China’s Growth Problem and the Needed Reforms

In a surprisingly frank analysis of the economic outlook for China, David Cui, head of China equity strategy for Bank of America Merrill Lynch, explained that the very well-known problem is that Chinese investment as a percentage of gross domestic product (GDP) is higher than what any other country has done. The debt that funds investment has led to a debt-to-GDP ratio in China that is among the highest in the world. And that debt is domestic, because excessive domestic savings make it expensive to attract foreign capital, and there is no need for foreign capital unless it brings along extraordinary expertise.

The overinvestment has led to overcapacity, from infrastructure to manufacturing. The per capital housing stock in China is one example, with 36 square meters of housing per capita being higher than many rich countries such as Singapore and China adding 1.3 square meters per capita per year. Since 40% of property demand is for investment, more than 10% of China’s GDP is driven by where people think housing prices will be next year.

On the monetary policy side, Cui says the government hasn’t cut interest rates significantly because that step could encourage more debt. Few manufacturers want to borrow to expand their capacity, so “people would only borrow and speculate on real assets.”

On the fiscal side, China has run deficits, with local government debt becoming particularly high. Since the new administration has tried to control local government borrowing, total government spending this year would be less than last year and the government is actually running a contractionary fiscal policy. Corporate capital expenditures have also shrunk.

Cui says exports are also under pressure because the government is holding the exchange rate high in order to globalize the renminbi (RMB). Many companies are therefore cutting salaries and some are laying off people, resulting in the consumption growth rate also slowing. “All the major drivers are slowing down,” he says.

The result is that financial system risk in China is high. Cui’s research showed that any country that grew the debt-to-GDP ratio more than 40% over four years had almost a 100% chance of a financial crisis. In China, the ratio is about 50%.

When growth slowed down in the past, the Chinese government could build highways and railways. With so much investment already in place, however, Cui says the government has fewer options and growth has been slowing.

One strategy China is trying to use to stimulate growth is the One Road One Belt (OBOR) program, which would increase outbound investment. With an economy of about US$10 trillion, however, outbound investment would need to increase by US$100 million to make a 1% difference and all the benefit has to come back to China, which Cui says seems unlikely.

Cui suggests that the twofold short-term solution China needs is another round of debt write-offs and a shut-down of excess capacity. Longer-term, he says, China needs to increase peoples’ incomes, reduce corporate returns, and redistribute income and wealth from the corporate sector to the consumer sector. The essence of such reforms would be to reduce local government incomes and pay farmers more, however, which means taking money from the most powerful group in China and paying the least powerful group. “It seems difficult to do. Signs are not encouraging,” he says.

The net result, Cui says, is that China is going to have a financial crisis within a year, with massive capital flight and many assets likely to be written off.

A Riddle, Wrapped in a Mystery, Inside an Enigma

Peking University Professor Michael Pettis says that his forecast is similar, though from a different perspective.

It became clear a decade ago, Pettis says, that the Chinese growth model is a common model. “We’ve seen dozens of cases. Brazil in the 50s and 60s, the Soviet Union in the 50s and 60s.”

There are two fundamental policies that countries have followed. First, developing countries don’t develop enough savings, so they put in polices that force up the savings rate. The second is to centralize the investment-making process. “The most important difference is that China followed the model to an extent we have never seen before,” Pettis says.

The reliance on investment resulted in investment being misallocated and debt growing faster than debt servicing capacity in every case. “The fact that we think this time is different is part of the history of the model.”

To force up the savings rate, countries constrain the growth in household income. China followed the Japanese model and used hidden taxes to constrain growth, Pettis says, including indirect transfers, an undervalued currency, low wage growth relative to productivity and financial repression. The household share kept contracting, consumption kept contracting and savings kept rising.

The result has been that credit grew 11%-12% per annum, compared to official GDP growth of around 7%. That official GDP level, however, overstates what happened; China’s GDP deflator of 1.2% means that the nominal GDP growth rate was 5.8%. Debt has thus been growing twice as quickly as the ability to repay it. The problem, Pettis says, is that reducing the growth in debt reduces the growth in investment, which in turn can lead to state-owned enterprises (SOEs) firing workers and consumption declining further.

One potential solution is a set of policies aimed at constraining credit growth, Pettis suggests, but the risk is that unemployment goes up. Another is to increase consumption, which requires reversing the transfers, relies on transferring wealth from the state sector to the household sector and also results in growth rates coming down. “The problem is how to effectuate these transfers. Most cases are failures,” he explains.

There are two types of countries that have managed the transfer process successfully, Pettis says: democracies, which are good at adjustment; or highly centralized autocracies, such as China in the ‘80s.

Pettis says that Xi has taken steps in recentralizing power and now has to implement policies to transfer wealth from the state sector to the household sector. “We will see if policies are implemented. If they are, we will have a non-disruptive adjustment.” Still, he says he “cannot figure out how China can grow faster than 3%-4%”

Pettis also believes there is no reason for China to liberalize the capital account, since it can be destabilizing. “You can only do that if you have a stable, flexible financial system, and you don’t,” he says. Moreover, the capital account ran a deficit last year, so more money left than came in and it wiped out the current account surplus. For the first time, reserves are contracting, and the People’s Bank of China (PBOC) had to sell dollars in order for net outflows to take place.

In summary, Pettis says, “we know a lot about this growth model. The probability is growth will slow.”



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