Last Friday, Business Spectator carried an article by China Spectator editor Peter Cai on what we can expect from our largest trading partner in 2015 (What can we expect from China in 2015?, January 16). The sensible conclusion of that piece was that ‘muddling through’ was the likely outcome.
While we may not see any dramatic and widespread reform, China is still likely to react swiftly and decisively enough to prevent any ‘Lehman moment' or dramatic slowdown in growth. The best days might be over for China, but it is ‘business as usual’ in most respects.
Rather than buy into the argument between bulls and bears, which is largely a speculative and somewhat boring argument about what real rates of GDP growth will be in 2015, this article is about what muddling through actually means for China and where the dangers of muddling through lie for Beijing.
This author has already written previously for Business Spectator about why China won’t have a Lehman moment, but that should not be the standard of the relative resilience or otherwise of the Chinese economy (Bears are circling bulls in the China shop, May 7). Briefly, China’s political economy in general (and banking system in particular) is different to that of open economies such as America’s and Europe’s.
There will be no freeze in Chinese interbank lending no matter how paranoid banks become of the credit-worthiness of each other -- which is what occurred during the Lehman moment -- because the government can force banks to lend, as it did in 2008.
To work out what ‘muddling through’ means, the first question must be about the status quo. Instead, the question should focus on what ‘business as usual’ means since ‘muddling through’ implies an absence of dramatic or decisive change.
The timeframe is around the early part of this century during the term of the Fourth Generation Leaders led by President Hu Jintao and Premier Wen Jiabao (the latter largely in charge of economic policy.) Up until the late 1990s, exports remained the major driver of Chinese growth. From early this century, China began to pursue a policy of massive increases in fixed-investment, especially in heavy industries such as steel and infrastructure building of which Australia has been a major beneficiary. Since state-owned-enterprises dominated these sectors, SOEs took the lead in the fixed-investment path.
From the middle of the previous decade, Beijing formally abandoned any plans to allow the domestic private sector to take the lead in economic affairs in all major sectors of the economy (with the exception of export-manufacturing which is dominated by foreign owned and invested firms) and instead insisted that SOEs were to take the lead in all these ‘strategic’ and ‘important’ sectors. With advanced economy markets slowing down during the global financial crisis, fixed investment -- which had already been growing at over 20 percent reach year prior to 2007 -- took the lead.
The most dramatic period was during 2009 when state-owned banks conducted the largest stimulus in global economic history, doubling formal bank loans from the year before and expanding the outstanding loan books of banks by around 58 percent in just one year. From mid-2008 to mid-2014, Chinese GDP doubled according to official figures.
During that same period, the volume of outstanding bank loans tripled. New debt issued by state banks over this period stood at around $US9 trillion, exceeding the entirely commercial banking sector of the United States. In the same period, private wealth in China increased by only just over half that amount (approximately $US4.5 trillion.)
In summary, SOEs massively increased their importance and role in the economy. Bank credit and corporate debt exploded, and the coffers of SOEs increased far faster than the increases in mean household income (which has been increasingly slower than economic growth.)
Indeed, the rise of the so-called shadow banking sector, which is now a huge problem for the government, is directly related to economic policy over the past decade. For example, local governments reacted to the accessibility of free credit to SOEs by creating their own investment entities. They poured much of the credit into speculative investments in the luxury residential housing market, forcing out at least 40 million rural households from their plot of land with inadequate compensation to facilitate such speculation, according to the Chinese Academy of Social Sciences research.
Starved of credit and opportunity, private businesses became increasingly reliant on the secondary shadow banking market to source funding, while SOEs were more than happy to make money on the side by using their access to cheap credit to lend to private firms on the secondary market at much higher interest rates.
Given this context, what does ‘muddling through’ mean? It means that SOEs will continue to be protected and coddled through privileged access to capital and commercial opportunity. But limited reforms will be pushed through to try and force the majority of SOEs to be more commercially responsive and adept even though China’s domestic private firms typically use the factors of production (labour and capital) two to three times more effectively than SOEs. Beijing will continue to do what it takes to prevent any Lehman moment, and some directives will be given to improve loan quality. Even then, credit is more likely to flow to more efficient SOEs at the expense of less efficient SOEs. But the supremely more efficient private sector will struggle to compete.
The central government will impose a number of ad hoc and periodic restrictions on banks to slowdown lending to local government financing vehicles without causing any hard landing for property asset prices and the economy more generally. This is a difficult balance but achievable with the suit of controls available to central authorities. Fixed investment growth will be slowed, but the absence of other major changes which ‘muddling through’ implies means that it will remain the dominant way China expands its economy. The upshot is that the country will continue to build lots more things that it doesn’t really need, even if the salad days of the commodity boom are over.
Does this matter? Is muddling through good enough?
If the standard is achieving moderately high growth, say 5-7 per cent, then it is probably adequate. After all, the closed banking system in the country means capital flight will be limited to special schemes (Capital flight is China’s house of cards, February 12) if still considerable. State-owned banks have access to around US$15 trillion of household savings which can be used by the government for further fixed investment stimulus if need be. This means little significant change to the SOE driven, fixed-investment model. But analysts will breathe a sigh of relief and tell us that China has ‘stabilised’ at a moderately high level -- we should be cautious but optimistic.
But if that was good enough, the fifth generation leaders would not be stressing out as much as they are behind closed doors. The problem with muddling through is that even if China manages to achieve 5-7 per cent growth, a number of problems with serious consequences remain.
For one, the concealed bad debt problem will grow, and will have to be written off eventually. Writing something off might be an accountant’s trick to begin again, but there will be consequences. A major one is that loans have been largely financed by household deposits. Writing off the bad debts of SOEs by state-owned banks delivers a huge hit against the capacity of households to access their accumulated savings over decades. This is serious.
Another consequence is that growing household wealth and consumption is a matter of political and economic necessity. By denying economic opportunities to the domestic private sector, the winners of Chinese economic growth will continue to be SOEs rather than private businesses and households. As mentioned, while state banks issued $US9 trillion worth of loans from mid-2008 to mid-2014, Chinese private wealth increased $US4.5 trillion. In comparison, whereas American debt increased $US6.6 trillion during the same period, net private American wealth increased $US22 trillion.
The point is not that America is the standard for what must happen, but that household incomes in China have increased at below the rate of economic growth and debt growth. Even Beijing knows these proportions must be reversed.
Who knows what 2015 has in store? Still, if China does indeed ‘muddle through’, it is no reason to breathe a sigh of relief.
Dr. John Lee is an Adjunct Associate Professor at the Strategic and Defence Studies Centre at the Australian National University, a senior fellow at the Hudson Institute in Washington DC, and a Director of the Kokoda Foundation defence and security think-tank in Canberra.