China: Reform Progres

Photo Credit: Associated Press

This post is motivated by Li Keqiang's recent speech, some recent Chinese Monetary Policy adventures, and a book I read last night: Avoiding the Fall: China's Economic Restructuring by Michael Pettis.

The theme here is restructuring. China needs to promote balanced growth. China needs to increase consumption. China needs to stop relying on debt fueld investment. We've all heard the headlines. 2014 should give us a good indicator of both the willingness to reform and the direction that policy makers will take it.

Premier Li and his forward guidance.

Two key numbers: Li identified targets of GDP growth at 7.5% and household consumption growth at 14.5% (China overshot GDP by .2% and undershot on HCG by 1.4% in 2013).

Following these statements Li reiterated the government's support for Investment, even stating (from this FT article), "We will take investment as the key to maintaining stable economic growth".

Interpretation of an interpretation is always a bit, well, of questionable value. But it'll be curious to see whether they will set a key target (aimed to reduce investment share) or if they will use it as an active discretionary fiscal policy tool to aid in the re-balance (which could easily be counterproductive).

If they actively target a path towards balancing the consumption/investment shares of GDP then this will, almost by definition reduce GDP growth significantly (via falling investment growth, perhaps even to negative growth). This is why the 7.5% target described earlier is a bit puzzling. Not too sure how you can have both.

Which turns me to Pettis's Avoiding the Fall.

The basic thesis of Pettis's book is that GDP growth MUST fall. The mechanism by which it will fall is not determined, nor is the timing of the fall. However, the debt servicing capacity will be reached at some point in the not so distant future (Pettis suggests as early as two or three years from now) in which case a hard landing will be forced on China.

Conceptually, framing this with an accounting identity is probably the easiest. So we have a basic GDP equation

GDP = Consumption + Investment + Government + Current Account

Alright, so remember:

- In a close economy Investment = Savings. But of course we aren't in a closed economy.
- If Investment exceeds Savings then that balance shows up as a Current Account surplus (or vice versa) which is simply the net exports. (ie. GDP that isn't consumed domestically but is consumed in foreign markets).

Now, a couple of items unique to China according to World Bank Data:

- Savings (Investment) increased from an already high 37% of GDP to 51% from 2000 to 2012
- Household Final Consumption dropped from an already low 47% of GDP to 35% from 2000 to 2012
- By comparison world averages were 22% and 60% respectively in 2012.

So the rebalance math is simple: Consumption growth > GDP growth > Investment Growth

So the trillion RMB question is how you get a relatively high GDP growth rate out of an economy that has manufactured it's growth via an expanding investment share of GDP. And this is a question that get's infinitely more complex when that investment portion is fueled by debt. Which is a key component of Pettis's argument.

A sense of urgency?

The main reason that the status quo can't last economically is Pettis's assumption that Chinese investment has at some level been misallocated, and is likely increasingly so. Pettis broadly describes misallocated investment as investment who's impact on GDP exceeds the economic wealth generated by it. This follows logically from his discussion on financial repression which I fully agree with.

Financial repression describes the subsidization of one sector at the expense of another. In this case, the simplistic description is that Chinese savers are given very low return on their assets (and few other avenues to preserve wealth) in order to provide very low rate loans to borrowers. These borrowers, with their below market debt can invest in projects that at the margin would not be economic. The longer this set up exists, the argument goes, the greater the number of uneconomic projects being undertaken.

Financial repression isn't necessarily all bad though. When a country has a very low existing capital stock the funneling of funds towards it's growth does not necessarily lead to economic missalocation (the China Development Bank story here shows the value). Countries like Japan and South Korea have utilized this method of development effectively in the past and have found themselves in the rarefied class of countries that blasted through the middle income trap.

While I might disagree, or at the very least remain agnostic, about the scale of misallocated investment I don't for a second doubt significant capital has in fact been misallocated. The Chinese government must implicitly accept this notion as well, or re-balancing would not then be required (if the economic worth of investment met or exceeded the capital outlay, then the project would be a good investment).

My divergence from Pettis's view is along the lines of timescale and urgency. I don't quite have my head around why dead limit capacity would form such a cliff. I agree that uneconomic acivities will have to be recognized at some point. I also agree that a slowdown in economic growth is inevitable. But a hard landing? I'm not convinced.

In order to avoid a hard landing, China needs to focus on two key items: recognizing and unwinding the loss generating debt and increasing the consumption share of GDP.

Chinese Loan Growth:

In January China's loan growth was shown to be the largest since the stimulus spending of 2009. What did this mean? Was it one of the many annual abberations caused by the Lunar New Year? Was it a bullish signal that the supply side is ramping back up? Was it another hail mary thrown onto the increasing mountain of debt that we hear is fueling China's growth?

February's numbers indicate another huge growth in loans. More of the same? Oliver Barron's article on Forbes illustrates the contradictory nature of some of the data:

Many of the data points released over the last two months have signaled a domestic slowdown, including the January manufacturing PMI reading at a six-month low of 50.5 and the February HSBC Flash PMI reading of 48.3, a seven-month low (a reading below 50 signals contraction). However, this data was somewhat puzzling as it contrasted with a 10% yoy growth in exports in January and a 23% yoy rise in new yuan loans, both of which suggest a relatively well-off economy.

His interpretation of these incredible loan volumes is something much simpler. And a strong indication that China's reform policy is pushing forward, while offering another indicator pointing towards a general slowdown:

As it is now emerging that the strength of bank loans can be partly attributed to off-balance sheet loans coming back on balance sheet, then the actual demand was actually much weaker than the headline figures suggest and the slowdown is confirmed.

IF this is the shadow banking system being rolled onto the balance sheet of Banks that is a solid first step towards the proper recognition of their magnitude, and also an indicator of how potential losses will be dealt with.

In the late 90's in the wake of the Asian financial crisis China addressed high levels of non-performing loans at the four state owned commercial banks by effectively transferring them out into state backed asset management companies. Is something like this possible now? It's hard to say but if we can get those assets out of the shadow banking sector and back onto the big banks balance sheets we'd at least know the scale of the problem.

 Interest Rate Liberalization:

Interest rate liberalization is typically a key to unwinding financial repression. Those incredibly high household savings rates now increase household income and capital is allocated more conservatively which reduces investment going forward.

Bloomberg reports on the progress here:

The People’s Bank of China moved toward freeing up interest rates in July by removing a floor on the rates banks can charge for loans. Three months later, the central bank started a “loan prime rate” based on weighted average costs charged to the best clients by nine major Chinese lenders and in December, it allowed banks to sell negotiable certificate of deposits with yields set by the market.

This, in conjunction with the deposit insurance indicated in the article, as well as the forward guidance on pushing for market determined interest rates should go along way to clear up current imbalances.

Hopefully, deregulation will also allow the entrance of other formal banks to cater to the many business, as described in this BBC article that are paying exorbitant rates:

Zhou Feng, the 30-year-old boss, told me that without the high-interest loans from shadow banks he couldn't take on large orders. He usually pays 24-30% for these loans, which in his case are usually for just three to five days, and give him much-needed cash.

Conclusion:

The reason for my optimism on China is twofold.

The first, and most important, reason is that there is alot of low hanging fruit. I've stressed on this blog previously the need to disentangle the aggregate macro picture from the more nuanced micro environment. The main reason that China has been able to produce the spectacular growth numbers that they have is quite simply that they started from such a small base.

The second, and almost equally as important, is that for whatever reason. The Chinese government has done an excellent job at choosing policy through this period. Was every choice the right choice? I wouldn't think so no. But this growth story could have gone off the rails at any number of times where the 'experts' would have acted incredulously that anyone had thought this wouldn't be the case.

I was only 12 when the '97 Asian financial crisis hit, but I can only imagine that a similar line of reasoning to Pettis's could have been made. Obviously, the continuation, or even acceleration of these policies have likely compounded the problem, but still.

Or imagine asking yourself in 2006 what would happen to China's export economy if the entire developed world had a complete financial meltdown and fell into an economic recovery that bordered, and continues to border on stagnation.

No, I'm going to need to see something materially change (for example a walk back on the plenum reforms), my benefit of the doubt goes to the Chinese government.