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China Grasps for a Growth Alternative

John Lee

Recent comment by our straight-shooting resources minister Martin Ferguson that “the resources boom is over” (following BHP’s decision to shelve the $30 billion Olympic Dam project) was immediately met by rebuttals from finance minister Penny Wong and trade minister Craig Emerson.

To be sure, rising capital, labour and equipment costs will be challenging for Australian miners. Recent news that the largest Chinese players will permanently shut down unprofitable steel mills add to worry and uncertainty. But much of the optimism is based on the decade-long orthodoxy—popular with executives and investment analysts hardwired into talking up the China story—that Chinese urbanisation has a long way to go. As China-bulls point out, half of the population is still classified as rural and will need modern housing and other infrastructure over time. According to the narrative, this effectively guarantees strong demand for commodities such as iron ore for the next couple of decades, while Beijing has several economic tools with which to arrest any immediate dramatic slowdown.

All of this is true, but the analysis is still incorrect. Timing for dramatic changes in commodity prices is impossible to predict. But the reality is that China’s voracious consumption of commodities over the past decade has remarkably little to do with the genuine demands of urbanisation, makes little economic or commercial sense, and cannot continue.

Since the mid-1990s, urbanisation has been advancing at the rate of less than 1.5 per cent each year. Yet fixed investment has been growing at 20 to 40 per cent each year for the past decade. Fixed investment as a proportion of GDP increased from 38 per cent in 1999 to 45 per cent in 2003 and over 50 per cent currently. During the periods of rapid industrialisation in Japan, Taiwan and South Korea, fixed investment did not rise above 33 per cent of GDP. That China is dangerously embarking on a unique and unprecedented economic path is further confirmed by the fact that formal bank loans increased from $750 billion in 2008 to $1.4 trillion in 2009. In the two years from 2008-2010, the amount of outstanding loans on the books of the country’s banks increased by 58 per cent.

Obviously, and much to Australia’s delight, fixed investment needs steel, and steel making needs iron ore. Chinese steel production jumped from about 100 million tonnes in 2000 to over 400 million tonnes in 2005, to around 850 million tonnes currently. Analysts and forecasters need good data—which isn’t available in China—and rely on models based on key assumptions about economic rationality. The problem then is that these dramatic increases make no sense. Since governments cannot force their populations to consume, and Beijing has little direct control over consumption levels for its exports in advanced American and European Union economies, the only available policy response to a slowdown was to ramp up fixed investment levels—in short encouraging eager state-owned-enterprises to build things for the sake of it.

In other words, Chinese levels of fixed investment, and levels of steel production specifically, over the past decade have been predominantly driven by politically-motivated stimulus policies rather than market-determined demand. The result of the unprecedented reliance on fixed investment to maintain jobs, stimulate economic growth in urban areas (which is vital for regime security) and as a way for ambitious provincial officials to exceed growth targets in a personal quest for political promotion are the increasingly well-documented ghost cities, tens of millions of uninhabited high-end apartments that are bought as speculative capital assets rather than as investments based on rental yield, and world class infrastructure projects that will be never be adequately utilised. Estimates by Chinese state-backed researchers suggest that still empty apartments built over the past four years could house over 200 million Chinese.

Indeed, China has had very little success in rebalancing its economy away from fixed investment and net exports, towards domestic consumption as a major driver of growth. Until recently, many Australian politicians, business leaders and commentators refused to accept the reality that our miners are the major beneficiary of a politically expedient growth model that does not make any economic or commercial sense. It is a model that is correctly and consistently described by outgoing Chinese Premier Wen Jiabao as “unbalanced, unstable, uncoordinated, and unsustainable”.

The laws of economics are one thing. But optimists will reply that you can’t argue against a sustained record of economic growth. The reality is that ‘capitalism with Chinese characteristics’—in place since the mid-1990s—is brittle, but at the same time more perversely resilient than western style systems in the West.

First the brittleness…

Overseeing an economic model that is driven by regime survival (growth at all costs in order to keep the CCP in power) leads to enormous resource and capital misallocation. For example, it is estimated that at least one third of all bank lending is based on ‘policy’ rather than commercial grounds. Over three quarters of all loans are given to centrally- and locally-managed State Owned Enterprises—who undertake the majority of fixed investment projects—with only about 10 per cent of loans allocated to the more efficient domestic private sector. Around half of all SOEs are either loss-making or break-even. When unable to repay their lenders upon maturity of loans, central and local governments frequently force banks to simply roll-over outstanding loans. These loans appear as assets on the books of banks, even if they are actually non-performing. Over the past couple of years, banks were forced to roll-over an estimated $1 trillion dollars of maturing loans taken out by local government SOEs. Don’t believe the official non-performing-loan ratios of Chinese banks which are stated as less than 1 per cent of outstanding loans. The true figure is much higher, with credible estimates of NPLs amounting to anywhere between 40 per cent to 80 per cent of GDP. Well respected academic Victor Shih estimates that total loan liabilities could amount to 150 per cent of GDP.

But there is also a built in, albeit temporary, resilience to China’s economic model, which explains why systemic problems can be seemingly absorbed. It comes down to China’s relatively closed and authoritarian political-economy. For instance, in 2010 there was about $13 trillion worth of deposits held by China’s five largest state-owned banks which together make-up around half of the banking sector. These five banks had about $3.75 trillion in formal loans on their books, even though off-book lending might well add another trillion dollars to the amount.

In a market economy with open capital accounts, concerns about loan quality would lead a significant number of corporate and individual depositors to withdraw their savings from local banks and transfer monies into safer international institutions. But the combination of a closed capital account, lack of alternatives to state-owned banks, and undeveloped corporate bond and other domestic financial instruments means that Chinese state-owned banks enjoy almost perfect savings capture within the country.

Unlike advanced economies, Beijing can also compel its banks to increase or decrease lending through a number of direct and indirect measures. The spread between deposit and lending interest rates (at about 3 per cent on average) is also one of the widest in the world and is set by the government. This means that Beijing can force depositors to effectively subsidise investment activity when needed. And when loans mature, Beijing can simply demand that they be rolled over, or that new loans be issued to SOEs to cover previous commitments. Never mind that the savings of China’s households is systematically eroded and placed in jeopardy!

But every Chinese economist knows that this model will eventually run out of steam. Capital factor productivity is rapidly deteriorating, meaning that politically-motivated fixed investment stimulus is becoming more and more expensive and less effective. Hidden and enormous NPLs will have to be reckoned with. China cannot repeat the policy of simply doubling fixed investment like it did from 2008-2010 to maintain rapid growth. No one knows what Beijing will do over the next year and beyond. But Australian forecasters need to be aware that the decision to slow-burn or dramatically wind-back investment levels is a political rather than commercial decision.

For the moment, China knows of no other way to stimulate growth, even as the state-dominated fixed investment model is suppressing household income and therefore domestic consumption. Our mining boom may have some years yet depending on the political calculations of China’s leaders. But growth in our major trading partner is not based on solid economic foundations. And any genuine economic rebalancing in China, or even an attempt at it, will be painful for Australia and even more trouble for the government’s fading hopes for a budget surplus.

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