The world economy reached an interesting turning point in 2014, when China overtook the United States as the world’s largest economic power as measured by purchasing power parity. But this event has received little attention, and most of commentators have dismissed the historic significance of the passing of baton from the US to China.
Instead, we have started the year with a gloomier outlook for China, which has been regarded as the single most important engine for the global economy until only recently. The country has lost some of its lustre and many bears are busily proclaiming the end of the country’s economic miracle, which has lasted more than three decades.
Even the World Bank, which has been relatively upbeat on China, has changed its tone. The bank’s chief economist Kaushik Basu said this week “the global economy is running on a single engine… the American one. This does not make for a rosy outlook for the world”.
Rapidly falling iron ore prices are bringing the bad news home to Australia, which has enjoyed an amazing run on the back of a China-fuelled mining boom. One of the single biggest factors weighing on the minds of central bankers and business leaders in Australia is without doubt the economic health of our largest trading partner.
So what can we expect from China in 2015? In fact, we can expect much the same as in 2014. Many of the country’s economic ills such as burgeoning local government and corporate debt, excess industrial capacity and a stagnant real estate sector will be with us for many years to come. This year will be another testing year for Chinese policymakers who are trying to push through a host of difficult reforms without bringing about a hard landing.
The single biggest risk for the economy is still the interlinked and rising problems of shadow banking, local government and corporate debts and the stagnant real estate sector. The problem has been highlighted in the IMF’s most recent survey of the country’s economic risk and performance. It describes the risk as “a web of vulnerabilities” “across the key sectors of the economy”.
This web of risks work like this: Chinese companies and local governments borrow heavily from both the banking and shadow banking sectors to finance their investment. The borrowing binge was put on steroids after Beijing unleashed its 4 trillion yuan stimulus package and the accompanied 10 trillion yuan credit expansion.
This has resulted in a rapid increase of indebtedness for both government and corporate borrowers. For example, ratings agency Standard & Poor’s estimates that total outstanding corporate debt in China was around $US14.2 trillion at the end of 2013, compared with $US13.1 trillion for the US.
As far as the Chinese local government debt is concerned, the picture is quite muddy despite the publication early last year of a comprehensive survey by the National Audit Office. According to the report, there has been explosive growth in local government debt, averaging 20 per cent increase for the last three years.
The total debt level, which includes both central and local government debt, is about 54 per cent of China’s GDP. The fiscal debt does not appear to be too alarming. However, a senior government adviser from the Development and Research Centre of the State Council, the Chinese cabinet, has warned about the risk of “hidden debt”.
“Hidden debt is more dangerous than official debt, it is much harder to regulate and control. In a way, the Chinese local government debt has become an invisible assassin that threatens the country’s economic security as well as social stability,” says Wei Jianing, a senior research fellow from the centre.
Many of strands of this web run through the real estate sector, which is one of the most important drivers of GDP growth. Banks and shadow banks are exposed to the sector through lending to developers as well as mortgage borrowers. Local governments are also heavily dependent on sales of land to developers as one of the major sources of tax revenues.
The IMF warns that “given these interconnections, a major shock to any part of the web would reverberate throughout the whole, creating a negative feedback loop that could considerably amplify the original shock.”
So how serious is the risk? Let’s hear it from the IMF first. The official verdict is “the government still has the capacity to absorb shocks and prevent the kind of loss of confidence or sudden stop that have triggered major problems in other countries -- such as a deposit run, freezing up of the interbank market, collapse of the real estate market, or capital flight”.
Andy Rothman of Matthews Asia reminds us that all major commercial banks in the country are state-owned and “there is no doubt that the Communist Party stands behind them”. Chinese banks are very liquid and have deposits equal to 140 per cent of GDP, compared to 55 per cent in the US. Both central and local government sit on trillions of dollars worth of high quality public assets not to mention the $4 trillion foreign exchange reserve war chest.
For people who like to draw an analogy between the US subprime crisis and the current housing downturn in China, there are few crucial differences. First of all, Chinese households are lightly geared and have to put down at least 30 per cent of the purchase price as a down payment before they can qualify for mortgages. In first tier cities such as Beijing and Shanghai, the minimum payment is 40 per cent.
Toxic products such as subprime mortgages and collateralised debt simply don’t exist in China.
Though analysts and commentators have been obsessed with debt and real estate, one of the biggest problems for China is actually the high cost of borrowing for small to medium size companies, which form the backbone of the economy. Consider these facts -- businesses with less than 1000 employees contribute to 70 per cent of GDP, 65 per cent of new patents and 90 per cent of new jobs.
However, the country’s state-owned banking sector favours large government and private enterprises over SMEs. Only 10 per cent of small companies can get credit from banks and 90 per cent of them have to resort to private lenders and pay usurious rates of up to 25 per cent, according to the deputy chair of economic and finance committee of the country’s national legislature.
So is there any good news to cheer about? In fact, there are a lot of silver linings to the dark clouds gathering around the Chinese economy. Lets start with the biggest misconception of all, China invests too much and consumes too little. Yes, the country invests a lot but at the same time, China also enjoys the strongest growth in consumer spending of any major economies, according to the IMF.
Consumption now accounts for 50 per cent of GDP in China. Though it is still considerably lower than the 70 per cent average for the developed countries, it is at least moving in a positive direction. The services sector has also overtaken the industrial sector as the largest segment of the Chinese economy and the re-balancing of the Chinese economy is steering in the right direction.
However, the long-term prosperity of China is really dependent on the ruling Communist Party’s revolve to push through a raft of bold reform policies announced at the end of 2013. Though many China watchers have been disappointed with the progress of reform so far, Arthur Kroeber of Gavekal Dragonomics, arguably one of the most respected China analysts, argues China’s record of reform is actually better than that of any major countries.
“Xi (Chinese president) and his premier Li Keqiang by contrast have done a neat job of running monetary and fiscal policies that are expansive enough to promote growth, but disciplined enough (so far) to limit the excesses that nearly took the economy off the rails in the previous administration,” he says.
The China research team at UBS also argues contrary to market perceptions, saying China has actually made substantial reform progress in 2014. Highlights include the lifting of the deposit rate ceiling and the draft plan for a deposit insurance scheme, new budget laws, local government debt solutions and mixed ownership reform for state-owned enterprises.
“We expect reforms to accelerate in 2015,” says a UBS research report on China’s economic outlook for this year.
At the start of 2014, many doomsayers were prophesying China’s own 'Lehman moment' and then shifted their focus to the real estate industry. After periods of hysteria and various scares, the sector stabilised with the economy managing to grow at a respectable 7.3 per cent. Not bad for a country that is supposed to be on the verge of collapse.
Professor Yu Yongding, one the country’s most distinguished economists and a former member of the monetary policy committee of the central bank has the following warning for China bears on an op-ed piece published on East Asia Forum.
“China has the extraordinary ability to muddle through and keep the economy going. In 2015, China should be able to hit its 7 per cent growth target. Despite vulnerability in its financial system, it is difficult to envisage how a crisis could play out in 2015. Betting on the coming collapse of the Chinese economy is a dangerous business. This is a lesson at least that China bears should have learnt.”
That China will muddle through another year seems to be the best possible bet.