Why China’s Hard Landing Is A Certainty
Why China’s Hard Landing Is A Certainty
Two years ago, Professor Michael Pettis of Peking University's Guanghua School of Management was something of a loner in his view that China’s infrastructure-led growth was creating gargantuan problems. Now, with land sales falling off a cliff, house prices reversing course and the central government forcing Chinese banks to roll over local government loans that had no hope of being repaid, the structural problems with China’s economy are widely accepted (at least in the international press … you don’t read much about it in the local papers).
The debate is no longer about whether China is overly dependent on infrastructure spending. It is blatantly obvious the associated buildup in local government debt is unsustainable. The question now is whether an adjustment can be made without a dramatic slowdown in the overall economy.
The proponents of the ‘soft landing’ scenario – GDP growth slowing from its current run rate of 10% per annum to 7-8% per annum – argue that China’s rapidly burgeoning middle class will pick up the slack. Increasing consumption growth rates, they argue, will offset the slowing growth in infrastructure spending.
There are two problems with this argument. Firstly, the Chinese authorities show no signs of reversing the policies that cause consumption to be such a small proportion of the overall economy in the first place.
Those that propagate the consumption argument seem to think consumption is low because of some genetic quirk amongst Chinese households that imbibes them with a sense of thrift and saving, in stark contrast to spendthrift Western consumers. The Chinese, we’re led to believe, are sitting on piles of savings just waiting to be unleashed in a wave of wanton consumerism.
Luxury brand owners would like that – sales of Louis Vuitton and Chanel are already soaring in Asia – but there’s nothing cultural about China’s lack of consumption. It is a result of specific government policies that transfer wealth away from households and towards borrowers, exporters and government.
By holding interest rates artificially low, wealth is being transferred from savers (households) to borrowers (businesses, state owned and otherwise). A controlled, low exchange rate translates to artificially high import prices, another direct wealth transfer from households to exporters.
It should come as no surprise that the consumption component of GDP has been shrinking (see the discussion between Nouriel Roubini and Patrick Chovanec below).
Far from unwinding these impediments, China has loosened monetary policy and stopped letting the exchange rate appreciate at the first sign of trouble. In the short term, the consumption proportion of GDP may well decline further.
Secondly, it’s a mathematical impossibility for growth in consumption to offset any meaningful slowdown in investment.
In 2011, investment represented 5.2% of China’s 9.2% overall GDP growth. Everyone agrees they are spending too much on investment. Yet even if they build the same number of houses, the same number of high speed rail lines, roads, subways systems and airports as they built in 2011, that would mean investment growth of zero.
Assuming net exports hold up in 2012 (an optimistic assumption given Europe’s economic woes), consumption, currently only one third of GDP, would need to grow 20% to generate overall GDP growth of 8%. That isn’t going to happen.
Of course, investment growth can be negative. The collapse in housing construction has deducted 1.2% from US GDP since 2008. In fact, I’d say a contraction in infrastructure spending is likely at some point.
With another government stimulus, the day of reckoning can be delayed. The Chinese Communist Party’s decennial leadership transition will take place at the end of 2012 and the last thing they want is economic turmoil. But everything I’m reading indicates Pettis is on the money. Whether it’s this year or next, China’s inevitable hard landing is coming.
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And what then for the Aussie dollar?
I'm guessing it's not up.
Steve,
Interesting discussion. Nouriel and Patrick were describing a slowdown to GDP growth of 5-6% as a hard landing. Is this what you mean by a hard landing or are you referring to a traditional hard landing (i.e. significant GDP contraction) as being inevitable?
Steve,
A great analysis of some larger China trends. As someone has has lived in China for over 15 years, I have mixed feelings about Michael Pettis' work. There is no doubt that investment makes up far too large a proportion on China's economy. Nonetheless, through 'great sacrifice' in terms of current personal consumption, China has built a staggering infrastructure, built it quickly and broadly speaking has somehow managed to finance it all without blowing up under a mountain of debt. The quality and quantity of schools, roads, trains, bridges, tunnels, airports, universities, hospitals, power plants, industrial parks and every other form of public and private infrastructure developed is amazing.
Whether investment controls focused on reigning in the creation of further local government debt slows China's GDP growth considerably is another matter. At present, the vast number of projects underway and with completion timeframes over the next 3 years, will keep GDP ticking over (and obviously continue to drive Australian commodity exports). 10 million low income housing units will commence construction this year. There are hundreds of subway lines under construction as well as a national high speed rail network. Building continues and much more is necessary in less developed regions. Banks continue to lend at a relatively robust rate. Taxation revenue grew by another 22% last year suggesting part of investment costs can be financed through recurrent national govt tax revenues.
Utilization rates of much of the infrastructure is very, very high within a short time after completion. New subway lines are packed within weeks of opening. Major high speed rail line tickets are sold out year round. With a few exceptions, the ghost satellite cities featured in the press a few years ago, have filled up as necessary social infrastructure was developed in adjacent areas (remote coal-rich Erdos being one of the exceptions as there is no surrounding rural population to move in)..
Pettis' key point is that a reliance on investment inevitably leads to 'bridges to nowhere'. It may well do so and there is no doubt there is waste in infrastructure development. However, from what I see around me, public and private infrastructure is well utilized, was built at a very reasonable cost (while land are labor costs are low thus making it the perfect time) and serves the public interest.
At present, on the consumption side of things, China also appears to be booming. From a macro perspective, only B2B consumption and some high end retail is reasonably captured by official figures, with the vast rest of B2C invisible and low key as it avoids taxes and understates income. That sector is doing quite well.
The picture of the thrifty Chinese consumer saving and not spending is simply untrue, with most Chinese citizens and particularly the young having money only in the compulsory social insurance system rather than in private bank savings accounts. The withdrawal of private cash from banks over the past 3 years has been enormous. Savers know a bad deal when they see one.
I would not be too negative. The overall business environment in China continues to quite good, individual businesses continue to invest in business growth and shoppers are buying more than ever (of course avoiding 17% VAT and other taxes by buying online through non-compliant small traders).
Thanks Chris, appreciate the thoughts from the coal face. For Australia's sake I really hope Pettis is wrong on this and lots of your anecdotal evidence suggests the money is being well spent.
It does need to be put into context though. China is a US$6 trillion economy. $3tr of that is being spent on investment - 10 million low income housing units is hardly a drop in the ocean.
The debt issue is still unresolved too. There's no doubt the boom has been financed with a lot of debt. If, as you suggest, it's financed a bunch of projects that all earn meaningful economic returns, then it won't be a problem. If, as Pettis suggests, large swathes of it have been spent on uneconomical projects, it is going to be a problem.
Personally, I find it hard to imagine how a bunch of bureaucrats could possible allocated the capital without lining their own pockets and helping their mates. But I'm probably just your typical Western sceptic who thinks his own system is the only one that works.
Hi Steve,
Appreciate the thought provoking post. Two questions for you:
1. Having the just lived (and invested) through the GFC, do you worry about anchoring your view on China with recent events that have occurred in the Western World in the last few years? E.g. I’d argue that the property crash in the US was an outlier relative to other housing ‘corrections’ that have occurred post WWII.
2. Related to above, how much credence do you give to the idea that China might have a cyclical slowdown (say for a year or two), but structurally will continue to develop / urbanise?
Without getting into a definition debate over what a ‘hard landing’ in China actually means, separating the cyclical vs structural is probably critical over the longer term. I’m no China cheerleader, but I’m not convinced that an implosion of China’s economy is a certainty.
Good questions Will. I doubt the government will let the housing market crash the way it has in the US. They also won't let the banks realise bad debts in a hurry. Much more likely, in my view, is a long drawn out period of slower economic growth.
What's more important for us, though, is that the rate of construction could slow dramatically. You don't need a dramatic crash in the price of housing to have a dramatic decline in the rate of construction. But it's hard to see where the money is going to come from to keep building at the rate they are.
This is where you need to dive deep into the genuine differences between the American and Chinese systems. At heart of the Chinese economic dilemma is misallocation (or more like "misappropriation") of national resources. Too much construction and not enough household consumption, and so on.
But where in the US there are safety nets and welfare institutions, etc... there is nothing comparable in China. Beijing is not about increasing citizen wealth - it's about creating jobs to give everyone something else to think about other than democracy and self-expression. Corruption and inefficiency is not a concern if it doesn't get in the way of creating jobs.
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