The Chinese Economic system has become a topic of feverish discussion in academic circles as a result of the consistently high and stable rates of growth China has been able to manage over the last 3 decades. China Model as this economic governance system is labelled is said to be based firstly on high infrastructure investment spending fueled by credit; secondly by an export-led manufacturing sector and thirdly although it is completely market driven at the bottom end State enterprises dominate at the higher end of the economy and fourthly by a higher level of government regulation to ensure people's welfare and prevent market distortions. Most of the large monopoly sectors including the infrastructure sector like railways, telecom, power, coal, oil and gas, roads, big airlines, etc are govt controlled. In addition the credit is directed by State owned banks. Though one must be fair, the State-owned Enterprises and Banks have been corporatised and operate like market entities with the managers incentivised to perform and grow their enterprises. Apart from the very large business sectors all business lies in the private domain.
This Model had built up two distortions over time - a world-record breaking Investment/ GDP ratio and unparalleled Trade Surplus figures. Since the global financial crisis as a result of the drop in demand by the Western nations, the Trade Surplus has been reined in. But the Investment/ GDP ratio has continued to escalate and now reached a ratio of 52% never reached for any nation earlier. While the overall Asset/ Infrastructure levels in China are still far low as compared to the west, the rates at which it is being increased has been made possible only by a rampant credit boom which has the potential to explode into a bubble. The Chinese economic administration has been aware of this dangerous distortion in the economy and has repeatedly emphasized its determination to change this state of things and move gradually from an infrastructure-based to a more consumption-based economy. But the move is fraught with danger and is likely to reduce the growth rates. So this has been constantly been postponed despite the stated Chinese resolve to make the necessary changes. But do we see signs that this long-delayed decision is being taken and that the China Model is now making a historic once in 30 year change to a more consumption based model?
China's Impressive Show in the post-Recession Period
All of us know that while the world economy went through a massive crisis in 2008, and yet the Chinese economy did impressively well. It dipped to 6.2% in Q1 -2009, and then bounced back to 11.9% by Q1-2010! In 2010, 2011 & Q1-2012 it has stayed above 8%. But since then it has stayed between 7.4 to 7.6%. Quarterly GDP rates can be seen here. This recovery was financed by a massive Fiscal Stimulus package launched by the Central government but in this credit boom the local governments have participated with enthusiasm. China indulged in this credit boom because it could. Its finances which had always been well balanced provided it the ample room to go in for this deficit financing. The LGFVs were at the were at the heart of the Stimulus implementation. The local government route with the hunger of local governments to invest in infrastructure were used by China to stimulate its economy during the global financial crisis. Moreover this was accompanied with continued investment push to the infrastructure sector. This tilt towards investment was further distorting the structure of the Chinese economy. But yes this infra investment push was temporarily rescuing the Chinese economy and maintaining the growth momentum. But all this credit cannot go on endlessly. More importantly the economy cannot be endlessly distorted. The managers of the Chinese economy (the NDRC and the other government economic think tanks) have known about this, but as this is going to be a relatively painful activity they have been reluctant to bite the bullet. But as recounted below, events are happening which force us to sit back and take notice. Finally maybe change is on the way?
Unusual Dry-Up of Liquidity
Short term interest rates in China have been zooming for the last one week. The short-term rates one-week interbank borrowing rates which are tracked as "Shibor" (Shanghai interbank borrowing rates -www.shibor.org) have reached an astronomical 8 % around 10th June 2013. A Chinese debt sale has failed after 2 years (Click here for Bloomberg report). Alongside this, in informal offshore currency markets the yuan has been declining. Which means that foreign funds are weak on China and money is leaving (as in the case of India and all Emerging Markets). The other great source of liquidity - the government & govt banks - too for the first time is keeping a lid on the liquidity flow. All this points to a Liquidity Crunch. China's Central Government debt seems to be in quite secure territory when compared to other Emerging Markets. So why is China reining in its expenditure? The Local Governments have a tendency to be profligate as they have the unchecked freedom to go in for large infrastructure investments. For some time now, the LGFVs have been rolling their interest payments - borrowing from the short-term market to pay their interest dues and then borrowing again when the short term obligations become due. With the current rise of short-term interest rates their outflows are going to increase and they are going to get badly hit.
Is it Deliberate
Changing the China Model
If and when the Chinese consumption engine gets activated the Chinese people would then start fuelling their own growth. Working, Earning, Building-Consuming - all parts of the cycle taking place in China.
Changing to Consumption Model - a Regional Perspective
The pessimistic China Bear Lobby (Peter Chovanec, Gordon Chang etc.) has long been crying itself hoarse predicting China Collapse. As expected it has again gone into overdrive predicting a hard landing for China. Crying wolf they hope would dissuade investors and so by choking investment with their alarmist projections they hope to serve as a self-fulfilling prophecy.
But this time around their is a greater degree of skepticism and alarm that China might be in for a tougher time. One has to be more cautious as the new Shadow Banking phenomenon has spread like wildfire over the last five years. The true scale of Shadow Banking is not known. However, at one extreme it could bring down the Chinese Financial system and the economy. At the best, tackling it would seriously challenge the Chinese economy and slow it down considerably. On the other hand the steady discourse of 7-8% growth by the normally proactive Chinese leadership indicates that it is not considering the 4% growth rate projections to be a serious possibility. Once earlier, China has once cleared up its banking system in 2003 to rid it off bad loans. The year after the transition from Jiang Zemin-Zhu Rongji to Hu-Wen leadership. And now we have similar problems arising once again when the Hu-Wen leadership has been followed by the Xi-Li leadership. This raises the interesting thought that during its last years in office each generation of Chinese leaders tends to overspend in order to squeeze out every bit of growth out of the system. This is probably done to leave behind a legacy of exceptional economic leadership. But the problems which this loose credit policy creates have to be resolved by the next set of leaders during their initial years. Or to put it in another way it could reflect a desire of the new leadership to place the inherited problems upfront on the table and then to start with a fresh slate.
5. Bernanke signals end of Cheap Money - world in fear - Click here ;
6. The Economist - Chinese Credit is analysed. It say's that Chinese companies are taking credit for Nothing - no performance. Click here ;
7. NYT - Diminishing Job prospects in a slowing Chinese economy. Click here ;
8. Mamta Badkar of BusinessInsider - Fitch warns that China's Credit Bubble is unprecedented. Click here; The Telegraph says the same thing here ; Also here about the Credit Squeeze in China ;
9. On the other hand surprising news is pouring in (NYT) that the US economy is in for a huge rebound. In the short run (2013) it stays low but steady (1.5%). But 2014 is expected to see dramatic change (3 to 3.5%) and 2015 to 2018 could see growth in the range of 3.5 - 4%. This is expected due to huge Shale Gas reserves resulting in Cheap Energy and the attainment of marketization of a new cycle of technologies especially artificial intelligence. This is astonishing as most prominent US economists have been quite pessimistic about the middle term prospects of the US economy. Click here ;
10. Euromoney - Credit Fears grow in China. Click here ;
11. Gordon Chang here persisting with his extreme views as always in Forbes. Click here ;
12. Regarding the painful nature of transition to a Consumption led system for China. Prof Michael Pettis at Peking University is very pessimistic. Click here to read.