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07-07-2012, 01:57 AM
By Andy Xie 06.29.2012 14:54
In the past decade China gained Western jobs and exports markets, but the loss of both means that serious systemic flaws are being laid bare
By most measures China's economy has slowed quickly since the last quarter of 2011. Electricity production, the National Bureau of Statistics reports, grew 1.7 percent in April and May from last year. Over the past decade the annual growth rate was 12 percent. Also in April and May, the railroad ton-kilometer figure grew by 1.3 percent compared to the same months last year, down from the 6 percent growth seen from 2005 to 2011.
Due to the resulting decline in commodity prices, the inflation situation has improved, which lessens pressure on the household sector. At the same time, the slowdown has not caused widespread reduction in employment. There may be some impact on construction jobs already, but, as the labor market was very tight before the slowdown, the employment picture remains healthy.
There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.
State-owned enterprises reported 11 percent growth in sales but 10 percent decline in profits in the first five months. Private enterprises may have fared worse. It appears that the slowdown has impacted government revenue and business profits rather than labor income.
Asset markets have fared badly this year. The stock market is depressed. Despite some pickup in the last two months, the property market is depressed and may remain so for several years. As the slowdown disproportionately hits business profits, asset prices will likely remain depressed.
Cutting Taxes
Government spending and property development have become grossly overextended in the past five years. There is a strong argument in favor of the current adjustment. The difficulties in these areas could not support a case for stimulus.
It is possible that, if the downward trend continues, the slowdown will impact the labor market. There is a case for some stimulus to stabilize the economy. The only effective tool is to cut taxes and issue fiscal bonds to plug the revenue shortfall. About 1 trillion yuan (2.1 percent of 2011 GDP) is needed to be effective.
The tax cuts should include reducing the top marginal income tax rate to 25percent from 45 percent and consumption and value-added taxes by 20 percent. These cuts will improve economic efficiency in addition to stimulating the economy.
Igniting Inflation
A labor shortage, the result of three decades of the "one-child policy,” and rising inefficiency due to the rapid expansion of the state sector make the economy prone to inflation. The money stock is too high for comfort. While falling commodity prices have eased inflationary pressure for the time being, it would be unwise to ignore the big picture. Cutting interest rates carries a serious risk to stability.
Cutting interest rates stimulates the economy by encouraging borrowing. Businesses and local governments have reached their limits in terms of borrowing. Their main collateral, land, is depreciating. Cutting interest rate alone won't ignite borrowing from them.
The household sector has 14.5 trillion yuan in debt. In theory, there is scope for the household sector to increase debt. However, the market value of the residential property under development is over 20 trillion yuan. The government needs to create a massive household debt bubble to digest the whole amount. So much debt created will likely lead to massive inflation, too.
Resisting the Debt Temptation
There must be strong temptation to load up the household sector with debt. As I travel around the country, I don't see any local governments accepting the current situation. They believe it is a result of the central government's tightening policy, not a bubble bursting. As the weakness of the property market continues, the pressure on local governments' finances becomes more and more acute. The pressure to do something will intensify. One trick is to lower mortgage interest rates, which may revive speculative demand for property, as was seen in the speculative hysteria of 2006-07 and 20009-10
South Korea did just that after its corporate debt bubble burst in 1998. This triggered a credit card debt crisis in 2002. Even today its household sector bears a crushing debt burden of 135 percent of disposable income. What South Korea did was to transfer corporate debt to the household sector. Its corporate sector is relatively low on debt.
Japan shifted debt from both the household and corporate sectors to the government, which now bears crushing debt burden of 200 percent of GDP. Japan's household and corporate sectors have lighter debt. In that regard, the redistribution of debt has been successful.
If China's household sector is successfully sucked into taking on debt, local governments and developers won't use the opportunity to unwind their leverage. They will likely double down and expand further. Local governments are incentivized to spend as much as possible. Property developers must follow their wishes. The end result is to create a bigger problem, taking down the household sector without saving anyone else.
Accepting Losses
Around the country, I see numerous property developments that are in the middle of nowhere and may never be sold. When the last property bubble burst in the mid-1990s, numerous buildings stood unfinished. The scale of unfinished buildings will be much bigger this time. Out of 4.5 billion square meters being built, 20 percent may never be finished.
Most tier-three cities have not seen significant population growth in the past decade. Yet, they are building properties equivalent to 20 to 30 percent of the existing stock. Many developments are far from the urban center. How would such developments be sold?
Obviously, the book losses, especially to the banking system, could be enormous. That will translate into pressure on the central government to stimulate speculation again. Only a massive bubble could allow such useless properties to be sold.
We must remember that the book losses exaggerate real losses. Most of the development cost is land value that went into the government's pocket. The losses merely expose that the past fiscal revenue was fictitious; they were merely bank loans, though booked with property developers, masquerading as fiscal revenues. The true economic losses are the construction costs up to now, which are not great. The country should and could write off the property bubble and move on.
Reforming Gov't Finance
In the past five years, the government's revenue has tripled, rising by 24 percent per annum. At the same time, local governments have taken on over 10 trillion yuan in debt through local government financing vehicles. Of course, some of the revenue is not reported, meaning that government resources have risen even more than what these numbers indicate. Yet, as I travel around the country, I hear local government officials all complaining about insufficient funding. As land sales have cooled in 2012, some local governments are having trouble meeting payrolls. Outside observers might find it bizarre. How could there be a shortage of money when revenues are rising at 24 percent per annum? However, insiders seem to have plenty of reasons why they need more money.
Local governments have resorted to vendor financing to keep their projects going. These vendors are exhausting their financing limits. There will be pressure on local governments to pay up. Some are already resorting to the prepaying of business taxes to keep up revenue. But, business profits are down sharply across the board. There are limits to how much money local governments can extract from businesses.
It is quite likely that local governments will resort to new ways to raise money from the household sector. Such measures will increase the tension between the government and the people. The tension will be especially acute in small townships where governments will have trouble paying employees whose numbers have mushroomed in the past decade.
The government's appetite for spending is a major source of instability. The internal pressure within government is for more spending. Without checks and balances, the government is likely to search for more and more revenue through oppressive means, destabilizing society along the way.
Retrenching SOEs
State-owned enterprises (SOEs) reported 4.6 percent net profit margin on sales and 7.4 percent return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4 percent decline in profits but 11.3 percent increase in sales. SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.
Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20 to 30 percent more than that for private companies and take about 50 percent longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China. Despite the low disposable per capita income of about 2,200 yuan per month in 2011, the country's demand for luxury goods seems to be insatiable. As one consequence, Hong Kong has become a luxury shopping center for mainlanders.
Declining Efficiency
Government spending plus SOE investment already exceed half of GDP, while household consumption is about one-third of GDP. The world has never seen such lopsided distribution between the state and household sector. Modern economic history demonstrates that government economic activities have low efficiency. Hence, government involvement in the economy should be limited to where the market doesn't work well. When SOE sales are 78 percent of GDP, the government obviously dominates the economy. Rising inefficiency is inevitable.
Many argue that China has been growing rapidly, hence the system must be pretty good. This view is misguided. Rising inefficiencies in the state sector were offset by rising export proceeds. The latter kept the economy's cash positive. The Chinese people paid the price by accepting wage increases below productivity growth. The difference was used to pay for the state sector's rising inefficiencies.
High inflation in the past three years, as reflected by near double-digit GDP deflator – the broadest gauge of inflation – reflects that lower wage growth is no longer sufficient to offset the increase in the state sector's inefficiency. China's inflation is always a tax on the household sector. There has been no exception. The tax inevitably pays for government expansion and/or SOE inefficiency.
The reason for the above is that Western economies are falling. In the past, they lost jobs to China and borrowed to support consumption. China benefited from both, gaining jobs and exports. The double benefits covered up lots of domestic problems. As the bond market no longer supports such unsustainable spending in Western economies, their demand has fallen and China's exports have fallen with it. At the same time, China's market share of global trade is so high that increasing it is difficult because the West doesn't have many jobs left to shift to China. The double benefits China enjoyed have become a double whammy.
Without another export boom, China's domestic problems are exposed. If the government tries to stimulate the economy by increasing money supply, more inflation and declining efficiency will result because the stimulus money mostly ends up in the state sector and export revenue won't rise sufficiently to pay for rising inefficiency.
The author is a board member of Rosetta Stone Capital Ltd
http://english.caixin.com/2012-06-29/100405636_all.html
In the past decade China gained Western jobs and exports markets, but the loss of both means that serious systemic flaws are being laid bare
By most measures China's economy has slowed quickly since the last quarter of 2011. Electricity production, the National Bureau of Statistics reports, grew 1.7 percent in April and May from last year. Over the past decade the annual growth rate was 12 percent. Also in April and May, the railroad ton-kilometer figure grew by 1.3 percent compared to the same months last year, down from the 6 percent growth seen from 2005 to 2011.
Due to the resulting decline in commodity prices, the inflation situation has improved, which lessens pressure on the household sector. At the same time, the slowdown has not caused widespread reduction in employment. There may be some impact on construction jobs already, but, as the labor market was very tight before the slowdown, the employment picture remains healthy.
There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.
State-owned enterprises reported 11 percent growth in sales but 10 percent decline in profits in the first five months. Private enterprises may have fared worse. It appears that the slowdown has impacted government revenue and business profits rather than labor income.
Asset markets have fared badly this year. The stock market is depressed. Despite some pickup in the last two months, the property market is depressed and may remain so for several years. As the slowdown disproportionately hits business profits, asset prices will likely remain depressed.
Cutting Taxes
Government spending and property development have become grossly overextended in the past five years. There is a strong argument in favor of the current adjustment. The difficulties in these areas could not support a case for stimulus.
It is possible that, if the downward trend continues, the slowdown will impact the labor market. There is a case for some stimulus to stabilize the economy. The only effective tool is to cut taxes and issue fiscal bonds to plug the revenue shortfall. About 1 trillion yuan (2.1 percent of 2011 GDP) is needed to be effective.
The tax cuts should include reducing the top marginal income tax rate to 25percent from 45 percent and consumption and value-added taxes by 20 percent. These cuts will improve economic efficiency in addition to stimulating the economy.
Igniting Inflation
A labor shortage, the result of three decades of the "one-child policy,” and rising inefficiency due to the rapid expansion of the state sector make the economy prone to inflation. The money stock is too high for comfort. While falling commodity prices have eased inflationary pressure for the time being, it would be unwise to ignore the big picture. Cutting interest rates carries a serious risk to stability.
Cutting interest rates stimulates the economy by encouraging borrowing. Businesses and local governments have reached their limits in terms of borrowing. Their main collateral, land, is depreciating. Cutting interest rate alone won't ignite borrowing from them.
The household sector has 14.5 trillion yuan in debt. In theory, there is scope for the household sector to increase debt. However, the market value of the residential property under development is over 20 trillion yuan. The government needs to create a massive household debt bubble to digest the whole amount. So much debt created will likely lead to massive inflation, too.
Resisting the Debt Temptation
There must be strong temptation to load up the household sector with debt. As I travel around the country, I don't see any local governments accepting the current situation. They believe it is a result of the central government's tightening policy, not a bubble bursting. As the weakness of the property market continues, the pressure on local governments' finances becomes more and more acute. The pressure to do something will intensify. One trick is to lower mortgage interest rates, which may revive speculative demand for property, as was seen in the speculative hysteria of 2006-07 and 20009-10
South Korea did just that after its corporate debt bubble burst in 1998. This triggered a credit card debt crisis in 2002. Even today its household sector bears a crushing debt burden of 135 percent of disposable income. What South Korea did was to transfer corporate debt to the household sector. Its corporate sector is relatively low on debt.
Japan shifted debt from both the household and corporate sectors to the government, which now bears crushing debt burden of 200 percent of GDP. Japan's household and corporate sectors have lighter debt. In that regard, the redistribution of debt has been successful.
If China's household sector is successfully sucked into taking on debt, local governments and developers won't use the opportunity to unwind their leverage. They will likely double down and expand further. Local governments are incentivized to spend as much as possible. Property developers must follow their wishes. The end result is to create a bigger problem, taking down the household sector without saving anyone else.
Accepting Losses
Around the country, I see numerous property developments that are in the middle of nowhere and may never be sold. When the last property bubble burst in the mid-1990s, numerous buildings stood unfinished. The scale of unfinished buildings will be much bigger this time. Out of 4.5 billion square meters being built, 20 percent may never be finished.
Most tier-three cities have not seen significant population growth in the past decade. Yet, they are building properties equivalent to 20 to 30 percent of the existing stock. Many developments are far from the urban center. How would such developments be sold?
Obviously, the book losses, especially to the banking system, could be enormous. That will translate into pressure on the central government to stimulate speculation again. Only a massive bubble could allow such useless properties to be sold.
We must remember that the book losses exaggerate real losses. Most of the development cost is land value that went into the government's pocket. The losses merely expose that the past fiscal revenue was fictitious; they were merely bank loans, though booked with property developers, masquerading as fiscal revenues. The true economic losses are the construction costs up to now, which are not great. The country should and could write off the property bubble and move on.
Reforming Gov't Finance
In the past five years, the government's revenue has tripled, rising by 24 percent per annum. At the same time, local governments have taken on over 10 trillion yuan in debt through local government financing vehicles. Of course, some of the revenue is not reported, meaning that government resources have risen even more than what these numbers indicate. Yet, as I travel around the country, I hear local government officials all complaining about insufficient funding. As land sales have cooled in 2012, some local governments are having trouble meeting payrolls. Outside observers might find it bizarre. How could there be a shortage of money when revenues are rising at 24 percent per annum? However, insiders seem to have plenty of reasons why they need more money.
Local governments have resorted to vendor financing to keep their projects going. These vendors are exhausting their financing limits. There will be pressure on local governments to pay up. Some are already resorting to the prepaying of business taxes to keep up revenue. But, business profits are down sharply across the board. There are limits to how much money local governments can extract from businesses.
It is quite likely that local governments will resort to new ways to raise money from the household sector. Such measures will increase the tension between the government and the people. The tension will be especially acute in small townships where governments will have trouble paying employees whose numbers have mushroomed in the past decade.
The government's appetite for spending is a major source of instability. The internal pressure within government is for more spending. Without checks and balances, the government is likely to search for more and more revenue through oppressive means, destabilizing society along the way.
Retrenching SOEs
State-owned enterprises (SOEs) reported 4.6 percent net profit margin on sales and 7.4 percent return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4 percent decline in profits but 11.3 percent increase in sales. SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.
Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20 to 30 percent more than that for private companies and take about 50 percent longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China. Despite the low disposable per capita income of about 2,200 yuan per month in 2011, the country's demand for luxury goods seems to be insatiable. As one consequence, Hong Kong has become a luxury shopping center for mainlanders.
Declining Efficiency
Government spending plus SOE investment already exceed half of GDP, while household consumption is about one-third of GDP. The world has never seen such lopsided distribution between the state and household sector. Modern economic history demonstrates that government economic activities have low efficiency. Hence, government involvement in the economy should be limited to where the market doesn't work well. When SOE sales are 78 percent of GDP, the government obviously dominates the economy. Rising inefficiency is inevitable.
Many argue that China has been growing rapidly, hence the system must be pretty good. This view is misguided. Rising inefficiencies in the state sector were offset by rising export proceeds. The latter kept the economy's cash positive. The Chinese people paid the price by accepting wage increases below productivity growth. The difference was used to pay for the state sector's rising inefficiencies.
High inflation in the past three years, as reflected by near double-digit GDP deflator – the broadest gauge of inflation – reflects that lower wage growth is no longer sufficient to offset the increase in the state sector's inefficiency. China's inflation is always a tax on the household sector. There has been no exception. The tax inevitably pays for government expansion and/or SOE inefficiency.
The reason for the above is that Western economies are falling. In the past, they lost jobs to China and borrowed to support consumption. China benefited from both, gaining jobs and exports. The double benefits covered up lots of domestic problems. As the bond market no longer supports such unsustainable spending in Western economies, their demand has fallen and China's exports have fallen with it. At the same time, China's market share of global trade is so high that increasing it is difficult because the West doesn't have many jobs left to shift to China. The double benefits China enjoyed have become a double whammy.
Without another export boom, China's domestic problems are exposed. If the government tries to stimulate the economy by increasing money supply, more inflation and declining efficiency will result because the stimulus money mostly ends up in the state sector and export revenue won't rise sufficiently to pay for rising inefficiency.
The author is a board member of Rosetta Stone Capital Ltd
http://english.caixin.com/2012-06-29/100405636_all.html