Monday, July 7, 2014

China's Economic Problems

I'm going to split this piece into six different parts:
1. China's Growth Model
2. China's Debt Problem
3. China's Geography and Urbanization
4. China's Demography
5. Environmental Degradation in China
6. China's Future Growth Prospects

China's Growth Model
China's current economic model is actually a very old economic model that has its roots in Alexander Hamilton's economic program for the US in the late 18th century. Both models rely on the use of a central bank to issue currency and debt, a strong central government to help fund domestic investment like infrastructure/public works or "internal improvements", and some form of protectionism in order to develop productive capability within the country. However, Hamilton's economic program also targeted high wages in order to support strong internal demand. China's current growth model relies heavily on cheap labor and suppresses internal demand while trying to boost capacity.

China's current growth strategy has three main parts:

1. Financial repression/high negative lending rates (lending rate=nominal interest rate-NGDP growth)
2. Wage suppression to boost exports
3. Undervalued currency
Notice that all of the three points above are just transfers. Financial repression is a transfer from those who are net long monetary assets to those who have a net short position. In other words, financial repression transfers real resources from those who are net savers to those who are net borrowers. Note that we can split an economy into three separate parts: households, businesses, and governments. Financial repression allows borrowers to get capital at very cheap costs while savers get ripped off by getting low returns on their savings. Financial repression effectively functions as a tax on households along with small and medium enterprises (SMEs) since SMEs tend to be more labor intensive. The beneficiaries of the tax are net borrowers. In China, the primary beneficiaries would be the corporate sector or the government sector. Since China follows a state capitalist model, almost all of the corporate sector IS the government sector. An IMF 2014 working paper estimated that the total value of the SOEs in China was around 190% of GDP in 2012.

Note: In the Chinese financial system, the only well functioning part is the banking system and, unlike in the US or in most of the developed world, savers have very few options on where they can place their savings. Since households are net savers, the design of the Chinese financial system transfers massive amounts of money from households to the government and corporates (who are really just a proxy for the government). Also note that households are not just net savers, but they also tend to consume most of their income. This means that the Chinese economic model has an extremely low household share of GDP with most of GDP coming from other sectors. Since governments and corporates consume a much smaller percentage of their income, when the household share of GDP is low, we end up seeing extremely high savings rates.
Note: S=Y-C so a low consumption share of GDP results in a high savings rate since C+S=Y

In addition to financial repression, the Chinese government also uses wage suppression in order to make it easier for large scale manufacturers to compete on an international level. So large Chinese firms not only get access to extremely cheap capital, but they also get access to cheap labor. Wage suppression also reduces the income that households get, which also holds down household income and results in a higher savings rate.

The third aspect of the Chinese economic model, the undervalued currency, acts as a tax on those who consume foreign goods. The proceeds of the tax go to large scale manufacturers and exporters. Those who are most likely to consume imported goods are primarily households in the middle class. Again, we're seeing a suppression of household income where the proceeds go to large scale manufacturers. This is another policy which will drive up the savings rate.

The historical precedents for China aren't too pleasing either. Today, China has the highest savings rate ever recorded with a savings rate of around 60%. The only time savings rates have reached near those levels in the past century was Japan in the late 80's, the US in the late 20's, Brazil in the 50's, and the Soviet Union in the 60's and 70's.

China's Debt Problem
Notice that the most important part of China's growth model is financial repression. Financial repression allows producers to borrow at very real rates while households get diminished returns on their savings. This incentive allows the corporate/state sectors in China to borrow very heavily to finance virtually anything. In turn, this policy (along with the undervalued currency) allows companies access to very cheap capital and has created a borrowing binge by Chinese corporates.

What's been the consequences of this borrowing binge? China has undergone one of the largest, if not the largest, debt bubbles in economic history. We've seen ghost cities spring up the size of Paris in parts of China that are completely uninhabitable where no one lives.

In terms of sheer size, the expansion we've seen in the Chinese banking system has been absolutely insane. In terms of banking assets/GDP at the end of 2011, the size of the (formal) Chinese banking system was 240% of China's GDP according to this report. Another report shows that bank loans (not total assets) of the Chinese banking system expanded at a rate of 15-20% since 2011 while NGDP has been growing at around 9% (officially from the Chinese government). This tells us that the minimum size of the formal banking system in China is over 300% of GDP and could be reaching 400%. On top of this, we've seen a surge of the shadow banking assets from <20% of GDP two years ago to around 50-70% of GDP today. In other words, the total Chinese banking system is now almost four times China's GDP and this is a lower bound, not an upper one. We're probably dealing with a country whose total banking assets range from 400-500% of GDP. There is no country nearly as large as China that has seen a credit expansion that large. Even the US didn't come close to having a credit bubble that size.

The reason why this economic growth model creates problems is because investment is driven by debt. 

China's Geography and Urbanization
We've seen urbanization in a scale that's never even been close to matched in world history. Note that urbanization is very pro-cyclical. During the boom, more people move into the cities which increases demand in the are and creates jobs--whether productive or not. During the bust, we see the opposite impact where a fall in demand leads to people leaving the city.

In the picture below, we can see how China's population is spread out throughout the country's landmass. In China, almost all of the country's population lives on the mid-Pacific coast in or near the Han core of the country. However, much of this investment and infrastructure development has come in the Western part of China. Note that the Western (and Northern) part of China is largely mountainous, the terrain is very rugged, and most of the area is not livable. Many compare the infrastructure and investment in Northern and Western China to that of the US in the 19th century, but there really is no comparison. When the US expanded west, the US was expanding into one of the most fertile areas in the world into a region that was easily hospitable with plenty of natural resources. With regards to China, the situation is very different. China's situation is much closer to when the Soviet Union went east or when Brazil went north in the mid-20th century, which was largely considered a waste.

There are massive Chinese ghost cities, real estate development, and infrastructure projects that are popping up in these completely uninhabitable areas where it's extremely expensive to maintain these projects. The idea of moving the entire rural populations to cities where maintenance of these high rise condos, large scale cities, and infrastructure is extremely expensive is simply not realistic or possible. On top of this, transportation of basic necessities like food or energy would be nearly impossible--especially considering the terrain we're dealing with.

China's Demography
China also has one of the world's worst demographics out of any country. Due to unintended consequences of China's one-child policy, there will soon be a rapidly aging population that will start to decline in about 15 years. However, the Chinese workforce has already started to decline while there were 18% more boys born than girls in 2013 according to CNBC. All of this is happening while the Chinese population will continue to grow until 2030, which implies a rapidly rising dependency ratio.

Note that until this year, China's one child policy actually caused a surge in growth rates by reducing the dependency ratio. If people all of a sudden have less children (one child policy), the immediate impact on the demographics is that the dependents start to fall because children don't have to be taken care of. As time proceeds however, the economic benefits will soon become an economic handicap and will do so very rapidly.

Another unintended consequence of the one child policy is that it's forced families to choose between having boys and girls. This policy has caused there to be many more boys being born than girls, even as of 2013. There are negative consequences to these policies that have driven up growth in the short term while effectively stealing growth from the future.

Environmental Degradation in China
Another factor that means reduced growth for China's future is the environmental degradation that's occurred in China. Pollution in China is probably the worst in the world with cities like Beijing and Shanghai having massive smog attacks, but the pollution isn't just limited to air pollution in the large cities. The amount of pollution in the water supply of China has led to massive amounts of the Chinese water supply being completely unusable. It leads to water that can't be used to grow crops or as drinking water.

Another problem with environmental damage in China has to do with the refinement and extraction of certain minerals from the ground like rare earth metals. Rare earth metals aren't actually rare, but they're used in making devices like computers, smartphones, and tablets. These metals are extracted/refined in China and exported to other parts of the world. The extraction and refinement of these metals is extremely damaging to the environment. It's so damaging that most countries do not allow the extraction and refinement of these (and other similar) minerals on their soil. However, China does allow such behavior, which causes front-loaded growth at the expense of future growth.

Let's not forget the building of large cities in the middle of nowhere near very harsh terrain. There are environmental costs to doing so. China has wiped out massive mountains in order to build those cities no one will live in. Scientists have already warned the Chinese government about consequences like soil erosion, massive flooding, and other consequences

China's Future Growth Prospects
The biggest driver of growth for China, as discussed earlier, was the economic growth model. The primary mechanism of driving growth was through financial repression, although other methods were significant too. The unsustainable growth in China's debt burden guarantees that China is very close to running into debt capacity constraints, especially for a developing country. Using very generous numbers and assumptions about China taking up a new growth model, Michael Pettis says the maximum growth China can attain is 3-4%. Of course, Pettis doesn't take into account all of the other factors I've discussed in this post, which could mean a realistic chance of China's actual growth ending up as less than the growth of the US over the next 10-15 years.

China has undergone a massive transformation over the last 30-40 years that has never been done by a country this large on a scale like this before in history. Previous examples show a bleak future for China over the next 15-20 years, but China's current path is not close to sustainable. Something will break in China; something crazy will happen. The question is what.


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