China’s Growth: The Debate

I thought I’d managed to leave China behind last week but Michael Pettis has such a good post up, that I’ve been inspired to return to the subject.

Last week John Ross had a go at Pettis for questioning the merits of China’s economic system.

As John has outlined in a long series of posts, he fundamentally believes that the key to long term economic growth is investment and that China is successful because, by directly controlling investment it can control growth.

There might be something in this, certainly for developing economies. But as Chris has argued it may be the case that governments in developed countries have less control.  In other words the Chinese model, which is similar in some respects to the South Korean and Japanese route to prosperity, can succeed in increasing GDP from a low base but doesn’t work in an advanced economy. If true, then this would undermine the argument of tjhose who claim that the UK, for example, could learn a lot from China.

On this very topic, an email landed in my inbox this morning from a broker in Hong Kong:

 Next year, more and more analysts will start to question when, like Japan and S.Korea before ,  China’s semi-capitalist or authoritarian capitalist system becomes too ossified with job done in building up native industry.

There will be more and more focus, too, in the wake of the $1 trillion plus surge in bank loans, on China’s already hefty weight of NPLs—finance /economic  hernias or worse ahead? !! 

NPLs = Non-performing loans.

As I said last week, China can continue growing because, despite exports being down and domestic demand being weak, it can keep increasing investment (or fixed capital formation). This has collapsed in the West where private companies have little desire to invest during a recession and where even if they did want to then they would find it difficult to raise the finance. In China however state owned companies are ordered to invest and state owned banks required to lend to them.

What we really have here are two issues – one long term and one short term, but both linked. The long term issue is the one referred to above – can China keep growing by investing. John Ross would point to the amount of people living in poverty and the lack of infrastructure in much of the country and say yes. But surely we eventually hit a point when simply investing more and more is not enough. One can only add so much to capacity.

In the long rule, many argue, that China needs to consume more domestically. In other words Chinese workers need to save less and spend more. This would not only provide a driver for growth other than investment/exports but would also help to address the global imbalances that have plagued the economy over the past decade.

But in the short term there is the issue of how sustainable current Chinese economic actually is.  This is where Pettis comes in. He received an email from a fund manager which casts light on some of the ‘investment’ currently driving Chinese growth:

I don’t know how much you travel around China.  Tom and I do a fair bit, and most recently we were in Guiyang.  I thought I’d seen insane excess in the past – 200 thousand square meter malls completely empty next to apartment complexes with 40 thousand units and 30% occupancy rates, etc. etc.  But what we saw over there is rather hard to fathom.  It seems the Guiyang city mayor had the same idea as the Shenzhen mayor – to move the old downtown to a piece of undeveloped land. 

Of course Guiyang has a quarter the population and probably a quarter the per capita income of Shenzhen.  They built sprawling new government buildings about a 20-minute drive north of town.  And then the residential high rise projects started going up.  From driving around the area, Tom and I figured well over 100 20+ storey buildings.  

What was most distressing was that the development has been totally uncoordinated – a project with 15 buildings here, in another field two miles away a project with one building, another mile in another direction three buildings, sprawled over what was easily over 30 square kms. of farmland well north of town.  Every building we got close enough to see was either incomplete/under construction, or empty.  Our tone gradually went from “Haha, another one!” to “Oh my God, another one.”  We conservatively guesstimated that we saw US$10bn of NPLs in one afternoon.  The only buildings that were occupied were six-storey towers built to accommodate the peasants who had been displaced by the construction. 

 The fund manager asks:

What will determine whether China experiences a steady slowdown (possibly sub-par growth rates over next decade) vs. a crash of the economy.  Is controlling credit and SOEs enough to prevent a collapse of the typically most volatile component of the GDP – fixed asset investment?  If they can prevent a crash, then maybe it’s all worth it ? 

(SOE = State Owned Enterprises).  

Pettis answers at first with a good discussion on the nature of debt (with a plug for Minsky) before saying:

So to get back to the original question, will we see a crash, or a steady slowdown?  My guess is that there is significant and rising instability in the banking system’s liabilities, and far more government debt than we think, all of which should indicate a rising probability of a crash, but I think the ability of the government to control both the liquidity of liabilities (i.e. to slow them down, or to forcibly convert short-term obligations into longer-term ones) and the process of asset liquidation (at least within the formal banking system – I don’t know about the informal), suggests that if a serious problem emerges we will probably see more of a “Japanese-style” contraction: a long, drawn-out affair as bankrupt entities are merged into healthier ones, liquidations are stopped and selling pressure is taken off the market by providing cheap and easy financing, and so on. 

This is a long way of saying what I have often argued – that what we should expect in China is not a financial collapse but rather a long period – maybe even a decade – of much slower growth rates than we have become used to.  There are many reasons to expect a short, brutal collapse followed eventually by a healthy rebound, but government control of the banking system eliminates a lot of the inversion that in another country would force a rapid adjustment.  This is not a note of optimism, by the way.  As the case of Japan might suggest, the long, slow adjustment may be socially and politically more acceptable but it may also be economically more costly. 

Grim stuff for China, but for me the really interesting stuff comes at the end, and neatly ties together the short and the long term issue:

China needs to increase domestic consumption for stable internally driven growth.  You can’t increase domestic consumption if you’re buying real estate.  So this is yet one other way that this whole liquidity injection is preventing a transition to a consumption-based economy.  You really do wonder how long the Chinese will keep up this level of “pump priming”.  If they realize how much they’re screwing themselves for the next decade, the central government might just tighten liquidity. 

In other words China’s current policies are delaying a shift to a more sustainable model.

In the end this the question on China. On the one hand John Ross believes that the investment driven, state directed growth can not only be used during the transition from developing to developed economy but can continue from that point onwards. People such as Michael Pettis disagree. They worry that in the long term the model won’t work and in the short term it may be pushed to its limits.

For what’s it worth, I lean more towards Pettis. I do think that there should be more government involvement in the economy. The industrial policy agenda that I’m keen on would involve the government helping private industry to grow. It would involve government loans to firms in key sectors and it would necessitate much closer co-operation between government, industry and unions than we have currently.

But I don’t take it as far as arguing for the nationalistion of vast chunks of the economy. I recognize that there are times (such as in the UK transport and housing sectors currently) where private industry is failing to invest when it should be investing. I’m more than happy for the government to step in. But I also recognize the potential danger of the Chinese approach of investing simply for investing sake.