CHINA
14 April 2019
China's precarious economic future
Dinny McMahon provides an excellent forensic investigation of the Chinese economy in his book "China's Great Wall of Debt", writes John West.
Dinny McMahon, a financial journalist, who was based in China from 2005-15, once believed that China's economic ascent was inevitable, as much of the world still does today. Indeed, this is a narrative actively cultivated by the Chinese leadership.
But McMahon is more pessimistic today. He believes while China’s ascent is still possible, it is now unlikely. The country faces immense challenges, and its capacity for reform is greatly compromised by vested interests.
The Chinese economy is currently driven by investment. But Westerners should stop being mesmerised by projects like China’s high-speed trains and 8-lane highways. Because much of that investment has gone into wasteful projects like factories and housing that no-one needs.
In fact, China suffers from widespread overcapacity in a vast array of industries like steel and cement. And while Shanghai and Beijing have housing shortages, in smaller cities there is a massive oversupply of housing. There are also public works that local governments will struggle to pay for -- airports with virtually no flights, excessive local government office space, and wasteful city beautification projects.
China cannot keep growing by building more and more infrastructure. It needs to find a new way of growing the economy.
This infrastructure construction has been made possible by a rapid accumulation of debt. Indeed, China's debt levels have ballooned since 2008. Other countries that have experienced a comparably large credit expansion, in a comparably short period of time, have invariably ended up experiencing some sort of financial crisis. China's debt cannot continue to accumulate without posing some real risks. So China’s economic model has to change.
Meanwhile, China's traditional comparative advantage -- that it was a cheap place to manufacture -- is no longer the case. The cost of energy and land is now expensive, even relative to the US. Factories are being forced to reduce their pollution levels. While this is a good thing, but it raises costs. The cost of labour is rising aggressively. That's in part because the endless supply of cheap labour, is no longer endless.
Indeed, the movement of Chinese people from the country to the city is declining. The demographics of villages are now heavily weighted to school-aged children and the retirees who look after them. Moreover, China's working age population has been shrinking since 2012 (a fallout from one-child policy), and will decline by tens of millions over the next decade. This will send wages higher in the coming years, while the cost of providing services to retirees will spike.
The thing that keeps the leadership in Beijing awake at night is the risk of China falling into a middle-income trap. Historically, only a handful of countries have transitioned from middle to high-income status. Incomes in China have now reached middle-income levels. And Beijing is genuinely worried that it may not be able to make the transition.
The reason that is typically given is that "China is different". And the way that it is different is because of the role of the government in the economy. Many believe that the Chinese government can see the problems in the economy and can fix them whenever the circumstances demand. There is a reason for this explanation. China has averaged 10 per cent annual economic growth for four decades because at pivotal moments it has been able to fix the problems.
This has given rise to a legend of sorts, or a deeply-held belief that China has managed to crack the code and do away with the business cycle, because economic management has been placed in the hands of a technocratic elite, undistracted by ideology, and has been able to make tough decisions in pursuit of one overriding goal, which is growth.
The extent to which this kind of thinking has permeated globally can be summed up by something Thomas Friedman once said "What if we could just be China for a day? We could authorise the right solutions". This comment is as much an expression of the frustration at the gridlock in US politics as anything else. But it is also a fair summary of how people think that China works. But that is not the China that McMahon saw during his ten years as a financial journalist from 2005 to 2015.
According to McMahon, China success has not been because of reform. But because of the government's willingness and ability to paper over the cracks, and to kick the can down the road. Any effort to reform has been routinely stonewalled and circumvented.
A Chinese expression, which is a favourite of foreigners in China is “heaven is high and the emperor is far away”, meaning that the government only has limited authority outside of Beijing. But McMahon prefers the following one -- “above there is policy, but below we have ways of implementing policy”. This is what makes China work. And it is also the biggest impediment to fixing a broken system.
The case in point is the financial system. China's response to the global financial crisis was a massive stimulus programme, not led by central government spending, as it was in other countries. In fact, it was led by state-owned banks massively increasing the volume of loans they made.
After one year, Beijing decided that the financial stimulus should be finished, and the pace of bank lending slowed accordingly. And yet there was no discernible impact on the economy. This was a complete mystery to anyone outside of the financial system. But after a while, it started to leak out that banks were using trust companies which would soon become the central pillar of the shadow banking system. Banks were moving loans off their balance sheets to the trust companies, and thereby removing any record of their loans from the banking statistics. So in reality, credit continued to expand rapidly.
After one year, the banking regulator in Beijing began to crack down. But the volume of credit extended by the financial system kept getting bigger and bigger. How? Because the shadow banks, while complying more or less with each new regulation designed to reign them in, managed to innovate around the rules. Bankers prepared multiple “work-arounds” in advance of new regulations so that they could continue to extend credit.
The reason all this happens is that the various levels of government are not of one mind. When Xi Jinping and Li Keqiang came to power they talked a lot about vested interests stonewalling reform. This is about more than corruption. The best example of vested interests exerting control over government was about an independent Chinese documentary (a rarity), "Under the Dome", about China's air pollution that was made by a former CCTV reporter in 2015. This was posted online in China for about one week, and had over one million views, before it was then scrubbed from the Chinese Internet.
One of the most interesting things was when the journalist explained that one of the reasons for China's chronically bad air was that the most highly refined gasoline produced in China was 2-3 grades lower in quality than that in developed economies, even though raising the quality by one grade would result in a ten per cent reduction in emissions.
Why wouldn’t China’s oil companies improve gasoline quality? Quite simply, the reason was that almost all of the members of the committee that sets China’s fuel quality standards are leading oil companies, namely, PetroChina, Sinopec and CNOOC. These companies are all owned by the central Chinese government, but were effectively holding the government to ransom for money.
Beijing sets diesel and gasoline prices as a way to keep prices low for consumers. But cleaner gasoline costs money, and the oil companies cannot claw by higher refining costs by charging higher prices, so they have asked the government to subsidise them to do it. However, the oil companies’ estimates of the required subsidy are higher than the government's own estimates. And until an accommodation is reached, the oil companies continue to produce this lower quality fuel at the expense of the public's health. In fact, the oil majors have managed to stonewall reform by arguing that if things aren't done on their terms it might lead to a disruption in the oil supply and might lead to instability.
McMahon has written that he is aware of several other instances of government agencies using exactly the same formulae to push back against reforms that would dilute their authority, influence or resources. It is hardly surprising that economic reform in China stalled about 2005/06.
What is the problem? Barriers to reform exist because people benefit from the status quo where state-owned enterprises and banks have a privileged position, as do “private enterprises” with close connections to the government.
They benefit from the way that the economy currently works. They benefit from fast growth. They benefit from government subsidies, power or prestige, or higher wages, or perks.
That's not unique to China. In any system there are those who benefit from the status quo. But the lesson from McMahon's time in China is that those vested interests have incredible scope to pushback, to stonewall and selectively implement reform, or to implement the letter but not the spirit of reform.
That said, for the first time in a very long time we are starting to see an effort to overhaul the economy in Beijing. But the single most important economic reform being implemented by Xi Jinping is not explicitly economic. It's his efforts to centralise political power. First by imposing greater discipline on the Chinese Communist Party. Then by moving government functions over to the Party. And then by consolidating Party power in his own hands.
No doubt there are a number of reasons why he is doing it. But from an economic perspective, McMahon imagines that Xi is hoping that this will give him the authority to get the rank and file to do what is asked of them. We are still in the early days of this process, so it remains to be seen whether he can change the dynamics that McMahon has described.
There are risks that come with this more centralised form of economic management. Lower level officials may go to great lengths to do what is asked of them, but at the expense of other things. We saw that in 2017 when officials in the North-East were so enthusiastic to transition the local power supply from coal to gas that people were left without enough heat through the winter because there just wasn't enough gas to supply their newly installed heating systems. The ham-fisted eviction of migrants from Beijing in 2017 led by the city's mayor was another example. In a more centralised system, officials prove their loyalty to the leader by overdoing it with unintended consequences.
In contrast, Xi’s supply side structural reforms envisage a forced march up the value-added chain for advanced robotics, semiconductors, AI etc by protectionism, subsidies, and government financing for buying foreign technology companies. This is an easy approach, which does not make enemies, and which state-owned companies love. But it leaves many inefficiencies in the economy. And it has provoked strong reaction from countries like the US, Japan and Germany, which see these industries as being of strategic importance to their economies.
In summary, China is facing incredible economic challenges at this moment. There is certainly a general level of optimism around the world that China will be able to get through those challenges and continue to grow rapidly, as it always has.
But McMahon thinks that this is due to an under appreciation of the dynamics that underpin the Chinese economy and what exactly needs to be changed.
McMahon does not know what's going to happen to the Chinese economy. But the inevitability of China’s continued rise is a long way from being a sure thing.
But McMahon is more pessimistic today. He believes while China’s ascent is still possible, it is now unlikely. The country faces immense challenges, and its capacity for reform is greatly compromised by vested interests.
China’s economic model reached use-by date
McMahon argues that China's economic model has well reached its “use-by date”. And he notes that the Chinese government thinks so too, as evidenced in its many reform initiatives.The Chinese economy is currently driven by investment. But Westerners should stop being mesmerised by projects like China’s high-speed trains and 8-lane highways. Because much of that investment has gone into wasteful projects like factories and housing that no-one needs.
In fact, China suffers from widespread overcapacity in a vast array of industries like steel and cement. And while Shanghai and Beijing have housing shortages, in smaller cities there is a massive oversupply of housing. There are also public works that local governments will struggle to pay for -- airports with virtually no flights, excessive local government office space, and wasteful city beautification projects.
China cannot keep growing by building more and more infrastructure. It needs to find a new way of growing the economy.
This infrastructure construction has been made possible by a rapid accumulation of debt. Indeed, China's debt levels have ballooned since 2008. Other countries that have experienced a comparably large credit expansion, in a comparably short period of time, have invariably ended up experiencing some sort of financial crisis. China's debt cannot continue to accumulate without posing some real risks. So China’s economic model has to change.
Meanwhile, China's traditional comparative advantage -- that it was a cheap place to manufacture -- is no longer the case. The cost of energy and land is now expensive, even relative to the US. Factories are being forced to reduce their pollution levels. While this is a good thing, but it raises costs. The cost of labour is rising aggressively. That's in part because the endless supply of cheap labour, is no longer endless.
Indeed, the movement of Chinese people from the country to the city is declining. The demographics of villages are now heavily weighted to school-aged children and the retirees who look after them. Moreover, China's working age population has been shrinking since 2012 (a fallout from one-child policy), and will decline by tens of millions over the next decade. This will send wages higher in the coming years, while the cost of providing services to retirees will spike.
The thing that keeps the leadership in Beijing awake at night is the risk of China falling into a middle-income trap. Historically, only a handful of countries have transitioned from middle to high-income status. Incomes in China have now reached middle-income levels. And Beijing is genuinely worried that it may not be able to make the transition.
Chinese contradictions and myths
In analysing China, there are many irreconcilable contradictions. On the one hand, you can see the excesses, waste and risk taking. The laws of economics suggest that this can only end badly. And yet the laws of economics seem to have been suspended in China. It has continued to go from strength to strength, seemingly without any consequences.The reason that is typically given is that "China is different". And the way that it is different is because of the role of the government in the economy. Many believe that the Chinese government can see the problems in the economy and can fix them whenever the circumstances demand. There is a reason for this explanation. China has averaged 10 per cent annual economic growth for four decades because at pivotal moments it has been able to fix the problems.
This has given rise to a legend of sorts, or a deeply-held belief that China has managed to crack the code and do away with the business cycle, because economic management has been placed in the hands of a technocratic elite, undistracted by ideology, and has been able to make tough decisions in pursuit of one overriding goal, which is growth.
The extent to which this kind of thinking has permeated globally can be summed up by something Thomas Friedman once said "What if we could just be China for a day? We could authorise the right solutions". This comment is as much an expression of the frustration at the gridlock in US politics as anything else. But it is also a fair summary of how people think that China works. But that is not the China that McMahon saw during his ten years as a financial journalist from 2005 to 2015.
According to McMahon, China success has not been because of reform. But because of the government's willingness and ability to paper over the cracks, and to kick the can down the road. Any effort to reform has been routinely stonewalled and circumvented.
How China works
One of McMahon’s earliest insights into how China works was seeing things get done by people getting around the rules in this highly bureaucratic and political society. He recounts a case where, under pressure from the government to increase currency trading, Chinese banks engage in bogus trading between themselves, which give the impression of a dramatic increase in currency trading. Rules are fluid in China, in contrast to Singapore where rules are rules. There is always a way to get things done.A Chinese expression, which is a favourite of foreigners in China is “heaven is high and the emperor is far away”, meaning that the government only has limited authority outside of Beijing. But McMahon prefers the following one -- “above there is policy, but below we have ways of implementing policy”. This is what makes China work. And it is also the biggest impediment to fixing a broken system.
The case in point is the financial system. China's response to the global financial crisis was a massive stimulus programme, not led by central government spending, as it was in other countries. In fact, it was led by state-owned banks massively increasing the volume of loans they made.
After one year, Beijing decided that the financial stimulus should be finished, and the pace of bank lending slowed accordingly. And yet there was no discernible impact on the economy. This was a complete mystery to anyone outside of the financial system. But after a while, it started to leak out that banks were using trust companies which would soon become the central pillar of the shadow banking system. Banks were moving loans off their balance sheets to the trust companies, and thereby removing any record of their loans from the banking statistics. So in reality, credit continued to expand rapidly.
After one year, the banking regulator in Beijing began to crack down. But the volume of credit extended by the financial system kept getting bigger and bigger. How? Because the shadow banks, while complying more or less with each new regulation designed to reign them in, managed to innovate around the rules. Bankers prepared multiple “work-arounds” in advance of new regulations so that they could continue to extend credit.
Local government shenanigans
A very similar thing happened with the debt of local governments, which traditionally were not allowed to borrow. But around 2008 they started setting up companies that could borrow on behalf of the government. It soon became clear that borrowing was completely out of control. Each crackdown has resulted in innovative work-arounds that make it harder to track the debt. Xi Jinping has said that local government debt is one of the two greatest threats to financial stability, even though Xi himself initiated one of the biggest crackdowns on local government debt that was supposed to put an end to the issue in 2015.The reason all this happens is that the various levels of government are not of one mind. When Xi Jinping and Li Keqiang came to power they talked a lot about vested interests stonewalling reform. This is about more than corruption. The best example of vested interests exerting control over government was about an independent Chinese documentary (a rarity), "Under the Dome", about China's air pollution that was made by a former CCTV reporter in 2015. This was posted online in China for about one week, and had over one million views, before it was then scrubbed from the Chinese Internet.
One of the most interesting things was when the journalist explained that one of the reasons for China's chronically bad air was that the most highly refined gasoline produced in China was 2-3 grades lower in quality than that in developed economies, even though raising the quality by one grade would result in a ten per cent reduction in emissions.
Why wouldn’t China’s oil companies improve gasoline quality? Quite simply, the reason was that almost all of the members of the committee that sets China’s fuel quality standards are leading oil companies, namely, PetroChina, Sinopec and CNOOC. These companies are all owned by the central Chinese government, but were effectively holding the government to ransom for money.
Beijing sets diesel and gasoline prices as a way to keep prices low for consumers. But cleaner gasoline costs money, and the oil companies cannot claw by higher refining costs by charging higher prices, so they have asked the government to subsidise them to do it. However, the oil companies’ estimates of the required subsidy are higher than the government's own estimates. And until an accommodation is reached, the oil companies continue to produce this lower quality fuel at the expense of the public's health. In fact, the oil majors have managed to stonewall reform by arguing that if things aren't done on their terms it might lead to a disruption in the oil supply and might lead to instability.
McMahon has written that he is aware of several other instances of government agencies using exactly the same formulae to push back against reforms that would dilute their authority, influence or resources. It is hardly surprising that economic reform in China stalled about 2005/06.
Future of reform in China
Economic reform in China is like motherhood and apple pie. In principle, everyone is in favour of reform. But state-owned enterprises claim that reform must be led by the experts, namely them.What is the problem? Barriers to reform exist because people benefit from the status quo where state-owned enterprises and banks have a privileged position, as do “private enterprises” with close connections to the government.
They benefit from the way that the economy currently works. They benefit from fast growth. They benefit from government subsidies, power or prestige, or higher wages, or perks.
That's not unique to China. In any system there are those who benefit from the status quo. But the lesson from McMahon's time in China is that those vested interests have incredible scope to pushback, to stonewall and selectively implement reform, or to implement the letter but not the spirit of reform.
That said, for the first time in a very long time we are starting to see an effort to overhaul the economy in Beijing. But the single most important economic reform being implemented by Xi Jinping is not explicitly economic. It's his efforts to centralise political power. First by imposing greater discipline on the Chinese Communist Party. Then by moving government functions over to the Party. And then by consolidating Party power in his own hands.
No doubt there are a number of reasons why he is doing it. But from an economic perspective, McMahon imagines that Xi is hoping that this will give him the authority to get the rank and file to do what is asked of them. We are still in the early days of this process, so it remains to be seen whether he can change the dynamics that McMahon has described.
There are risks that come with this more centralised form of economic management. Lower level officials may go to great lengths to do what is asked of them, but at the expense of other things. We saw that in 2017 when officials in the North-East were so enthusiastic to transition the local power supply from coal to gas that people were left without enough heat through the winter because there just wasn't enough gas to supply their newly installed heating systems. The ham-fisted eviction of migrants from Beijing in 2017 led by the city's mayor was another example. In a more centralised system, officials prove their loyalty to the leader by overdoing it with unintended consequences.
Concluding comments
More fundamentally, McMahon suggests that the concept of reform under Xi seems to be radically different. There is much scope to improve the efficiency of the economy by liberalisation, such as, land reform or breaking up state monopolies. But such liberalisation is difficult because of vested interests, and is being avoided.In contrast, Xi’s supply side structural reforms envisage a forced march up the value-added chain for advanced robotics, semiconductors, AI etc by protectionism, subsidies, and government financing for buying foreign technology companies. This is an easy approach, which does not make enemies, and which state-owned companies love. But it leaves many inefficiencies in the economy. And it has provoked strong reaction from countries like the US, Japan and Germany, which see these industries as being of strategic importance to their economies.
In summary, China is facing incredible economic challenges at this moment. There is certainly a general level of optimism around the world that China will be able to get through those challenges and continue to grow rapidly, as it always has.
But McMahon thinks that this is due to an under appreciation of the dynamics that underpin the Chinese economy and what exactly needs to be changed.
McMahon does not know what's going to happen to the Chinese economy. But the inevitability of China’s continued rise is a long way from being a sure thing.