Recently the research house CLSA issued an in-depth special report on Chinese economy called Misunderstanding China, trying to debunk certain so-called western illusions about China’s economy. Some of its points, such as the party’s influences on domestic financial institutions, the absence of a mature legal system and etc., are fairly reasonable. However, we believe that this report still illustrates a typical optimists’ view on China’s economy that we do not agree with. Therefore, we find it very necessary to clarify our standpoints of the Chinese Economy by raising our counter-arguments to some of CLSA’s assertions, with which we disagree most.
We want to focus on the economic issues without digging much into politics. We find three major points raised by CLSA extremely misleading. They are:
1. China is not export-driven. Everything does come from China, but it isn’t really made there and contributes relatively little to China’s economy.
2. China is the world’s best consumption story. Household consumption is a small share of GDP, but that does not mean Chinese consumers don’t spend and the rebalancing is taking place.
3. In China, local debt is, ultimately, national (or Communist Party) debt and thus is not a time bomb.
They are wrong. First, export means significantly to the economy, though net export’s share of GDP has been declining and the contribution of net export to GDP growth was negative last year. China’s an investment-driven economy does not mean that mean the export sector is no longer a significant part of Chinese economy. Net export does account for a smaller proportion of the GDP, but gross exports still takes a large share of the whole economy (shown in the chart). When gross export’s share of GDP dropped in 2008 China was in crisis too. China is the largest exporter in the world so export must matter. A collapse of export would cause catastrophic effect to employment which probably cannot be seen from the GDP number.
Moreover, the declining net export’s share of GDP does not make us worry less either. Some may argue that it is rebalancing that China’s growth relies less on current account surplus (net export is the dominant share of it), but that’s not true. There are two types of rebalancing. Since current account surplus equals to saving minus investment, its share of GDP would decline under two circumstances. When investment grows faster than saving, current account surplus’s share of GDP would drop; it would drop as well when saving declines faster than investment. The latter is good rebalancing, but the first one is bad. Unfortunately what we are seeing now is the first type. As net export’s share of GDP shrinks, investment’s share of GDP has risen to an unprecedented level.
Figure 1 Export and net export’ s share of GDP
Source: National Bureau of Statistics, General Administration of Customs
If we look at consumption, rebalancing is not happen yet either. It is not growing fast enough. CLSA asserted that despite the fact that consumption’s share of GDP is quite low China’s consumption is already strong and that the rebalancing of Chinese economy is already underway. To support their position, CLSA shows that retail sales growth is faster than GDP growth. However, they made at least five mistakes here. First, retail sales growth is a nominal figure while GDP growth is real. If we deduct the price difference, retail sales growth is not faster than GDP growth. Second, retail sales cannot represent household consumption in China. Lots of the sales are government purchases and some of the components are investment-related goods, like jewelry and home appliance. Third, even if we pretend that retail sales data is a good indicator for household consumption, it still does not mean rebalancing is taking place. Why? Because if rebalancing is really taking place, not only does retail sales growth become faster than GDP growth, but investment growth has to be slower than GDP growth. Unfortunately investment growth is still much faster than GDP growth. Fourth, consumption growth is unlikely to surge if household disposable income increases slowly and household income has been lagging GDP growth for many years. Last, as economic growth decelerates, retail sales growth is slowing down too, which makes it very difficult to say that rebalancing is happening. Mark Williams from Capital Economics wrote the following words last month: Figures released this week confirm that investment spending rose last year to 49.2% of GDP, up one percentage point from 2010. Meanwhile, the share contributed by household consumption remained rooted at 34.9%, dashing hopes that rebalancing had already started. We believe that China’s rebalancing will not happen until it abandons the current investment-driven development model. To achieve this goal, China has to transfer wealth from the state sector to the household sector. Privatizing the state-owned assets, tax abates or raising interest rate can be effective weapons, but we have not seen any of these taking place.
Figure 2 China’s saving and investment
Source: China Statistical Yearbook 2011
CLSA says that local government problem is no problem since the central government guarantees everything. This represents a common mistakes made by many analysts on the street. We agree that China’s local debt is implicitly guaranteed by the central government and it will ultimately become national debt, but it does not make us worry less about it. On the contrary, it is the most worrying thing from our perspective. The local government debt, estimated as 10.7 trillion RMB, combined with the explicit central government debt account for around 40% of the GDP. This does not seem to be very high compared with developed economics, so some people argue that there is no problem if central government guarantees everything. However, if the government’s guarantee could resolve the debt problem, then I suppose most of the debt crisis in history could easily be avoided.
The real problem of the local government debt is that many of the investment fueled by these borrowing are not economically viable, besides the fact that the real debt-to-GDP ratio is approaching 100%. If an increase in debt will lead to greater increase in the asset value, it is economically viable and is a good borrowing. If the opposite happens, when the return of the investment is less than the debt servicing cost, we call it misallocated investment and the money borrowed is simply wasted. We believe that many of the investment projects in China since 2008 are not economically viable. Governments around the world have the nature to overestimate benefits and understate the costs of such investment. Bent Flyvbjerg of Oxford University wrote a paper Survival of the Unfittest: Why the worst infrastructure gets built, in which he suggests that political pressure would lead to misrepresentation and lying on the value of infrastructure projects and China is a perfect example. Typically there are two ways out an unsustainable debt problem- by default or by borrowing new debt to service the old ones as long as the interest rate is favorable enough. It will never be a problem if one could always borrows new money continuously with very low interest rate. But someone has to pay. Creditors pay in the first case, and it is the households who will pay the debts in the second case. Central government taking all local debts does not mean the problem is resolved. China has to continue to repress interest rates to let depositors pay the debts, which transfers wealth from households to local governments and other government-affiliated entities that created those bad debts. Consequently, their disposable income will not increase fast enough and consumption’ share of GDP can’t pick up either. The outcome is definitely bad for China’s rebalancing.
Wang Chen and Chen Long
Central Banking Seminar