First published: 25th September 2015
The 66th anniversary of the founding of the Peoples Republic of China will be celebrated on 1st October with fanfare. But this Year of the Goat – which in Chinese astrology heralds calm after the more tumultuous Year of the Horse – isn’t quite going according to plan. The economy is not collapsing, as I have pointed out recently here, but things aren’t going well. Specifically:
- a slower-growing, and highly indebted economy is running into some serious stress (next round of major high-frequency indicators for September, as well as Q3 GDP, due 19th October)
- the economic reform agenda calling for liberalisation and greater reliance on market mechanisms is running into resistance, and proving divisive, and difficult to implement
- President Xi’s political strategy of greater centralised command and control, including the anti-corruption campaign, is stifling reform and initiative, and undermining the authority of government
High growth is the CCP’s part of the social contract with citizens, but high and still rising debt has become a major headwind. Reform and liberalisation are regarded as important but also as reminders of how the CCP’s Soviet counterpart was consumed by them in four short years. China is determined, above all else, not to allow the same thing to happen. Strengthening the CCP, therefore, and standing up for its ideals and convictions – which Chinese leaders regret their Soviet counterparts never did – are seen as the only appropriate remedy. The problem, if you use extra-legal methods, curb opponents, and don’t have a trusted system of checks and balances, is that there’s no one else to blame if something goes wrong.
So at 66, the simultaneous pursuit of high growth, reform and liberalisation, and the emphasis on Party primacy and ‘purity’ is exposing China to fundamental ‘internal contradictions’. I examined these in 2013, for example here, arguing that China had reached the end of extrapolation. Two years on, this remains the view, and how China manages these contradictions in 2016 and years to come will engage our full attention. Something has to give: it won’t be the Party in the first instance.
August squalls emphasised underlying economic issues
A surprising and poorly communicated mini-devaluation of the Yuan, cloaked as a reform measure to help the pitch for inclusion in the IMF’s SDR, was followed almost immediately by market intervention to support it that may have cost $200 billion or more. Confusion surrounding Yuan policy accentuated the authorities’ prior failure to prevent what ended up as a 40 per cent fall in local equity markets in spite of extraordinary administrative and financial measures. The former cost credibility, while the latter may have cost as much as $250 billion. These disturbances reminded us that China’s economic downturn merited serious attention, and perhaps more importantly, they forced people to ask questions about the long-taken-for-granted competence of the authorities to manage macroeconomic risk, and whether internal politics were now intruding in some way.
On official data, the economy has been slowing down steadily since 2011, from double-digits to about, or now just below, 7 per cent,. Contrary to some excited commentary though, China’s economy is not collapsing, even if the growth numbers are overstated, and it is in a serious condition. Some provinces in the north-east of the country where heavy industry is prevalent may now be be in a sort of recession, in which GDP growth is around 2-3 per cent. Even using China’s official growth statistics, the economy as a whole may only be growing at about 5.5 per cent on an underlying basis, given that stimulus measures this year already add up to nearly 1.5 percent of GDP.
Actual growth may be even softer, but there certainly hasn’t been much anecdotal evidence of millions of workers leaving the cities for rural areas as they did in 2008-09. China’s unemployment data are poor and not credible. Yet a more accurate measure than the official 4.3% is around 6-7%, according to the International Labour Organisation, and it is most likely rising.
The fall in the growth of real estate investment, which soared from 8 to about 16 percent of GDP in the last decade, has been in the forefront of the aggregate slowdown. Real estate investment is barely rising at all now. The stock of unsold residential accommodation stands at between 25-40 months of supply in cities where the largest investment has occurred, that is, other than in so-called Tier 1 cities of Beijing, Shanghai, Shenzhen and Guangzhou.
While real estate investment has been a popular focus thanks to colourful reports and visitor impressions of ghost cities and empty apartment blocks, the decline in manufacturing investment has been as, if not more, striking also against a backdrop of overcapacity.
Industrial overcapacity
Although data on capacity usage are hard to come by in China, a State Council directive in 2013 estimated that in a broad sample of industrial products, China’s capacity utilisation rate had fallen from about 90 per cent in 2007 to less than 75 per cent. It will certainly have dropped further since then, underscored by the fact that producer (or selling) prices in China have fallen in 42 consecutive months to August 2015.
Overcapacity has been a persistent feature in China since the 1990s, though WTO accession in 2001 and the 2008 credit stimulus programme both relieved pressure at important moments. With neither of these options now open, the growth in capacity in recent years has again pulled away from new production, resulting in an overhang of perhaps 30-40%. The Conference Board in China has examined the mining equipment (metals, minerals and coal) sector, which receive large subsidies so as to help lower production costs further down the production chain; power generation; and metal cutting machine tools. All experienced high double-digit annual capacity growth between 2000-2013, and are now experiencing varying degrees of overcapacity.
They have also all experienced excessive levels of inventories which have typically been used to collateralise loans. This practice has been rampant in China, and embraced a wide range of commodities. One recent, small but symbolic example of collateralised metal schemes running into losses was the case of the Famya Metal Exchange in Kunming, capital of Yunnan province. Investors lent money, promised double digit returns, to this non-ferrous metals entity with product as collateral. The exchange now owns many years worth of stock, and the collateral has fallen substantially in value, incurring losses for both the exchange and its investors.
Collateralised commodity schemes that have gone sour are certainly one of several reasons for the steady rise in non-performing loans, which the IMF’s recently published Article IV report estimates at 5.4% of GDP (officially declared NPLs, 1.4%, plus ‘special mention’ loans).
Given this backdrop, China’s investment-led growth model is bound to re-balance, that is the investment rate will decline, one way or another. The investment rate at 46 percent of GDP is exceptional, and we should expect it to follow the path of the other Asian tigers, which retreated from high to much lower levels. Japan’s hit 40% in the early 1970s, and dropped to 30% as the bubble burst, before sliding further to 20%. Singapore’s reached the same as China today in 1985 and dropped back to 30% by 2000, and South Korea’s peaked at 35% in 1995, before also falling back to 30% last year.
Beijing acknowledges that the investment rate has to fall but has demonstrated a marked reluctance to allow inefficient firms, and those with surplus capacity to go bankrupt or be taken over. Steel producers with significant excess capacity are still in business, solar panel manufacturers similarly, and recently it was announced, for example, that the government would make good the bond holders of the loss-making, smelting and forging company, China National Erzhong Group, which is one of the central government’s 112 main SOEs.
SOE reform prospects limited
State owned enterprises, which should be the centrepiece of reforms and capacity shutdowns have been the target for anti-corruption measures, executive pay restraint, the reduction of salary gaps, reorganisation, raising dividend payments, and reductions in administrative red tape. Formally, China still wants to turn central SOEs into leading global firms.
But there is no intention to subject them to market disciplines, transfer their functions to the private sector, let alone privatise them, or allow the ownership structure to change, even if new private capital is allowed to come in. Caixin online recently published a piece on the problems in getting even de minimus change to plant roots in the oil industry here.
The iron triangle of Part, State, Business remains sacrosanct. In fact, a just published reform plan, that had been widely anticipated for many months, falls far short of encouraging private sector competition, let alone any forms of privatisation. Roughly 75,000 state enterprises in telecommunications, power, energy, aviation and banking are protected, while the approximate 80,000 that aren’t also get privileged access to cheap land and loans, and aren’t pressured to acknowledge financial discipline. State enterprises are, therefore, going to sustain overcapacity and deflation in China for the foreseeable future.
Xi’s unintended consequences?
Xi’s commitment to centralisation, the purity of the Communist Party, and a robust, persistent, and extra-legal anti-corruption campaign are having negative consequences on economic growth and the success of the reform agenda. The curbs on compensation in state enterprises and on conspicuous consumption by senior party cadres, for example, would be expected to curb economic growth, but these would normally be of limited consequence.
More seriously, the concentration of power by President Xi, while a bona fide attempt to overcome what he has argued to be the sloppiness, corruption and gridlock brought about by his predecessors, has had other consequences. Xi’s so-called ‘small leading groups’ have taken over the most important functions of government and administration. These groups are not small and now outnumber government ministries. Xi himself minds the most important ones, sidelining Premier Li Keqiang, whose position has been associated traditionally with the highest level of economic leadership. Li’s position looks rather uncertain and if not before, he could certainly be replaced at the next Party congress in 2017, especially in view of what is going on in the economy. The authority of government ministries, held responsible for reform implementation, has been undermined, eroding their accountability and effectiveness. The reform agenda, itself, has been further set back by a series of measures designed to curb the media, non-governmental organisations, the courts and other civil and human rights authorities.
In a nutshell, command and control are progressively edging out reform and market mechanisms as the main tools for guiding the economy’s uncertain transition over the medium-term. This suggests not only that economic growth will continue to drift lower over the short-term, erratically perhaps, but also over the medium-term to about 4%. These years will pose a significant test for President Xi. If all goes well, he will see his term out in 2022, having chalked up the CCP’s 73rd year in office, one more year than the Soviet CP lasted in power. Quite what China will look like then, we’ll see.
