http://www.morganstanley.com/GEFdata/di ... igest.html
Dec 02, 2005
Morgan Stanley: One Client at a time
Global: China Slowdown -- Early Not Wrong
Stephen Roach (New York)
The die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle
About six weeks ago, I threw in the towel on the ever-elusive China slowdown call (see my 21 October dispatch, “Wrong on the China Slowdownâ€). In doing so, however, I cautioned that we simply may have been too early in looking for a downshift in Chinese economic activity. Based on intelligence gathered during a recent visit to Beijing, I am increasingly convinced that is, indeed, the case. In my view, the die is now cast for a significant slowing of Chinese GDP growth in 2006. At work is likely to be a downturn in China’s all-powerful investment cycle, driven by an important and surprising contraction in bank lending.
China’s booming investment cycle is on an unsustainable path. For 2005, we estimate that fixed asset investment is likely to exceed 46% of Chinese GDP -- astonishing by historical standards for China or any other economy. Given China’s special investment needs as a large developing country -- namely, urbanization, industrialization, and infrastructure -- there is every reason to look for an investment-led growth dynamic. But the Chinese investment cycle has gone well beyond what those fundamentals might suggest. Even in the heydays of their own development booms, the investment shares of the Japanese and Korean economies never got much above the low-40% range. I very much agree with Andy Xie who recently argued that China is now at a point where its ever-rising investment share is a recipe for excess capacity and deflation (see Andy’s 22 November dispatch, “China: Toward a Deflationary Landingâ€).
The consensus view in the markets is that China will sustain its investment boom through the 2008 Beijing Olympics -- that it will simply not accept the potential embarrassment of a growth slowdown until after that momentous event is over. Old China hands also note that the Chinese economy never slows immediately after the unveiling of a new development plan. With the 11th five-year plan covering the 2006-10 interval, this historical tendency also suggests any slowdown could be deferred until after 2007. Consider the implications of that possibility: If China stays the course of its investment-led boom, then the fixed asset investment share of its GDP could well be in the 55-60% range by 2008 -- a recipe for a monstrous overhang of excess capacity. With Chinese inflation already quite low -- the CPI increased at only a 1.2% y-o-y rate in October 2005 -- China is not that far away from outright deflation. Should its capacity overhang continue to build through 2008, a deflationary endgame in China would be more likely than not, in my view.
Nor would this be a great thing for the global economy. Despite its relatively small share in the global economy -- only about 5% of world GDP (at market exchange rates) -- China now spends more on fixed investment than any country in the world. In dollar terms, China’s fixed asset investment was running at an annual rate of close to $1,100 billion in the first three quarters of 2005 (at market exchange rates) -- in excess of annualized 2005 investment totals in the US ($987 billion), Japan ($733 billion), and the Euro-zone ($651 billion). If China’s investment boom remains unchecked and its currency continues to appreciate, its dominance in shaping the global investment cycle will only grow. This underscores the distinct possibility of Chinese-led gluts in worldwide capacity -- not just a problem for China but increasingly a deflationary risk for the global economy. In short, China’s investment-led growth boom is now in the danger zone.
So what stops it? The simple answer is one word -- reforms. Up until now, China’s investment binge has been funded largely by its “policy banks†-- huge organizations that were originally integral parts of the country’s central planning apparatus. China would, in effect, gather a massive reservoir of national saving, and the policy banks would then distribute the proceeds to state-owned enterprises, which employed and paid workers. Bank lending in China has not been a market-based, risk-adjusted credit allocation process. It was, instead, the open-ended state-directed funding of a state-owned economy. Unfortunately, given the precarious conditions of a largely unprofitable state-owned enterprise sector, policy lending was also a recipe for a huge build-up of non-performing bank loans (NPLs). Chinese reforms are bringing this vicious circle to an end. It started with an especially aggressive push toward state-owned enterprise reforms in the early 1990s -- shuttering the worst of the lot and privatizing the survivors (actually “corporatizing†since the state still maintains partial ownership). And now the reform process is moving into the next stage -- changing the funding mechanism by converting policy banks into commercial banks.
This could well be the tipping point for China’s runaway investment boom. The public listing of China’s policy banks changes the very character of the nation’s financing architecture. Charged with delivering profitability and shareholder value, publicly listed banks are bringing the days of open-ended policy lending to a close in China. Credit allocation must now follow the best practices of international commercial lending standards. So far, only one of China’s major policy banks has floated its shares, but two others are expected to follow suit within the next year. Collectively, these three institutions account for about 40% of total bank lending in China. The implications are that policy lending must give way to commercially viable lending. To do otherwise is a recipe for open-ended NPL creation -- an outcome that would represent a major failure for Chinese banking reform.
In my conversations with Chinese banking officials and regulators two weeks ago in Beijing, I got the distinct impression that this change in credit culture is now being put in place. Given the legacy effects of a state-owned economy and state-directed policy lending, this is not something the Chinese come by naturally. But there are two key elements of Chinese banking reform that are facilitating this dramatic transformation -- the first being the establishment of strategic partnerships between China’s policy banks and international commercial banks. Secondly, Chinese banking reform also entails the centralization of huge networks of branch banks. Between them, the three policy banks still have over 46,000 branches offices throughout China. Historically, these branches have had great autonomy -- closely tied to local governments and their local employment imperatives. As publicly listed companies, however, branch autonomy is now giving way to an increasingly centralized system of tight internal controls -- necessary not only for consolidated banking system efficiency but also essential for the efficacy of Chinese monetary policy.
There are signs that this dramatic shift in the Chinese bank lending culture is already working. A turn in the bank lending cycle may now be at hand. After peaking out at close to 5.5 times nominal GDP in 2003, total bank lending in China has since declined to around 5 times nominal GDP in 2005. This compression still has a considerable distance to go on the downside; after all, this same ratio was 4.5 times Chinese GDP as recently as 2000. As newly listed Chinese banks, along with those that are about to become listed, move to put their lending practices on a commercially sound basis, I suspect that the days of open-ended Chinese bank lending will quickly draw to a close. At that point, the excesses of a bank-financed investment boom will then come under increasingly intense pressure. All this points to a prompt and significant deceleration of runaway Chinese investment growth. As a senior Chinese banker put it to me over lunch in Beijing a couple of weeks ago, “Policy lending is out. Profitability and shareholder value are in. As commercial banks, our lending must slow. A big investment slowdown is coming -- sooner rather than later. I worry about Chinese growth in 2006.â€
The cynics dispute this claim, arguing that the State won’t allow it. But in the end, the State can’t have it both ways -- drawing on international capital willing to bet on banking reform and holding on to uneconomic, state-directed policy lending practices. China doesn’t need 9%-plus GDP growth to keep the magic alive -- 7-8% will do just fine. A more rational, market-based system of credit allocation could go a long way in restoring sanity to an overheated Chinese investment cycle. The sooner the better, in my view. The alternatives of excess capacity and deflation -- and the hard landing that would then occur -- are unacceptable to Chinese reformers. We were wrong on the China slowdown call in 2005, but my guess is we were only early. In light of what I just learned about the rapidly changing bank lending culture in China, I am quite comfortable with the out-of-consensus possibility that Chinese GDP growth is about to slow into the 7-8% range.
Slowdown in China's economy
-
China_Watcher
- Posts: 50
- Joined: Sat Oct 29, 2005 6:13 am
-
China_Watcher
- Posts: 50
- Joined: Sat Oct 29, 2005 6:13 am
Slowdown in China's economy
Asia Pacific: 2006 Outlook †Déjà Vu
Andy Xie (Hong Kong)
The outlook for next year appears similar to that one year ago. We expect muddling through again. While the current business cycle is overextended and full of imbalances and fragilities, low inflation has allowed central banks around the world to maintain stimulus.
Globalization of manufacturing and capital flow is the key to prolonging the current business cycle. The fact that inflation remains low – despite the massive liquidity boom – is due to the increasing price elasticity of goods supply resulting from the entry of China and other emerging economies into the global supply chain.
The hedge fund boom has fundamentally altered how risks are priced. Hedge funds help central banks by keeping risk premiums low everywhere, which has made borrowing easier. Easier financing has led to a global property boom, which is at the heart of demand creation in this business cycle.
A business cycle usually ends when central banks tighten quickly in response to an inflation problem. As inflation has been very slow to creep up in this cycle, central banks do not have to end the cycle. Instead, a shock, probably due to structural fragility in some emerging economies, could bring it to an end. Until the shock happens, we see it as a case of muddling through.
Gradual Slowdown
We are forecasting 6.2% GDP growth for Asia ex-Japan in 2006, down from 6.9% in 2005. The main reason is that we expect the region’s export growth to decelerate to 11.7% in 2006 from 17.5% in 2005. The main driver of export deceleration is the peaking of the factory relocation to China. Our assessment is based on the deteriorating profitability of China’s export sector.
Our forecast is consistent with a soft landing for the current business cycle. The growth in this cycle has been stronger and lasted longer than in previous cycles. The region’s exports averaged 16.4% growth between 1992 and 1995 compared with 18.3% between 2001 and 2005. Conventional wisdom would suggest a sharper slowdown on the way down. However, the current business cycle has behaved very differently from the previous one. We are still expecting stronger than usual growth next year.
Lasting Bubbles
Even though the current business cycle is old, the policy environment is still stimulative. US interest rates have yet to reach the neutral zone. The euro zone’s real interest rate is still near zero. Japan has not begun to tighten. As a result, global money supply remains ahead of GDP growth.
Globalization of manufacturing has allowed the major central banks to maintain stimulus. The price elasticity of the global supply curve has increased sharply due to the entry of China and other emerging economies into the global supply chain. Hence, inflation reacts much more slowly in response to money supply than before.
Instead, the excessive money supply has flowed into asset markets, which has stimulated demand by inflating asset prices. In that regard, the globalization of capital flows has played a vital role. The rise of the hedge fund industry has fundamentally changed how risks are priced. As this industry is compensated on annual performance, the future is increasingly irrelevant to risk pricing. The low risk premium everywhere has made borrowing much easier than before.
The easier borrowing terms have led to a global property boom that is at the heart of demand creation. In the US, consumption demand depends on borrowing against rising property prices. In China, investment demand depends on property construction and hence high property prices.
We estimate that the global asset bubble, mainly in property, may amount to US$15 trillion, which would make it the biggest bubble in history. However, players in the global financial markets are not scared, as there is a belief that the central banks will not burst the bubble. Hence risk premiums are kept low, sustaining the bubble. There is a self-reinforcing relationship between the central banks and hedge funds, which is sustaining global GDP growth despite the existence of imbalances and structural fragilities.
Risks
Bubbles burst when they are least expected to. In 1990, the bookstores in the US were full of books on Japan’s different but more effective economic model. In 1996, the World Bank had just come out with a study on the ‘East Asian Miracle’. In 2000, several large funds threw away their long-held skepticism on the tech story and bought NASDAQ. History is full of examples of those who thought bubbles would last forever.
The current bubble, just as previous ones, will burst unexpectedly, in our view. As long as inflation remains low, the central banks are unlikely to burst it by tightening. Considering the extent of overcapacity in China, it is difficult to imagine that inflation will get out hand. Hence, we would expect the burst to be triggered by a shock, probably due to internal fragilities in emerging economies.
China and India, the two countries at the centre of the current bubble, look the most vulnerable. China has invested its export income unproductively, creating overcapacity and empty buildings. China’s investment demand is based on excessive optimism about the future. ‘Build first and they will come’ has been taken to the extreme. History tells us that such optimism often turns suddenly to pessimism. Should this happen, asset prices could fall precipitously, leading to a demand crash.
India depends on capital inflow to fund its consumption-led growth, like a poorer version of the US. However, the optimism felt towards an emerging economy can be fickle. As US interest rates rise and the optimism becomes more expensive to maintain, sentiment could turn quickly, leading to devaluation and rising real interest rates. We see India as a candidate to experience the kind of capital flight that hit Southeast Asia in 1996.
While we expect moderate deceleration in the coming year, it is important for investors to mind the risks. When sentiment towards China or India turns negative, we think investors should rapidly decrease the beta in their portfolios. ‘Believe’ is okay. ‘Be prepared to run’ is vital.
Andy Xie (Hong Kong)
The outlook for next year appears similar to that one year ago. We expect muddling through again. While the current business cycle is overextended and full of imbalances and fragilities, low inflation has allowed central banks around the world to maintain stimulus.
Globalization of manufacturing and capital flow is the key to prolonging the current business cycle. The fact that inflation remains low – despite the massive liquidity boom – is due to the increasing price elasticity of goods supply resulting from the entry of China and other emerging economies into the global supply chain.
The hedge fund boom has fundamentally altered how risks are priced. Hedge funds help central banks by keeping risk premiums low everywhere, which has made borrowing easier. Easier financing has led to a global property boom, which is at the heart of demand creation in this business cycle.
A business cycle usually ends when central banks tighten quickly in response to an inflation problem. As inflation has been very slow to creep up in this cycle, central banks do not have to end the cycle. Instead, a shock, probably due to structural fragility in some emerging economies, could bring it to an end. Until the shock happens, we see it as a case of muddling through.
Gradual Slowdown
We are forecasting 6.2% GDP growth for Asia ex-Japan in 2006, down from 6.9% in 2005. The main reason is that we expect the region’s export growth to decelerate to 11.7% in 2006 from 17.5% in 2005. The main driver of export deceleration is the peaking of the factory relocation to China. Our assessment is based on the deteriorating profitability of China’s export sector.
Our forecast is consistent with a soft landing for the current business cycle. The growth in this cycle has been stronger and lasted longer than in previous cycles. The region’s exports averaged 16.4% growth between 1992 and 1995 compared with 18.3% between 2001 and 2005. Conventional wisdom would suggest a sharper slowdown on the way down. However, the current business cycle has behaved very differently from the previous one. We are still expecting stronger than usual growth next year.
Lasting Bubbles
Even though the current business cycle is old, the policy environment is still stimulative. US interest rates have yet to reach the neutral zone. The euro zone’s real interest rate is still near zero. Japan has not begun to tighten. As a result, global money supply remains ahead of GDP growth.
Globalization of manufacturing has allowed the major central banks to maintain stimulus. The price elasticity of the global supply curve has increased sharply due to the entry of China and other emerging economies into the global supply chain. Hence, inflation reacts much more slowly in response to money supply than before.
Instead, the excessive money supply has flowed into asset markets, which has stimulated demand by inflating asset prices. In that regard, the globalization of capital flows has played a vital role. The rise of the hedge fund industry has fundamentally changed how risks are priced. As this industry is compensated on annual performance, the future is increasingly irrelevant to risk pricing. The low risk premium everywhere has made borrowing much easier than before.
The easier borrowing terms have led to a global property boom that is at the heart of demand creation. In the US, consumption demand depends on borrowing against rising property prices. In China, investment demand depends on property construction and hence high property prices.
We estimate that the global asset bubble, mainly in property, may amount to US$15 trillion, which would make it the biggest bubble in history. However, players in the global financial markets are not scared, as there is a belief that the central banks will not burst the bubble. Hence risk premiums are kept low, sustaining the bubble. There is a self-reinforcing relationship between the central banks and hedge funds, which is sustaining global GDP growth despite the existence of imbalances and structural fragilities.
Risks
Bubbles burst when they are least expected to. In 1990, the bookstores in the US were full of books on Japan’s different but more effective economic model. In 1996, the World Bank had just come out with a study on the ‘East Asian Miracle’. In 2000, several large funds threw away their long-held skepticism on the tech story and bought NASDAQ. History is full of examples of those who thought bubbles would last forever.
The current bubble, just as previous ones, will burst unexpectedly, in our view. As long as inflation remains low, the central banks are unlikely to burst it by tightening. Considering the extent of overcapacity in China, it is difficult to imagine that inflation will get out hand. Hence, we would expect the burst to be triggered by a shock, probably due to internal fragilities in emerging economies.
China and India, the two countries at the centre of the current bubble, look the most vulnerable. China has invested its export income unproductively, creating overcapacity and empty buildings. China’s investment demand is based on excessive optimism about the future. ‘Build first and they will come’ has been taken to the extreme. History tells us that such optimism often turns suddenly to pessimism. Should this happen, asset prices could fall precipitously, leading to a demand crash.
India depends on capital inflow to fund its consumption-led growth, like a poorer version of the US. However, the optimism felt towards an emerging economy can be fickle. As US interest rates rise and the optimism becomes more expensive to maintain, sentiment could turn quickly, leading to devaluation and rising real interest rates. We see India as a candidate to experience the kind of capital flight that hit Southeast Asia in 1996.
While we expect moderate deceleration in the coming year, it is important for investors to mind the risks. When sentiment towards China or India turns negative, we think investors should rapidly decrease the beta in their portfolios. ‘Believe’ is okay. ‘Be prepared to run’ is vital.
-
China_Watcher
- Posts: 50
- Joined: Sat Oct 29, 2005 6:13 am
Slowdown in China's economy
China: GDP Revision Does Not Alter Overinvestment Story
Andy Xie (Hong Kong)
China’s National Bureau of Statistics (NBS) has revised up China’s 2004 production-based GDP by 16.8% to Rmb 15,988 bn (or US$1930.7 bn, translated using the 2004 average RMB/US$ exchange rate). We forecast China’s nominal GDP to grow by 12% in 2005, hence the revised 2004 data imply an increase in the (reported) production-based forecast to Rmb17,906 bn (or US$2.2 trn).
Expenditure-based GDP data have yet to be revised. China reported expenditure-based GDP of Rmb14,239 bn for 2004, or 4% higher than the production-based figure. We would expect the NBS to mark up the expenditure-based GDP figure to match the production-based figure.
In our view, a figure of US$2.2 trn is roughly right for China’s 2005 GDP. We expect fixed investment to account for 47%, consumption 47.5%, and the current account surplus 5.5%. This would put 2005 per capita income at US$1,675. The revision does not alter China’s overinvestment story at all. A fixed investment to GDP ratio of 47% is too high. Micro evidence of overcapacity and low returns on capital are much more important than GDP data in portraying the overinvestment story.
Revising Up Production-Based GDP by 16.8%
China embarked on a nationwide business census in 2004 to better estimate its GDP. The census mobilized 3 million people and targeted the industrial and service sectors. As expected, the census found the service sector bigger than previously recorded and reported. The NBS has hence revised up 2004 production-based GDP by 16.8% to Rmb15,988 bn. We forecast China’s nominal GDP to rise by 12% in 2005, which would lift total nominal GDP to Rmb 17,906 bn, putting China’s GDP per capita at US$1,675. This is consistent with our observations at the micro level.
The census results are not surprising. Developing countries usually have a gray economy, mainly in the service sector, at around 20% of GDP. It is a matter of choice as to if and when this should be included. While a census may capture it, it is difficult to gauge what is happening in the gray economy on an annual basis. China has now started to include this sector in its GDP accounts, which should make its GDP structure non-comparable to that of most developing economies.
Based on the census, the NBS has revised up service-sector value added by 48.7% to Rmb6,502 bn in 2004. Its share in GDP rises to 40.7% from 31.9%. The value added of the industrial sector has been raised by 2.1% to Rmb7,390 bn, but its share in GDP declines to 46.2% from 52.9%. The value added for the primary sector has not been revised (Rmb2,096 bn), and its share in GDP drops to 13.1% from 15.2%.
Expenditure-Based GDP Has Yet to Be Revised
China reported expenditure-based GDP of Rmb14,239 bn in 2004, or 4% higher than the original production-based figure. The discrepancy between production and expenditure-based GDP has become increasingly significant since 2003, which we attribute to underestimation of production-based GDP.
It is very difficult to obtain accurate data for a vast economy undergoing rapid structural change, such as China’s. Below, we present a rudimentary analysis, partly using official data and partly our own observations at the micro level, to argue that US$2.2 trn appears a reasonable estimate for the size of China’s economy for 2005, and that the overinvestment story is very much intact.
We think China’s urban consumption is Rmb10,000 per capita at most. For the purposes of illustration, a taxi driver in Beijing might make about Rmb30,000 per annum, with a spouse who earns, say, another Rmb10,000 per annum. We believe such a family of three might typically look to save around 25% of its income, and could therefore afford Rmb30,000 consumption per year, or Rmb10,000 per capita.
Such a level of family income is, in fact, somewhat above average among China’s urban population. The Chinese government reported the urban population at 542.8 mn last year, implying growth of 4.7% per annum over the past decade. Assuming this rate of growth is maintained, it would put China’s urban population at 568.3 mn in 2005. Based on our observations, this would in turn imply total urban consumption of Rmb5.7 trn at most.
The government reported Rmb3,509 bn of urban consumption and Rmb1,645 bn of government consumption in 2004 (expenditure-based GDP data). These figures total Rmb5,154 bn, and are probably understated, in our view. We believe a portion of fixed investment may actually be consumption, with some government officials and state-owned enterprise (SOE) employees expensing part of their consumption to investment projects under their care.
China reported rural consumption of Rmb 2,391 bn in 2004, by a rural population of 757 mn. We think this figure is probably not too far off. We estimate that rural per capita consumption is around one-third of urban per capita consumption, implying rural consumption of around Rmb 3,333 per capita and Rmb2,493 bn in total.
Based on the rudimentary observations outlined above, we would tentatively put China’s total consumption at Rmb8-8.2 trn for 2005. Against the Rmb7.5 trn total consumption reported for 2004, the implied 10% growth is reasonable, we believe. The point of the above exercise is to dispute suggestions that China’s consumption is vastly understated. We can find no evidence to suggest that China’s consumption should be much bigger than is currently reported.
As regards investment statistics, we would expect the government to have a reasonable idea of the sums involved, since it approves almost all significant investments. However, there is also considerable confusion with respect to the available statistics. China has two data series on fixed investment. The series in the expenditure-based GDP accounts (‘gross fixed capital formation’, or GFCF) is smaller than that reported by the NBS each quarter (‘fixed asset investment’, or FAI). The key conceptual difference between the two lies in investment transaction costs (e.g. acquisition costs of assets, which are included in FAI but excluded in GFCF). On the other hand, GFCF is theoretically net of asset disposals, while FAI is not. This discrepancy, however, has been widening since 2002, making us suspicious of statistical anomalies. In 2004, GFCF was Rmb6,235 bn and FAI was Rmb7,048 bn. Most FAI is done by SOE or contracted out by them. As noted earlier, some government officials and SOE employees expense their consumption expenditure to investment projects under their care. Leakage in construction contracts is also significant. As a rule of thumb, we think it may be necessary to deduct as much as 10% from the reported FAI to reach a more realistic figure. This 10% should already be counted in consumption. We expect the NBS to report FAI totaling Rmb8.8 trn in 2005. Deducting 10% implies that the GFCF in expenditure-based GDP should be around Rmb8 trn.
We forecast China to report a current account surplus of US$130 bn, or Rmb 1.1 trn, in 2005. However, current account data are distorted by hot money flows. We have observed a big difference between the change in foreign exchange reserves and trade surpluses since the speculation in Chinese currency began. We think that it is better to look at the trade surplus as a good indicator for the current account surplus. Even the trade surplus may be distorted by over- or under-invoicing of exports or imports. Since hot money inflows have cooled in recent months, the trade surplus is probably more accurate, though. We expect China to report a trade surplus of US$100 bn, or Rmb810 bn, for 2005.
In total, we estimate China’s expenditure-based 2005 GDP at Rmb 17-17.2 trn, or US$2.1 trn, whereas we think the government is likely to report Rmb 17.9 trn (US$2.2 trn). The gap between the two is not big, considering the quality of data. Again, our analysis serves to demonstrate that China’s GDP is not grossly understated. In fact, if anything, we think US$2.2 trn is a slightly optimistic figure for 2005 GDP.
GDP Revisions Do Not Alter the Overinvestment Story
Of our estimated Rmb 17-17.2 trn GDP for 2005, Rmb 8 trn or 47% is fixed investment. While the ratio looks smaller than before the revision, it is still extremely high. One good thing from the revision is that we feel fairly confident in the 47% figure, which is entirely consistent with our opinion that investment is excessive.
Further, overinvestment is a micro phenomenon. Without overcapacity and low returns on capital, we could not draw a conclusion on overinvestment in China regardless of the appearance of the macro data. The macro data support our micro observations. It would be naive to assume that changing a macro number alters reality at the micro level.
In our view, China cannot sustain FAI above 35% without creating non-performing assets in the financial system. The difference between 47% and 35% is US$250 bn. This suggests that China has to shift that much demand to consumption from investment.
We believe the only effective way to increase consumption quickly is to grant ownership of government-owned assets to the Chinese people. We estimate that the government currently owns 100% of GDP in assets (SoE, land, and mineral resources). Securitizing these assets and distributing them to population could increase consumption by 5% of GDP or US$100 bn, solving half of China’s structural imbalance, on our estimates.
China also needs to cut random charges in healthcare and education systems, in our view. Both are state-owned monopolies and take advantage of their position to overcharge at random. Uncertainty over healthcare and education costs is a major deterrent against consumption. Introducing private ownership and competition into these two markets could lift consumption’s share of GDP further, potentially solving the other half of China’s structural imbalance.
Andy Xie (Hong Kong)
China’s National Bureau of Statistics (NBS) has revised up China’s 2004 production-based GDP by 16.8% to Rmb 15,988 bn (or US$1930.7 bn, translated using the 2004 average RMB/US$ exchange rate). We forecast China’s nominal GDP to grow by 12% in 2005, hence the revised 2004 data imply an increase in the (reported) production-based forecast to Rmb17,906 bn (or US$2.2 trn).
Expenditure-based GDP data have yet to be revised. China reported expenditure-based GDP of Rmb14,239 bn for 2004, or 4% higher than the production-based figure. We would expect the NBS to mark up the expenditure-based GDP figure to match the production-based figure.
In our view, a figure of US$2.2 trn is roughly right for China’s 2005 GDP. We expect fixed investment to account for 47%, consumption 47.5%, and the current account surplus 5.5%. This would put 2005 per capita income at US$1,675. The revision does not alter China’s overinvestment story at all. A fixed investment to GDP ratio of 47% is too high. Micro evidence of overcapacity and low returns on capital are much more important than GDP data in portraying the overinvestment story.
Revising Up Production-Based GDP by 16.8%
China embarked on a nationwide business census in 2004 to better estimate its GDP. The census mobilized 3 million people and targeted the industrial and service sectors. As expected, the census found the service sector bigger than previously recorded and reported. The NBS has hence revised up 2004 production-based GDP by 16.8% to Rmb15,988 bn. We forecast China’s nominal GDP to rise by 12% in 2005, which would lift total nominal GDP to Rmb 17,906 bn, putting China’s GDP per capita at US$1,675. This is consistent with our observations at the micro level.
The census results are not surprising. Developing countries usually have a gray economy, mainly in the service sector, at around 20% of GDP. It is a matter of choice as to if and when this should be included. While a census may capture it, it is difficult to gauge what is happening in the gray economy on an annual basis. China has now started to include this sector in its GDP accounts, which should make its GDP structure non-comparable to that of most developing economies.
Based on the census, the NBS has revised up service-sector value added by 48.7% to Rmb6,502 bn in 2004. Its share in GDP rises to 40.7% from 31.9%. The value added of the industrial sector has been raised by 2.1% to Rmb7,390 bn, but its share in GDP declines to 46.2% from 52.9%. The value added for the primary sector has not been revised (Rmb2,096 bn), and its share in GDP drops to 13.1% from 15.2%.
Expenditure-Based GDP Has Yet to Be Revised
China reported expenditure-based GDP of Rmb14,239 bn in 2004, or 4% higher than the original production-based figure. The discrepancy between production and expenditure-based GDP has become increasingly significant since 2003, which we attribute to underestimation of production-based GDP.
It is very difficult to obtain accurate data for a vast economy undergoing rapid structural change, such as China’s. Below, we present a rudimentary analysis, partly using official data and partly our own observations at the micro level, to argue that US$2.2 trn appears a reasonable estimate for the size of China’s economy for 2005, and that the overinvestment story is very much intact.
We think China’s urban consumption is Rmb10,000 per capita at most. For the purposes of illustration, a taxi driver in Beijing might make about Rmb30,000 per annum, with a spouse who earns, say, another Rmb10,000 per annum. We believe such a family of three might typically look to save around 25% of its income, and could therefore afford Rmb30,000 consumption per year, or Rmb10,000 per capita.
Such a level of family income is, in fact, somewhat above average among China’s urban population. The Chinese government reported the urban population at 542.8 mn last year, implying growth of 4.7% per annum over the past decade. Assuming this rate of growth is maintained, it would put China’s urban population at 568.3 mn in 2005. Based on our observations, this would in turn imply total urban consumption of Rmb5.7 trn at most.
The government reported Rmb3,509 bn of urban consumption and Rmb1,645 bn of government consumption in 2004 (expenditure-based GDP data). These figures total Rmb5,154 bn, and are probably understated, in our view. We believe a portion of fixed investment may actually be consumption, with some government officials and state-owned enterprise (SOE) employees expensing part of their consumption to investment projects under their care.
China reported rural consumption of Rmb 2,391 bn in 2004, by a rural population of 757 mn. We think this figure is probably not too far off. We estimate that rural per capita consumption is around one-third of urban per capita consumption, implying rural consumption of around Rmb 3,333 per capita and Rmb2,493 bn in total.
Based on the rudimentary observations outlined above, we would tentatively put China’s total consumption at Rmb8-8.2 trn for 2005. Against the Rmb7.5 trn total consumption reported for 2004, the implied 10% growth is reasonable, we believe. The point of the above exercise is to dispute suggestions that China’s consumption is vastly understated. We can find no evidence to suggest that China’s consumption should be much bigger than is currently reported.
As regards investment statistics, we would expect the government to have a reasonable idea of the sums involved, since it approves almost all significant investments. However, there is also considerable confusion with respect to the available statistics. China has two data series on fixed investment. The series in the expenditure-based GDP accounts (‘gross fixed capital formation’, or GFCF) is smaller than that reported by the NBS each quarter (‘fixed asset investment’, or FAI). The key conceptual difference between the two lies in investment transaction costs (e.g. acquisition costs of assets, which are included in FAI but excluded in GFCF). On the other hand, GFCF is theoretically net of asset disposals, while FAI is not. This discrepancy, however, has been widening since 2002, making us suspicious of statistical anomalies. In 2004, GFCF was Rmb6,235 bn and FAI was Rmb7,048 bn. Most FAI is done by SOE or contracted out by them. As noted earlier, some government officials and SOE employees expense their consumption expenditure to investment projects under their care. Leakage in construction contracts is also significant. As a rule of thumb, we think it may be necessary to deduct as much as 10% from the reported FAI to reach a more realistic figure. This 10% should already be counted in consumption. We expect the NBS to report FAI totaling Rmb8.8 trn in 2005. Deducting 10% implies that the GFCF in expenditure-based GDP should be around Rmb8 trn.
We forecast China to report a current account surplus of US$130 bn, or Rmb 1.1 trn, in 2005. However, current account data are distorted by hot money flows. We have observed a big difference between the change in foreign exchange reserves and trade surpluses since the speculation in Chinese currency began. We think that it is better to look at the trade surplus as a good indicator for the current account surplus. Even the trade surplus may be distorted by over- or under-invoicing of exports or imports. Since hot money inflows have cooled in recent months, the trade surplus is probably more accurate, though. We expect China to report a trade surplus of US$100 bn, or Rmb810 bn, for 2005.
In total, we estimate China’s expenditure-based 2005 GDP at Rmb 17-17.2 trn, or US$2.1 trn, whereas we think the government is likely to report Rmb 17.9 trn (US$2.2 trn). The gap between the two is not big, considering the quality of data. Again, our analysis serves to demonstrate that China’s GDP is not grossly understated. In fact, if anything, we think US$2.2 trn is a slightly optimistic figure for 2005 GDP.
GDP Revisions Do Not Alter the Overinvestment Story
Of our estimated Rmb 17-17.2 trn GDP for 2005, Rmb 8 trn or 47% is fixed investment. While the ratio looks smaller than before the revision, it is still extremely high. One good thing from the revision is that we feel fairly confident in the 47% figure, which is entirely consistent with our opinion that investment is excessive.
Further, overinvestment is a micro phenomenon. Without overcapacity and low returns on capital, we could not draw a conclusion on overinvestment in China regardless of the appearance of the macro data. The macro data support our micro observations. It would be naive to assume that changing a macro number alters reality at the micro level.
In our view, China cannot sustain FAI above 35% without creating non-performing assets in the financial system. The difference between 47% and 35% is US$250 bn. This suggests that China has to shift that much demand to consumption from investment.
We believe the only effective way to increase consumption quickly is to grant ownership of government-owned assets to the Chinese people. We estimate that the government currently owns 100% of GDP in assets (SoE, land, and mineral resources). Securitizing these assets and distributing them to population could increase consumption by 5% of GDP or US$100 bn, solving half of China’s structural imbalance, on our estimates.
China also needs to cut random charges in healthcare and education systems, in our view. Both are state-owned monopolies and take advantage of their position to overcharge at random. Uncertainty over healthcare and education costs is a major deterrent against consumption. Introducing private ownership and competition into these two markets could lift consumption’s share of GDP further, potentially solving the other half of China’s structural imbalance.
-
China_Watcher
- Posts: 50
- Joined: Sat Oct 29, 2005 6:13 am
Slowdown in China's economy
http://www.samizdata.net/blog/archives/008435.html
Thoughts on China's future
James Waterton (Perth, Australia) Asian affairs • Globalization/economics
Trackbacks to this post (5)
I have been wandering through the fascinating nation of China of late, so I have not had much time to peruse the blogosphere - I guess this means that for a month I had a life. I was fortunate enough to spend a few days in the beautiful city of Lijiang in Yun'nan province. This mid-sized Chinese town is famed for its wonderfully restored 'old city', a cobbled and confusing maze of shops, traditional inns with gorgeous courtyards and a grid of small canals filled with luminous fish and gushing clean water. A beautiful place to while away a few days, but Lijiang is not really known for its nightlife. So on the evening of the 25th of December, I got trawling through some of the past articles on Samizdata. Reading through the comments section on this post, I noticed that an article I wrote early in 2005 got a mention. It was a pity I was not around a computer regularly, because a debate raged in the comments section that I would have very much liked to have been a part of. For all my appreciation of China, I am one of the few Sino sceptics.
I should explain. I am not a sceptic of the aspirations of the billions of Chinese people who sense greatness in the Chinese identity. After all, I'm mentioning a deeply rich culture backed up by a vast talent pool on the mainland and in the diaspora that has the capacity to change the world radically in the future. I am, however, deeply pessimistic about China in its current nominally Communist incarnation, for reasons I have outlined in a previous post. I will not go into specifics; if you're curious, please read my rationale here.
Some interesting developments have taken place between now and then, however. These merit further analysis. One or two of the commenters in the mentioned Samizdata piece stated that they were keeping abreast of banking developments in the Middle Kingdom. In 2002, Chinese officials admitted that 25% of the loans written by the state owned banks were non-performing. Standard and Poors and a number of others said it was closer to 50%, and possibly more. Within the space of four years, the Chinese administration has revised its estimation of the rate of non-performing loans down to an average of about 12%. How can this be done so fast? I'm not really sure. We are, of course, talking about the writing down or otherwise accounting for of many hundreds of billions of dollars of bad loans. I assume that it's due to the fact that most or all of the bad loans have been transferred to special "asset management" companies set up by the government. I suspect that the banks have been able to revise their non-performing loans (NPL) ratio down so quickly by performing a debt-to-equity swap with these holding companies. The article linked to immediately above believes the asset management companies have taken a chunk of the banks' loans and issued them with 10 year bonds in return.
This solution is clearly economic sophistry. At the end of the day, someone has to pay the tab - at some stage depositors are going to want their money. The equity in these holding companies is effectively (if not nominally for the time being) worthless - after all, their assets consist of a bunch of loans that will never be repaid. What is being done about the essentially state-owned industrial sector, which was - and most likely still is - the major recipient of these loans? There's a saying in China that goes something like "The mountains are high and the Emperor is far away". I have no doubt that this thinking pervades China's provincial administration and its state-owned industrial sector, and it explains the pervasive corruption that is, contrary to official publications, as rampant as ever. For every high-profile trial and execution of an apparently "senior" official on corruption charges, there are hundreds of thousands more who not only escape undetected, but are also politically untouchable into the bargain. Quite simply, the central government cannot be everywhere at once, and its reach is frequently limited by local powerbrokers. Consider this case in Guangdong, one of China's more prosperous provinces, where the central government could not exercise its will due to local political considerations, even though humiliating international media attention was beaming down. And who is to say that the central government is not as corrupt as its provincial counterparts? It is hardly unreasonable to say that corruption probes have a definite glass ceiling when it comes to the powers that be in Beijing.
I believe that the Chinese banking sector's dire straits constitute the gravest threat to global stability in the coming years. The Chinese government is always harping on about its "deepening" banking and state-owned industrial enterprise reforms, and this is a mantra is being repeated across the world. Unfortunately, the Chinese state is so opaque that it's impossible to verify the veracity of such claims, and the unrealistic numbers being thrown at us by the Communist party (like the drop of NPLs from 25% to 12% in less than five years) and the shonky juggling of bad debt from one insolvent bank to another woefully undercapitalised holding company do not inspire much confidence in the nature of the reforms. Frankly, I believe the banking sector is too far gone to reform without collapse. In international terms, the crisis in the Chinese banks and SOEs is an elephant that stands in the middle of the room, but everyone is either perceiving it as a mouse or trying to pass it off as a mouse. I believe the Australian government is in the latter category, as are a great many others around the world.
I speculate that governments like Australia's are acting as they are because they realise the Chinese state is very brittle and unlikely to withstand economic collapse. The massively stimulating US$50 billion or thereabouts annual injection of foreign direct investment is holding the Chinese state together for the time being. Thus, a number of states such as Australia have an interest in talking up Chinese economic reforms - and concealing the parlous nature of the Chinese economy - in the hope that investor confidence will not flag and the Chinese will trade and consume their way out of their problems. Our current economic health is due to huge demand in booming and resource-hungry China. Thus we see documents like this (pdf) that echo the "deepening reforms" mantra consistently spouted by the Chinese administration. Puff pieces like this create and sustain the irrational exuberance that swirls around the legend of the Chinese economic miracle, and inevitably amplifies economic pain when the collapse eventuates. The strategy of our governments may work, but it is an extremely high-risk gamble. The more investment in and commercial intertwinement with China increases, the more outsiders will suffer if the system unravels.
And perhaps the cracks are already becoming evident even to the man on the street. When I was in China in late 2005, ATMs were frequently out of order. I work in the banking sector in Australia, and when an ATM is out of order this nearly always means the machine has dispensed all its money. This was not a problem in late 2004 during my previous Chinese visit - ATM operations at that time were indiscernible to those in Australia. I am speculating here, because I'm not really an expert on this kind of money velocity issue, but perhaps the sudden patchiness of the ATM network is a sentinel of a solvency crisis.
And the collapse could come sooner than we think. In 2007, as per the agreement China entered into upon joining the WTO, it must open up its retail banking sector to foreign banks. This is a potential tripwire. Even if only a small number of Chinese are concerned about the health of their local banks (and thus their savings), when Citibank opens up next door the run on Chinese banks could easily spin out of control. I am assuming that the government is trying to spread the notion of confidence and stability in the retail banking sector. If the Chinese do not panic come 2007 or any time in the subsequent 20 years or so, the banks should be able to reduce their NPL rate to a "more manageable 5%". It wouldn't be the first time that people have left their money in a bank that is essentially insolvent because they believe the government will cover any losses incurred. This is a questionable assumption, however, and if I was Chinese I probably would not run the risk.
I am concerned by the consequences of a Chinese economic collapse, and these concerns reach far beyond any short to medium term economic pain. I fear a worldwide economic slump prompted by the collapse of China and its supposedly free market will provoke a popular backlash against globalisation and the liberal market reforms carried out in the 80s in the most successful economies of the West. Capitalism and liberalism will be blamed if people create a nexus between China's collapse, its market reforms and its intertwining with the greater world economy. There is no shortage of people who will quickly jump to the fallacious conclusion that the free market sunk China - those who protested in Hong Kong and other places would grab plenty of (misguided) ammunition from such a catastrophic event. Ask any one of those economic curmudgeons about post communist Russia's economy, and I will bet you penny to a pound that their standard response would be "capitalism failed Russia". This is about as sensible as saying that modesty failed Paris Hilton, for anyone who knows anything about post-Soviet "free market reforms" will know that they were in fact nothing of the sort. This type of thinking could very well gain traction because it makes sense prima facie. Policy reversals may follow and suddenly we're staring down the barrel of a neo-Keynesian revolution. Consider what the average person knows about China's economy. We're all told about China's free market reforms and its burgeoning capitalist class in the mainstream media - we're not told about the Chinese government's meddling in the economy and its mandating of compulsory totalitarian-style imposts on big private companies like internal "political cells", its retention of control over huge swathes of industry, its equity market (there is currently a ban on IPOs on Mainland bourses) which is stuffed with companies who are controlled by local governments and even the military, rather than shareholder, the board and a CEO. Most importantly, we're not told about the largely intractable problems with China's banking sector. Most people truly think China operates under a free market economic system. If the dog's breakfast that is China Inc fails with all the accompanying pain and fallout, there's a real danger that free market liberalism will be made the scapegoat internationally.
As I speculated above and in my previous article, Chinese economic collapse will probably preface political revolution. This is in itself an interesting, though disturbing proposition. What would post-communist China look like? Firstly, I should mention that a democratic revolution seems fanciful at best. There is no ANC-type shadow opposition waiting in the wings. The Party is the State, and the Party brooks no opposition. Here are what I consider to be the two most likely outcomes:
1) The military will overthrow the Party. If the banking sector collapses, so too will large chunks of the state-owned industrial sector that are afloat solely due to loans from the state-owned banks. Millions upon millions will be out of work - millions more will lose their pensions and benefits. Many tens - perhaps hundreds - of millions of people will pour onto the street to vigorously and violently protest their loss of savings and/or employment. In its death throes, the Communist Party will order a brutal military crackdown. Trouble is, a military is made up by people with aspirations, families, hopes etc. People who would have lost their savings, too. People whose parents, family and friends are suddenly out of work and without benefits. Most of the officers and soldiers will have no end of sympathy for their countrymen under such circumstances, and it's difficult to imagine the chain of command will survive under such conditions. The Communist top brass will lose control of the military, which will regroup under a new command. The old political order will be drawn and quartered, Mao will be evicted from his mausoleum and his portrait ripped down from the gate of the Forbidden City. There is no democratic tradition in China, however the country is steeped in a history of rule-by-decree. Expect this for many years to come. Perhaps the best outcome would be highly imperfect democratic elections in several years time.
2) The country breaks up along the lines of regional powerbrokers. Along with rule-by-decree, China also has a long history of warlordism and disunity. Due to the lack of any credible and widespread opposition movement in China, the possibility of a complete breakdown of central control is high if the Communists depart the scene and the military doesn't fill the vacuum. Hong Kong would almost certainly go its own way. Those provinces with large populations of non-Han citizens like Tibet and Xinjiang may declare their independence - perhaps bloodily ejecting the old order. Inner Mongolia may reunite with Mongolia. There is scope for large-scale dismemberment of the modern Chinese state. That left over will be fractured and ruled perhaps by the old regional party bosses reincarnated as warlords or whoever is able to wrest power from them and maintain it.
Some mention Taiwan as a wildcard that could be used as a distraction by the Central government. I think this unlikely. If the economy collapses, a war with Taiwan is not likely to distract anyone from their sudden poverty. Militarily, it seems unrealistic, too. The military will be stretched to breaking point in an attempt to reign in the chaos on the Mainland, so a massive invasion or attack on Taiwan looks unfeasible.
I truly hope that I am wrong about my bleak assessment, mainly due to the turmoil and potentially massive loss of life that would undoubtedly accompany such an event. I am also deeply concerned about the potential illiberal and protectionist measures that may be enacted in the West and elsewhere in the wake of a Chinese meltdown. The world has made a grave error of judgement in heavily backing an economy designed, constructed and administered by a group of ostensibly reformed Communists. This fact alone should have cooled the foreigners' ardour. As it stands, the potential for unprecedented economic losses from Chinese investments is enormous. I think we could be facing a very painful depression, which may very well be "cured" with a protectionist, welfarist New Deal-like solution. Scary times ahead.
Thoughts on China's future
James Waterton (Perth, Australia) Asian affairs • Globalization/economics
Trackbacks to this post (5)
I have been wandering through the fascinating nation of China of late, so I have not had much time to peruse the blogosphere - I guess this means that for a month I had a life. I was fortunate enough to spend a few days in the beautiful city of Lijiang in Yun'nan province. This mid-sized Chinese town is famed for its wonderfully restored 'old city', a cobbled and confusing maze of shops, traditional inns with gorgeous courtyards and a grid of small canals filled with luminous fish and gushing clean water. A beautiful place to while away a few days, but Lijiang is not really known for its nightlife. So on the evening of the 25th of December, I got trawling through some of the past articles on Samizdata. Reading through the comments section on this post, I noticed that an article I wrote early in 2005 got a mention. It was a pity I was not around a computer regularly, because a debate raged in the comments section that I would have very much liked to have been a part of. For all my appreciation of China, I am one of the few Sino sceptics.
I should explain. I am not a sceptic of the aspirations of the billions of Chinese people who sense greatness in the Chinese identity. After all, I'm mentioning a deeply rich culture backed up by a vast talent pool on the mainland and in the diaspora that has the capacity to change the world radically in the future. I am, however, deeply pessimistic about China in its current nominally Communist incarnation, for reasons I have outlined in a previous post. I will not go into specifics; if you're curious, please read my rationale here.
Some interesting developments have taken place between now and then, however. These merit further analysis. One or two of the commenters in the mentioned Samizdata piece stated that they were keeping abreast of banking developments in the Middle Kingdom. In 2002, Chinese officials admitted that 25% of the loans written by the state owned banks were non-performing. Standard and Poors and a number of others said it was closer to 50%, and possibly more. Within the space of four years, the Chinese administration has revised its estimation of the rate of non-performing loans down to an average of about 12%. How can this be done so fast? I'm not really sure. We are, of course, talking about the writing down or otherwise accounting for of many hundreds of billions of dollars of bad loans. I assume that it's due to the fact that most or all of the bad loans have been transferred to special "asset management" companies set up by the government. I suspect that the banks have been able to revise their non-performing loans (NPL) ratio down so quickly by performing a debt-to-equity swap with these holding companies. The article linked to immediately above believes the asset management companies have taken a chunk of the banks' loans and issued them with 10 year bonds in return.
This solution is clearly economic sophistry. At the end of the day, someone has to pay the tab - at some stage depositors are going to want their money. The equity in these holding companies is effectively (if not nominally for the time being) worthless - after all, their assets consist of a bunch of loans that will never be repaid. What is being done about the essentially state-owned industrial sector, which was - and most likely still is - the major recipient of these loans? There's a saying in China that goes something like "The mountains are high and the Emperor is far away". I have no doubt that this thinking pervades China's provincial administration and its state-owned industrial sector, and it explains the pervasive corruption that is, contrary to official publications, as rampant as ever. For every high-profile trial and execution of an apparently "senior" official on corruption charges, there are hundreds of thousands more who not only escape undetected, but are also politically untouchable into the bargain. Quite simply, the central government cannot be everywhere at once, and its reach is frequently limited by local powerbrokers. Consider this case in Guangdong, one of China's more prosperous provinces, where the central government could not exercise its will due to local political considerations, even though humiliating international media attention was beaming down. And who is to say that the central government is not as corrupt as its provincial counterparts? It is hardly unreasonable to say that corruption probes have a definite glass ceiling when it comes to the powers that be in Beijing.
I believe that the Chinese banking sector's dire straits constitute the gravest threat to global stability in the coming years. The Chinese government is always harping on about its "deepening" banking and state-owned industrial enterprise reforms, and this is a mantra is being repeated across the world. Unfortunately, the Chinese state is so opaque that it's impossible to verify the veracity of such claims, and the unrealistic numbers being thrown at us by the Communist party (like the drop of NPLs from 25% to 12% in less than five years) and the shonky juggling of bad debt from one insolvent bank to another woefully undercapitalised holding company do not inspire much confidence in the nature of the reforms. Frankly, I believe the banking sector is too far gone to reform without collapse. In international terms, the crisis in the Chinese banks and SOEs is an elephant that stands in the middle of the room, but everyone is either perceiving it as a mouse or trying to pass it off as a mouse. I believe the Australian government is in the latter category, as are a great many others around the world.
I speculate that governments like Australia's are acting as they are because they realise the Chinese state is very brittle and unlikely to withstand economic collapse. The massively stimulating US$50 billion or thereabouts annual injection of foreign direct investment is holding the Chinese state together for the time being. Thus, a number of states such as Australia have an interest in talking up Chinese economic reforms - and concealing the parlous nature of the Chinese economy - in the hope that investor confidence will not flag and the Chinese will trade and consume their way out of their problems. Our current economic health is due to huge demand in booming and resource-hungry China. Thus we see documents like this (pdf) that echo the "deepening reforms" mantra consistently spouted by the Chinese administration. Puff pieces like this create and sustain the irrational exuberance that swirls around the legend of the Chinese economic miracle, and inevitably amplifies economic pain when the collapse eventuates. The strategy of our governments may work, but it is an extremely high-risk gamble. The more investment in and commercial intertwinement with China increases, the more outsiders will suffer if the system unravels.
And perhaps the cracks are already becoming evident even to the man on the street. When I was in China in late 2005, ATMs were frequently out of order. I work in the banking sector in Australia, and when an ATM is out of order this nearly always means the machine has dispensed all its money. This was not a problem in late 2004 during my previous Chinese visit - ATM operations at that time were indiscernible to those in Australia. I am speculating here, because I'm not really an expert on this kind of money velocity issue, but perhaps the sudden patchiness of the ATM network is a sentinel of a solvency crisis.
And the collapse could come sooner than we think. In 2007, as per the agreement China entered into upon joining the WTO, it must open up its retail banking sector to foreign banks. This is a potential tripwire. Even if only a small number of Chinese are concerned about the health of their local banks (and thus their savings), when Citibank opens up next door the run on Chinese banks could easily spin out of control. I am assuming that the government is trying to spread the notion of confidence and stability in the retail banking sector. If the Chinese do not panic come 2007 or any time in the subsequent 20 years or so, the banks should be able to reduce their NPL rate to a "more manageable 5%". It wouldn't be the first time that people have left their money in a bank that is essentially insolvent because they believe the government will cover any losses incurred. This is a questionable assumption, however, and if I was Chinese I probably would not run the risk.
I am concerned by the consequences of a Chinese economic collapse, and these concerns reach far beyond any short to medium term economic pain. I fear a worldwide economic slump prompted by the collapse of China and its supposedly free market will provoke a popular backlash against globalisation and the liberal market reforms carried out in the 80s in the most successful economies of the West. Capitalism and liberalism will be blamed if people create a nexus between China's collapse, its market reforms and its intertwining with the greater world economy. There is no shortage of people who will quickly jump to the fallacious conclusion that the free market sunk China - those who protested in Hong Kong and other places would grab plenty of (misguided) ammunition from such a catastrophic event. Ask any one of those economic curmudgeons about post communist Russia's economy, and I will bet you penny to a pound that their standard response would be "capitalism failed Russia". This is about as sensible as saying that modesty failed Paris Hilton, for anyone who knows anything about post-Soviet "free market reforms" will know that they were in fact nothing of the sort. This type of thinking could very well gain traction because it makes sense prima facie. Policy reversals may follow and suddenly we're staring down the barrel of a neo-Keynesian revolution. Consider what the average person knows about China's economy. We're all told about China's free market reforms and its burgeoning capitalist class in the mainstream media - we're not told about the Chinese government's meddling in the economy and its mandating of compulsory totalitarian-style imposts on big private companies like internal "political cells", its retention of control over huge swathes of industry, its equity market (there is currently a ban on IPOs on Mainland bourses) which is stuffed with companies who are controlled by local governments and even the military, rather than shareholder, the board and a CEO. Most importantly, we're not told about the largely intractable problems with China's banking sector. Most people truly think China operates under a free market economic system. If the dog's breakfast that is China Inc fails with all the accompanying pain and fallout, there's a real danger that free market liberalism will be made the scapegoat internationally.
As I speculated above and in my previous article, Chinese economic collapse will probably preface political revolution. This is in itself an interesting, though disturbing proposition. What would post-communist China look like? Firstly, I should mention that a democratic revolution seems fanciful at best. There is no ANC-type shadow opposition waiting in the wings. The Party is the State, and the Party brooks no opposition. Here are what I consider to be the two most likely outcomes:
1) The military will overthrow the Party. If the banking sector collapses, so too will large chunks of the state-owned industrial sector that are afloat solely due to loans from the state-owned banks. Millions upon millions will be out of work - millions more will lose their pensions and benefits. Many tens - perhaps hundreds - of millions of people will pour onto the street to vigorously and violently protest their loss of savings and/or employment. In its death throes, the Communist Party will order a brutal military crackdown. Trouble is, a military is made up by people with aspirations, families, hopes etc. People who would have lost their savings, too. People whose parents, family and friends are suddenly out of work and without benefits. Most of the officers and soldiers will have no end of sympathy for their countrymen under such circumstances, and it's difficult to imagine the chain of command will survive under such conditions. The Communist top brass will lose control of the military, which will regroup under a new command. The old political order will be drawn and quartered, Mao will be evicted from his mausoleum and his portrait ripped down from the gate of the Forbidden City. There is no democratic tradition in China, however the country is steeped in a history of rule-by-decree. Expect this for many years to come. Perhaps the best outcome would be highly imperfect democratic elections in several years time.
2) The country breaks up along the lines of regional powerbrokers. Along with rule-by-decree, China also has a long history of warlordism and disunity. Due to the lack of any credible and widespread opposition movement in China, the possibility of a complete breakdown of central control is high if the Communists depart the scene and the military doesn't fill the vacuum. Hong Kong would almost certainly go its own way. Those provinces with large populations of non-Han citizens like Tibet and Xinjiang may declare their independence - perhaps bloodily ejecting the old order. Inner Mongolia may reunite with Mongolia. There is scope for large-scale dismemberment of the modern Chinese state. That left over will be fractured and ruled perhaps by the old regional party bosses reincarnated as warlords or whoever is able to wrest power from them and maintain it.
Some mention Taiwan as a wildcard that could be used as a distraction by the Central government. I think this unlikely. If the economy collapses, a war with Taiwan is not likely to distract anyone from their sudden poverty. Militarily, it seems unrealistic, too. The military will be stretched to breaking point in an attempt to reign in the chaos on the Mainland, so a massive invasion or attack on Taiwan looks unfeasible.
I truly hope that I am wrong about my bleak assessment, mainly due to the turmoil and potentially massive loss of life that would undoubtedly accompany such an event. I am also deeply concerned about the potential illiberal and protectionist measures that may be enacted in the West and elsewhere in the wake of a Chinese meltdown. The world has made a grave error of judgement in heavily backing an economy designed, constructed and administered by a group of ostensibly reformed Communists. This fact alone should have cooled the foreigners' ardour. As it stands, the potential for unprecedented economic losses from Chinese investments is enormous. I think we could be facing a very painful depression, which may very well be "cured" with a protectionist, welfarist New Deal-like solution. Scary times ahead.