Saturday, 4 January 2014

China's debt problem

If you have seen, or heard about, China's wonderful infrastructure, have you wondered where the money is coming to finance all this ?  The laws of economics apply equally to China, as to the rest of the world. There is no free lunch. So where is the money really coming from ? This is a complicated question ; China's economic model is not easy to grasp for any outsider, but perhaps we can take a peek at it.

Infrastructure spending is not necessarily a profitable business - returns to investors are meagre from roads, railways, etc etc. In China, as in most countries, the government is the one that invests in, and builds infrastructure.  Since 1980, China has been growing at double digit rates. That growth resulted in big increases in tax revenues to the government. Chinese are also a nation of big savers. With growing incomes, came growing savings which were all vacuumed into the state banking system. The government spent a lot of it on infrastructure - banks are all under government control anyway and they were told to lend to industry and infrastructure. Since all land is owned by the government and since land prices rocketed, governments made huge money leasing land to the private sector. All in all a massive party, if you'll pardon the pun.

Came 2008 and the global financial crisis. China being an economy that relied heavily on exports, the effect was instantaneous. However, China could not afford to slow down; the political legitimacy of the Communist Party is predicated on continuing high growth and economic prosperity. So it turned the tap on investment - banks were told to lend, no matter what and growth rates continued to be high. Cities built shiny buildings, huge metros, big highways, added manufacturing capacity etc etc much of which is underutilised and certainly not providing decent economic returns. If you invest with little or no return, some day or the other you have to pay the bill.

Now the chickens are coming home to roost. China suffers from the same problem as India - the central government is largely fiscally prudent, but state and local governments indulge in the worst form of profligacy. Out came the data a few days ago that China's local public debt has exploded from very little to US$ 3 trillion - 58% of China's GDP. Since 2008, 80% of bank lending has been to local governments. And much of this money has gone into spending that will generate no return. While 58% of GDP is itself not a very high figure and much lower than say US or Japan, the rate of growth in debt is staggering (70% in 3 years) and if it continues like this, it will reach unsustainable levels.

China has a debt problem. The Chinese government knows this very well and a year or so ago forced banks to contract lending.  The impact on growth was immediate - it alarmed the government and they turned the tap on again.  A few weeks ago, China faced a short term liquidity crisis and the central bank was forced to pump cash into the economy.

The world will watch China's actions carefully. They will fiddle with the tap turning it on and off and adjusting the flow to check the growth in public debt and at the same time not let economic growth go down too much. This is an inexact science and to manage this at a national level, and that too for the second largest economy in the world, is extremely tough to do. If they get it wrong, the consequences will not be just economic - given China's system,  it will be political as well.

Longer term, the cliche of an investment led economy turning to a consumption led economy is the medicine economists prescribe for China. Easy to prescribe, not easy to administer. Unlike in say India, where political legitimacy is not dependant on macroeconomics, in China it is. If the economy wobbles, so will China's Communist Party. Any political turbulence in China will be painful, not just for China, but for the whole world.

I know economics is a dull and boring subject, but watching what China does and what the outcome is, will be fascinating if you are interested in such things. China is not a gold mine anymore. There are significant risks to the global economy from China. The party may not be coming to an end, but the music is sounding a bit off key and not so loud at the moment. Funny, you could also say that about the Communist Party.


Anonymous said...

Every economy seems to be struggling with basic principles not being followed. China atleast spent money on building infrastructure and lent to businesses to set up factories.... thankfully not like India where the money was to go towards investments in infra and business but reached the caymans fattening accounts of politicians/their cronies and never reached any intended!!!

Sriram Khé said...

There was something by Soros on the China debt issue that flashed on my screen yesterday, which I didn't read because of the extra long trip (did I tell you that the delayed flight knocked off my connection to Eugene, and the airline had me stay put in Denver for the night?) I am always suspicious of Soros--he is not by any means an unbiased commentator--but it seemed like he, too, wanted us to watch out for China's soaring debt and the balancing the Party has to do because slower economic growth means problems.
(though the growth with all the environmental impact is an awful bargain as we have both often noted!)

Ramesh said...

@Shy - Yes, most governments tend to squander away money. Its a bit like giving a flower garland to a monkey as an old Indian saying grows. Oh - the amount of money that the Chinese politicians have swindled is many times more than what their Indian counterparts have done - corruption in China is staggering.

@Sriram - Yes, Soros commented on the risks from China as part of his overall assessment of risks in 2014. He has a similar take. The problem with China is opaqueness and the difficulty in comprehending risks for an outsider. It takes a lot to understand China and there are not too many with that capability outside of that country.

Prats said...

The benefit which China has is the physical manufacturing which is getting all the push which is the most to gain out of all this infrastructure.

Imagine if one day China stops all the exports the world would go helter skeltor. There is hardly something I use which is not manufactured in China. I believe the answer to China's debt lies in the gradual rise in export taxes to fund all the infrastructure debt along with fiscal control on the future debt spending on infra.

Ramesh said...

@Prats - Yes industry has benefited from infrastructure, but there has also been lots of spending in China which benefits nobody - ghost cities, highways to nowhere, manufacturing plants where none are needed, etc etc

China is losing its competitive edge of low cost in mnaufacturing - they are no longer low cost. The advantage they now have is that nobody can produce on such scale with such reliability as China.

gils said...

I am less than zero when it comes to economics. By investing in infra and defence on such a heavy scale, maybe china is reinventing the imperial wheel?? from what I understand from history, when the European powers reached the same situation at home, they looked outwards for riches and that probably made them go mad after the 'new world'!! who knows where china might turn to? maybe that's the reason why they so religiously guard after every square inch of visible surface, over and under the world wide oceans?

Ramesh said...

@Gils - That's an interesting thought - excess capacity leads to expansionism outside. China's big reach into Africa to secure sources of raw material and food can be seen in that context. Maybe Maybe .....

Currentnews OfIndia said...

Thanks for sharing this with us, I completely agree with you.. More news here : Indian News Site

Ravi Rajagopalan said...

@Ramesh: I could be completely wrong and talking at 30,000 feet. But it appears that India's big advantage over China is not democracy and a free press, it is that it is not (yet) an investment lead economy on the scale of China. It still has a reasonable balance between consumption and investment and while it is not perfect, it is much better than China. Would I be correct? If so, we have of course squandered this advantage by putting in so many inefficiencies, a slothful and wasteful civic infrastructure, a rent-seeking civil service, a "chalta hai" culture - and of course topped off by egregious corruption. If these could be corrected our economy could right itself in no time - even at the risk of senior politicians swindling money. What say you?

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