China's debt-fuelled economy expands oh so smoothly

by Michael Collins, Investment Commentator at Fidelity International

September 2016

The People’s Daily is the Communist Party of China’s flagship media outlet. When it has an exclusive from an “authoritative person” it means the article has the sanction of President Xi Jinping.

In May this year, in the third of these exclusives within 12 months, the authoritative source warned the “fantasy of stimulating the economy though monetary easing should be dropped”. The person described the explosion of debt to stimulate the economy after 2008 as China’s “original sin”.

The source forecast that China’s economic growth would follow an “L-shaped path” rather than a V- or U-shaped one. That is, economic growth would level out around the government’s target of 6.5% to 7%, after dropping from the double-digit growth rates of the 2000s.[1] In due course, in July, a report showed China’s annual economic growth rate for the second quarter was 6.7%, smack on the first-quarter’s outcome.

The GDP match between the first and second quarters fanned the scepticism of those who question the smoothness and pace of China’s economic expansion. But even if judged as valid, the GDP result was worthy of concern. Basically, the report confirmed that a lending burst from state banks enabled China to scrape out its slowest economic growth rate in about 25 years – exactly the kind of stimulus the source said was unsustainable.

These events highlight that China’s policymakers have embarked on perhaps the riskiest course they could have taken when China’s economic crisis deepened in recent years. They could have allowed growth to cool as they pushed through reforms to address distortions and modernise China’s economy into one driven by consumption – one with flourishing private and services sectors. Instead, China’s stewards have chosen to double-down on the broken investment- and export-led economic model by resorting to short-term stimulus in the form of easier monetary policy (that fuels state-led investment) and a lower yuan. The danger is that by enlarging the country’s distortions they could set up a bigger crunch.

China’s policy elite are struggling to move beyond the broken economic model because their reform drive appears no match against the debt-created imbalances they need to solve.

As well, they are up against vested interests, politics and the sheer complexity of overhauling the world’s second-biggest economy. Such indecision creates doubt about the growth rates China can achieve when high debt levels rule out further monetary stimulus.

To be sure, even those who question the official statistics think China’s economy is growing at about 4% a year, a rate most countries would envy. Consumption and the services sector are expanding at more than double that pace so there is a rebalancing occurring of sorts. Beijing has embarked on some of the 300-plus reforms announced in 2013 that include loosening the one-child policy, encouraging free enterprise and strengthening property rights for farmers.[2] The country has healthy government finances, a large pool of domestic savings, low household debt, well-capitalised banks that are shielded from bank runs, and the country’s debts are typically in yuan, not foreign currency. A slowing in credit growth to a two-year low in July hints that policymakers are pulling back from debt stimulus. The warning in the People’s Daily might well have exaggerated dangers for political purposes. But whatever the motives, the warning rang true. It emphasises the risks of China’s current course and showcases the multiple dilemmas China confronts in modernising its economy. Among other challenges, many reforms are at cross-purposes or are politically testing, if not impossible. Such difficulties are only more apparent now that China’s debt pile has risen to what would be crisis levels in other countries.

Two retreats

The original sin referred to by China’s “authoritative” source is the lending frenzy Beijing encouraged from 2008 to counteract the loss of demand for its exports when the advanced world plunged into recession, a drop in demand that broke the industrialisation model China had pursued since the late 1970s. Lending – largely by state banks as the shadow financial sector was reined in – has boosted total debt from about 140% of GDP in 2007 to about 250% of GDP now. Corporate debt is estimated to have jumped from about 100% of output to about 175% over that time. Even in June, new credit climbed 1.6 trillion yuan (A$325 billion), to take total debt to about US$30 trillion. (The outcome for July was a much lower 488 billion yuan.)

The extra lending is a policy reversal but, at the same time, it lessens the immediate risk of a debt crisis among companies and local governments – that’s why it’s so tempting. But while buying time for policymakers, it makes their job more fraught. The lending has frothed up the country’s property markets. It has sparked bubbles on the country’s stock markets in 2015 and on its commodity markets in 2016. The investment the lending enabled has boosted overcapacity, encouraged uneconomical projects, crowded out private investment and raised longer-term financial risks, especially for state banks.

The other retreat from the shift to a consumer-led, market-driven economic model is Beijing’s decision to pursue a lower exchange rate, a policy that acts against consumers by reducing their spending power. Over 2016, China has allowed the yuan to decline about 6% against a basket of the major currencies and 3% against the US dollar, even if that hasn’t triggered global anxieties the way Beijing’s 1.9% devaluation of the yuan against the greenback did in August last year when China announced it would let market forces hold more sway in setting the value of the currency.

A lower yuan favours exporters and helps China postpone an industrial slowdown by sending its excess capacity abroad. But the risk for China is that a lower yuan might trigger private capital outflows and could prompt trade retaliation by other countries, a rising menace as the populist backlash against globalisation swells in western countries. Apart from triggering trade retaliation, the danger for the global economy is that a lower yuan causes China to emit a deflation shock to a world already struggling against a general, even if mild, decline in prices. That, in turn, would only further weaken China’s export markets.

Quandary after quandary

Any number of areas could highlight the dilemmas China’s policymakers confront in their modernising quest. One obvious economic quandary, for instance, is that the attempt to boost consumerism is straining China’s export industries. Wages growth is an economically sensible and politically palatable way to boost consumption and is thus an essential ingredient in creating a consumer-led economy. Authorities, accordingly, in recent years have encouraged higher salaries by mandating increases in minimum wages while allowing market forces to boost pay cheques as firms compete to attract workers amid strong economic growth. Wages are estimated to have jumped about 30% in China in the past three years, a great boost for consumption.

But higher wages make China a less attractive hub for manufacturing exporters. A survey by the Japan External Trade Organisation found that in 2015 the average manufacturing worker in China was paid US$424 a month. This was about US$100 more than the cost of employing the same skills in Thailand (US$348) and Malaysia (US$317) and almost US$200 more than in the Philippines, Indonesia and India. Even more concerning from a competitive point of view, the typical Chinese factory worker costs more than twice as much as a labourer in Vietnam, Pakistan and Cambodia and more than three times as much as staff in Sri Lanka and Bangladesh.[3]

Foreign companies, as a result, are pulling production from China or relocating planned plants elsewhere. Foxconn from Taiwan, for instance, which has long made iPhone components in China, plans to build 12 factories in India that will employ one million workers. The 2016 survey by American Chamber of Commerce in the People’s Republic showed that about 25% of US businesses in China had shifted or planned to move operations out of China.[4] The Boston Consultancy Group finds that some of that production is returning to the US because its manufacturing cost-competitiveness index shows that “at the factory gate, China’s estimated manufacturing-cost advantage over the US has shrunk to less than 5%”.[5] The Hong Kong-based Fung Business Intelligence Centre said that shifting production is behind the 0.6 and 1.7 percentage point drops in China’s apparel market share in the US and EU respectively in 2015, as Vietnam and Bangladesh gained market share.[6] A loss of jobs lowers overall consumption.

The most-readily available weapons Chinese policymakers have to combat the loss of competitiveness and export-related jobs are to reduce the yuan and to suppress wages growth, options that thwart the modernisation drive. In March, Beijing urged provinces to be “steady and cautious” in approving wage increases while some provinces such as Guangdong have frozen minimum wages for two years.[7] Such steps undercut the ability of China’s masses to share in China’s prosperity and risk stoking the unrest that Beijing is trying to stave off by protecting the export sector.

Such steps go against the policy change in China’s reform plan of 2013 that authorities would let market forces play a more “decisive”, rather than “basic”, role in allocating resources.[8] This policy shift can be read as a commitment to overhaul the state sector while encouraging the development of the private sector – two essential modernisation moves. Authorities, however, are yet to shake up the many loss-making state companies that carry so much of China’s corporate debt or open up industries such as finance and energy among others to private enterprise.  

If China’s policymakers are to ease up on debt stimulus and reduce their yuan manipulations, the question begs how China is to maintain an economic growth rate of 6.5% to 7% when its modernisation drive is so fragmented and risky in itself anyway. Perhaps the People’s Daily’s authoritative source could soon let investors know how economic growth can keep that L-shape in a China not driven by fantasy stimulus.

Financial information comes from Bloomberg unless stated otherwise.