More on the China-bearish ‘factor mobilisation story’
Andy Lees makes a few good points today about the Chinese labour market regarding the difference between economic growth from mere factor mobilisation and economic growth from increased productivity. He writes:
For some time now I have been highlighting the unsustainable nature of China’s economic growth; how it has been a Soviet style factor mobilisation story rather than a productivity story – (in comparison to Japan or South Korea at their peak, China has to employ 40% more capital to obtain similar growth) – and how it is rapidly exhausting those factors of production. The demographic dependency ratio is now starting to soar reducing its available workforce. This in turn will reduce free capital and therefore its capital to labour ratio, lowering productivity still further. The lack of productivity growth in agriculture means the rural economy has exhausted its supply of labour such that the continued industrialisation has to be met with increased agricultural imports resulting in a swing in the terms of trade away from manufactured goods.
On Friday I used some of Andy’s analysis to suggest that China is losing competitiveness in its export markets. While wage rate suppression and capital substitution might make sense on a micro level, these tactics are poison on a macro level since it supresses consumer demand. And increasing internal demand is key to the shift in China’s economic policy. China’s rebalancing toward a more internal demand-focused economic policy is vital because protectionist sentiment is still high, and with the US dollar still relatively weak, the Chinese currency is depreciating on a trade-weighted basis. Translation: if the currency wars break out again, China will get the stick. So wage rates will rise.
Obviously, the right way to deal with the increased labour costs (Lewis Turning Point) is via the increased productivity that comes from moving up the value chain, rather than substituting capital for labour. Let Vietnam have the lower value-added production.
Even so, Michael Pettis suggests that rebalancing through wage increases will not be enough. He believes:
"The way that its growth model works suggests that it cannot happen except with a sharp contraction in investment growth, something we are not seeing, and the empirical evidence so far seems to support the theory. It will probably take a couple of years of this kind of unbalanced growth before this point is more widely recognized, but I suspect that another year or two of stagnant consumption as a share of GDP is finally going to convince policymakers. Until then, expect more of the same, and with it rapidly rising debt levels."
And I believe that last part about debt is right. Andy Lees supports Michael’s contention with some numbers:
You may recall back in 2006 Ernst & Young issued a report that China’s bad debts may be as high as USD900bn, outstripping the country’s massive foreign exchange reserves at the time. Aside from large banks, the estimate includes bad loans in state investment companies, credit cooperatives, and other vehicles set up by the government to dispose of the loans. At the time the government dismissed this as fantasy and Ernst & Young were forced to withdraw the report, presumably if they wanted to continue lucrative business in the country. Fitch, PriceWaterhouse and McKinsey Global Institute subsequently issued reports, which although not quite as extreme nevertheless made similar observations and suggested that the problem was significantly worse than Japan’s 15 years earlier. Fitch said official NPL’s were USD206bn with another USD270bn problem loans plus another USD197bn in NPL’s that have been taken off the bank’s books and with the management agencies, which are not treated as NPL’s, but are future liabilities on the government. That USD673bn it said was a very conservative estimate due to the quality of accounting etc, and was therefore not credible. It said in reality the figures would be far higher and “Given the weakness already discussed, we believe Chinese banks remain acutely vulnerable to an economic slowdown”. You cannot prepare to deal with a loan situation as bad as China’s. You simply keep cycling as fast as possible and hope something turns up.
The BIS agreed. In mid 2007 it said that should the Chinese economy slow significantly, the banking system would face a sizeable amount of bad debt. According to government data, about 40% of industrial State owned enterprises (SOEs) make losses, with the bulk of profits coming from relatively few firms. “Evidently, the longer these resource misallocations are allowed to continue, the greater the eventual fallout”. The BIS said that the SOE’s easy access to bank credit has lowered the marginal return on capital to the point that productivity levels are 30% lower than in private firms. “High rates of investment were also observed in East Asia in the 1980’s and early 1990’s, culminating in the 1997 – 98 crisis”.
So, all this capital investment means debt. More capital investment means even more debt. The reason these debt numbers are hidden from view is not just because of the leverage hidden in commodity vendor financing, but also the land-collateralized debt taken on by state owned enterprises (SOEs). Because the capital investment rate is so high in China, non-performing loans can be hidden by the ever-increasing credit afforded the SOEs.
According to some media reports, the financial arms of local governments have borrowed some 6 trillion yuan although you will recall that Victor Shih, a researcher with Northwestern University in the United States, estimated that China’s total local government borrowing from 2004 to 2009 was around 12 trillion. In 2009 when the central government launched its CNY4trn (USD486bn) stimulus package local governments were required to finance 2/3rds of it. Even before the crisis the local authorities had been leveraging their public sector services by putting them in limited companies which could then tap the banks for money, ie using them as funding platforms. Poorer local authorities borrowed from other local governments using the proceeds to establish these financing platforms. The more you dig, the more China appears like a sovereign version of Enron, which as you recall was also the darling of the stock market for many years enjoying spectacular growth.
To me there is certainly something Ponzi in all of this. As soon as the capital investment growth rate slows, the marginal debtors will be swamped and the NPLs will start to show up. The only way to mask this is by maintaining the capital investment – which can only make the eventual losses that much greater.
Bottom line: if and when capital investment growth slows, expect a lot of losses and then we will have to see how these losses get socialised and whether policy makers double down on the capital investment story.