Mizuho Securities. [8]

Higher “net interest margins” translated into expected average profit margin gains of 29% for the banking sector in just one quarter over last year.

The undervalued yuan is still one of the best bargains on the planet, especially since the burgeoning Chinese economy offers plenty of places to invest it. China’s exchange rate policy continues to suck in dollars – hot money and investment dollars as well as export earnings – that contribute to the real estate and stock market bubbles.

China’s forex reserves are ballooning to ridiculous levels – ridiculous as in $3 trillion. The immense reserves – and the exchange rate policy that enabled them – are no longer a source of reflexive national pride. They are a source of anxiety, as Zhou Xiaochuan, the head of the People’s Bank of China, conceded:

“Foreign-exchange reserves have exceeded the reasonable levels that we actually need,” Zhou said. “The rapid increase in reserves may have led to excessive liquidity and has exerted significant sterilization pressure. If the government doesn’t strike the right balance with its policies, the build-up could cause big risks,” he said, without elaborating. [9]

In the current environment, an ever-growing mountain of foreign exchange represents a double headache. Forex inflows have to be purchased using yuan, and then yuan bonds issued to sop up the excessive liquidity – the sterilization pressure Zhou is talking about, and a most unwelcome contributor to China’s worrisome inflation rate. Meanwhile, the forex has to generate some kind of return, but there’s no good place to put $3 trillion – thanks in part to the inrush of Chinese dollars, the rate on short term US Treasury paper is near zero.

Raising interest rates in a global environment of rock-bottom interest rates is not a recipe for success, as Brazil is learning. Rapid appreciation of the yuan is emerging as a possible measure to curb inflation and cool the economy.

Even so, allowing rapid yuan appreciation in order to put China’s financial and forex policy on an even keel is an unnerving leap into an unknown of diminishing exports and growing unemployment that the Chinese government is still hesitant to make.

In sum, China’s response to its overheating and structurally unbalanced economy is not a profile in courage. Maybe it’s a disaster waiting to happen. Over at the quant-hive Seeking Alpha, Craig Pirrong pontificated:

… whether Chinese economic management can avoid the kind of catastrophe that Roubini and I consider to be likely depends on your view of the efficacy of centralized economic management of the type that China practices. The Thomas Friedmans of the world, and arguably Obama, believe that such dirigisme is superior to the messy, decentralized, unplanned and non-centrally coordinated actions of greedy individuals in markets. People like me, conversely, believe that the visible hands of greedy, largely ignorant, and short-sighted politicians and bureaucrats is likely to lead to inferior outcomes.

Pirrong’s smug celebration of free-market omniscience is a little harder to digest when one remembers that, in 2006-2008, the invisible hand was not efficiently allocating capital. Instead it was engaged in busy, sticky self-gratification as hedge funds and investment banks pumped subprime debt into the financial markets to give them an excuse to sell more derivatives and borrow more money until leverage was over 35:1… so they could buy and sell more derivatives.

The credit default swap (CDS) market grew to $60 trillion – or $38 trillion, depending on how you keep score (for comparison purposes, total US GDP is $14 trillion).

A delicious vagueness was part of the whole CDS magic. The swaps were almost entirely synthetic, written and purchased by financial institutions that had no exposure to the underlying security or commodity. The market was unregulated, open only to the so-called “experienced”, ie deep-pocketed investors, and characterized by fearsome information asymmetries.

Despite declarations of its defenders that the existence of this global casino promoted efficiency and liquidity, the global market’s fundamental lack of transparency came back to bite it. As the real estate market finally soured, a spasm of panic and mistrust in 2008 caused the entire financial system to seize up; the market lost the ability to price the complex and opaque swaps, capital flowed out of the financial companies, and credit was unobtainable. Titanic leveraging converted into titanic deleveraging and the financial markets were overwhelmed.

The financial companies thereupon slunk back to the public trough like whipped hounds to convert to bank holding companies to avail themselves of government-insured deposits, or to obtain government assumption of toxic waste debt in order to enable mergers between stronger firms and their crippled rivals.

The public – the “little guys” who were disqualified from participating in the derivatives financial orgy in the first place – were not allowed to simply play the role of fascinated and eventually horrified bystanders. When the mess unraveled, they paid the toll in lost retirement savings, lost homes, lost jobs, and the cutbacks in public services that came with collapse of tax revenues in the recession.

The only force to survive intact was the industry’s invincible self-regard, made possible only by its convenient and conveniently short memory, the tender mercy of bespoke politicians and regulators worldwide, and the co-dependent driveling of the fanboy financial press.

In contrast to the United States, China’s financial system is biased toward regulation, government management, keeping a lid on international capital flows, and ignoring calls for financial innovation that serve primarily to enlarge and fatten the profits of the financial sector.

China’s wishlist for reform of the international financial system is incorporated in the April 14 declaration at Sanya, Hainan, after a summit of the leaders of Brazil, Russia, China, India and South Africa – the BRICS group of nations.

The declaration makes it clear that the PRC believes that the current default attitude – ignoring the role of the sizable Chinese government stimulus in averting a global recession and finger-wagging China for its exchange-rate peccadilloes while disregarding the Western world’s colossal financial fail – should be abandoned.

Instead, the PRC is yearning for an endorsement of China’s government-knows-best financial policy on a global scale: a coordinated international effort to make the international flow of capital and trade in derivatives more transparent and susceptible to multilateral intervention.

The conclusion that the United States, by reason of its serial regulatory and fiscal transgressions, is no longer fit to lead the international financial system (or impose fealty to its free-market nostrums) is also made clear by the call for a new reserve currency protected from the machinations of the US Federal Reserve.

16. Recognizing that the international financial crisis has exposed the inadequacies and deficiencies of the existing international monetary and financial system, we support the reform and improvement of the international monetary system, with a broad-based international reserve currency system providing stability and certainty. We welcome the current discussion about the role of the SDR [the special drawing rights of the International Monetary Fund] in the existing international monetary system including the composition of SDR’s basket of currencies. We call for more attention to the risks of massive cross-border capital flows now faced by the emerging economies. We call for further international financial regulatory oversight and reform, strengthening policy coordination and financial regulation and supervision cooperation, and promoting the sound development of global financial markets and banking systems.

17. Excessive volatility in commodity prices, particularly those for food and energy, poses new risks for the ongoing recovery of the world economy. We support the international community in strengthening cooperation to ensure stability and strong development of physical market by reducing distortion and further regulate financial market. The international community should work together to increase production capacity, strengthen producer-consumer dialogue to balance supply and demand, and increase support to the developing countries in terms of funding and technologies. The regulation of the derivatives market for commodities should be accordingly strengthened to prevent activities capable of destabilizing markets. We also should address the problem of shortage of reliable and timely information on demand and supply at international, regional and national levels. The BRICS will carry out closer cooperation on food security. [10]

Good luck with that.

The counterintuitive lesson that the US and Europe seem to have derived from the financial meltdown is that debt, stimulus, reform, and regulation are only going to make matters worse. With an unwillingness to regulate capital and derivative markets domestically, the will to regulate them internationally is non-existent.

The most interesting social experiment in the world today is communist China’s attempt to manage economic stresses through classic national Keynsianism, while the United States gyrates in an apparent death spiral of deregulation, austerity, and defunding of its national and local government services.

To be sure, China has to date displayed a distinct aversion to the hard choices that would reform its economy and put it on a firm footing for sustainable growth – such as pricking the real estate bubble and undertaking a major and risky appreciation of the yuan.

The difference is that Chinese Keynesianism retains the fiscal, regulatory, and political means for intervention, adjustment, redirection, and if desirable, deregulation and privatization.

In the United States, once the revenue and regulatory apparatus is gutted as a result of political calculation and national disillusionment, will there be any turning back?

Perhaps that’s the real approaching train wreck.

1. China’s train wreck, Washington Post, Apr 21, 2011.
2. Estimated War-Related Costs, Iraq and Afghanistan, Infoplease, by end of the fiscal year of 2011.
3. China’s bad growth bet, Aljazeera, Apr 18, 2011.
4. Great China Debate Continues: How Fast, How Long?, Wall Street Journal, Apr 25, 2011.
5. Why Nouriel Roubini Is Wrong on China’s Economy, Apr 19, 2011.
6. Click Here for the Chinese text of Xinhua.
7. Click Here for the Chinese text on Sina.com.
8. Hefty Chinese bank profits expected despite govt tightening, Reuters, Apr 25, 2011.
9. Zhou Says $3 Trillion China Reserves Have Risen Beyond ‘Reasonable’ Level, Bloomberg, Apr 19, 2011.
10. Sanya Declaration of the BRICS Leaders Meeting, Chinese Embassy in Norway, Apr 14, 2011.

Peter Lee writes on East and South Asian affairs and their intersection with US foreign policy.


Peter Lee is creator of the Patreon Peter Lee’s China Threat Report.