Consumption to drive China's growth

Shijiazhuang, China. This place is as big as New York, but you've
probably never heard of it before. 5 million living in the
metro area, 11 million in the urban area. Image from Wikipedia

In my previous post, I wrote about China's falling growth rate, its extraordinarily fast debt buildup and how debt was used to finance unsustainable investment projects. With investment bound to shrink as a share of GDP, other sources of growth have to step up for China to maintain economic growth at a rate high enough to avoid social tensions and large scale unrest. GDP growth can only come from four sources: investment, government, consumption and net exports. Since investment growth, as I laid out in my previous post, is out of the picture, let's look at the other three sources.

Government spending

Government, especially local government, who makes a lot money by selling land to real-estate developers, is not a likely source of growth unless it starts issuing bonds or finds a way to beef up revenue by imposing new taxes. A quarter of their revenue is linked to real-estate development and this source of revenue started falling late last year. With debt at 58% as a share of GDP, according to official figures, local governments are in no position to increase debt burdens, especially as revenues are falling. In addition, the central government has imposed quotas on local government debt.

China doesn't offer a lot in terms of public services (education, healthcare, benefits) and some have pointed out that changing this is a possible source of growth. However, the hukou system prevents rural migrants from registering themselves with the city government, which excludes them from the services available to official citizens. Those 'illegal citizens' have no right to social housing or healthcare (if I'm not mistakes, it also excludes their children from public schooling). Migrant workers can choose to stay in the city, forced to live in overpriced cellars or leaky shacks, or return home to the countryside where jobs are tough to find and incomes far lower. Increasing available services would leave close to 200 million, maybe more, without access to those services.

Although many have advocated for the reform of the hukou system, which keeps migrant workers in conditions similar to illegal immigrants, city governments are heavily opposed to it. Increased demand for services offered by the cities would strain their budgets and lead to more migrants flocking in once the system has been reformed, with potentially dire consequences for rural economies. A funding shortfall could be met by transfers from the central government, but so far that idea hasn't gone down well. In any case, services have to be funded somehow. Financing growth in government spending with debt is an open question, but raising taxes, as we shall see, is not really a good idea, as it would decrease household incomes (more below). The government might sell bonds domestically, but selling bonds on the international market would drive up the RMB exchange rate, which China as an export oriented nation is keen to avoid. All of this is to say that government spending is not a likely source of growth in the near future.

Exports

Export growth has been falling even faster than China's overall growth rate. Current account balance as a share of GDP stands at 2% compared to more than 4% between 2006 and 2011. Underutilized manufacturing capacity would allow for more export growth if it only weren't for weak global demand. Also, wage growth has been on a tear lately and this has put pressure on industries where labor costs are a significant part of the total cost of production. A lot of companies have moved their plants from the coastal region closer to Mongolia or even to other countries such as Vietnam and Bangladesh, where labor is cheaper. In fact wages have risen so fast that some Western companies are bringing manufacturing back home. On demand manufacturing (which is time critical) and automation, when combined, make it cheaper for some companies to produce goods closer to the home market. 

The export-oriented manufacturing sector is mostly producing goods with no local input in terms of product development, marketing or branding. As a result, the manufacturers suffer from low margins. Their only competitive advantage is mass production at a low price. Chinese goods have already flooded the world market and it is questionable how much more of that the world can absorb. China could step up its game by moving further up the value chain, and there are a few success stories such as Xiaomi that prove it can be done, at least domestically, but it takes years to penetrate world market. And don't expect Western companies to give up without a fight. Xiaomi might be a success in China, but it will face companies like Samsung and Apple who have more money, talent and experience once it wanders out its home territory. Furthermore, large scale asset purchase programs, designed to reflate asset prices, are also boosting Western manufacturing through lower exchange rates. So it is not difficult to arrive at the conclusion that exports are not going to the savior of China's GDP growth.

Household spending

Consumption only makes up about 35% of China's economy. That's very low compared to Western countries where consumption makes up 55-70% of the economy. In fact China has one of the lowest shares of household consumption in the world, it's only eclipsed by a few oil exporters, Luxembourg and Macao. Obviously, something is holding back household consumption in China. That something is financial repression and an underdeveloped financial sector. An underdeveloped financial sector means Chinese household don't have a lot to choose between when saving money for the future. Chinese household can't invest abroad so they're limited to bank deposits, stocks and real estate. Let's look at stocks and real estate first and then return to bank deposits.

Stocks
Long term investors in Chinese stocks haven't benefited from economic growth, because listed companies, national regulators nor brokerages have investors' objectives at heart.

For more than 20 years, China's capital market has been known not only for its heavy government influence but also as a rumor mill. So much speculative news does the rounds that it is possible to find fairly accurate information about a listed company's financial performance even before any official announcement. - from Caixin

Below is a chart comparing the Shanghai stock market in blue (lhs) and China's GDP market by dots (rhs). This chart alone should be proof enough that China's stock market performance has no correlation to China's economic growth. Although wealthy Chinese have ways of getting their money out of the country and investing in foreign stocks, average citizens are limited to whatever is available in China.

Chart from TradingEconomics

Most people in China don't make enough money to buy real estate. Also, Chinese banks are so backwards that they don't even offer mortgages, which means that everything has to be bought outright. There's also no consumer financing in China (ie. no credit cards, auto loans or anything of the sort). Most people who want to invest in real estate, or anything else for that matter, do so through shadow banks.

A decade ago, conventional banks, which are almost all state-owned and tightly regulated, accounted for virtually all lending in China. Now, credit is available from a range of alternative financiers, such as trusts, leasing companies, credit-guarantee outfits and money-market funds, which are known collectively as shadow banks. Although many of these lenders are perfectly respectable, others constitute blatant attempts to get around the many rules about how much banks can lend to which companies at what rates. - from The Economist

These companies operate in a regulatory no-man's land, which allows them to escape scrutiny by regulators but also investors. Stories of people who have lost everything are commonplace.

Shadow banks, which barely existed before China’s credit surge in 2009, now have assets of at least 30 trillion yuan ($4.9 trillion), or more than 50% of GDP, according to estimates by ANZ, a bank. The government’s attempts to slow the pell-mell growth in credit extended by conventional banks have only steered more business to their shadowy cousins. In fact, investments from mainstream banks have been the shadow banks’ biggest source of funds. - from The Economist

Small and medium-sized real estate developers and businesses have limited access to bank financing and are therefore reliant on shadow banking. SEOs also lend money to shadow banks, those loans are in turn bought by well-connected bankers in state controlled banks and are mostly left unreported on the balance sheet. Ordinary citizens have also used shadow banks to invest in real estate projects, but as the real estate boom begins to deflate, many have lost their money, especially in smaller cities off the coast. The state has tried to crack down on shadow lending practices, but as soon as it puts out one type of financing, another one pops up. China has resisted developing its proper capital markets, but that void was filled by untrustworthy financiers operating in the shadows with no accountability. And all of that, as we shall see, was done to fund economic growth, at the expense of stagnant household income, of course.

Financial repression

The state has kept interest rates deposits artificially low for years, resulting in cheap, below market cost, loans to state owned enterprises (SEOs) and well-connected manufacturers. A subsidized price always increases demand. Keeping interest rates lower than they otherwise would be makes previously unprofitable investment project seem more lucrative, which led to an investment boom that I covered in my previous post.

With no good alternatives to deposits (shadow banking is a recent development and not a very secure one), households were forced to save more of their income the lower the interest paid on deposits. This is in part because of the backward nature of China's capital markets (no mortgages, no consumer financing), but also because China doesn't offer much in the form of social welfare (education, healthcare), especially to migrant workers in cities who are stuck between a rock and a hard place because of the hukou system. The capital markets are underdeveloped precisely because the state wanted to use the deposits to fund investment in the tradable goods sector. Purchases of consumer durables, real estate, education and healthcare are funded with savings. The lower the interest rate, the more you have to save, simple. Suppressed interest rates are the reason why China's savings rate is so ridiculously high. It has nothing to do with national characteristics as some would say.

Anything that reduces consumption, in other words, without changing total production or total investment, must cause an increase in exports relative to imports. - from The Great Rebalancing, by Michael Pettis

What's more, total production didn't remain the same - a lot of those savings got pumped into new manufacturing capacity designed to increase exports. Since consumption was hampered by the need to save, export growth far outpaced import growth. Exporting capital means importing demand, but also exporting unemployment. Employment growth has been an important part in keeping social tensions under a lid. To further increase exports, thus securing employment in the manufacturing sector, China kept its exchange rate artificially low.

Devaluing the currency is the equivalent of transferring resources from net importers (which includes primarily the household sector) to net exporters, which is composed mainly of the tradable goods sector. In so doing it reduces consumption by reducing disposable household income and increases production by lowering input costs, thus pushing up the savings rate. - from The Great Rebalancing, by Michael Pettis

China is already a manufacturing powerhouse and there's not enough demand in the world to absorb any meaningful increase in Chinese manufacturing. Debt driven investments are also slowly deflating and local governments are weighed down by debt and falling revenue from real estate developers. Consumption is the only source of growth that could power China's growth in any meaningful way. To increase consumption, household income has to grow, and it has to grow faster than GDP. Alternatively, the state could start offering public services. That would not increase incomes, but it would decrease the need to save. Potential solutions include reforming the hukou system, offering more public services, deregulating interest rates, developing a modern, functioning capital market by reforming and liberalizing banking and lending (which could include legitimizing but also regulating shadow banks, ie turning them into proper banks). Opening up the capital account would also be a step forward, but it's obvious that the Chinese capital market is not ready to compete with foreign banks and investment funds.
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A lot of what I wrote in this post has been gleaned from Michael Pettis' blog posts and his book The Great Rebalancing. For anyone interested in global capital flows, Pettis' blog is a must read. He sheds light on the European debt crisis from a capital and trade account perspective, which is very refreshing. I highly encourage you to start by reading his latest post, here.

China is reverting to the mean, predictably so

A photo of one of China's ghost cities, from the Daily Mail.

Lately, China's economics growth figures have disappointed to the downside. To many observers, this wasn't a surprise. A reversion to the mean was bound to happen, as described by Lant Pritchett and Lawrence Summers in Asiaphoria Meet Regerssion to the Mean:

However, predicting future levels of output by the extrapolating the current growth rate into even the near, much less the distant, future is on very weak scientific footing. The single most robust and striking fact about cross-national growth rates is regression to the mean. There is very little persistence in country growth rates over time and hence current growth has very little predictive power for future growth. Hence, while it might be the case that China continues for another two decades at 9 percent per capita growth, given the regression to the mean present in the cross-national data this would be a 3 standard error anomaly. - (this and following emphasis mine)

So it is not at all surprising that China failed to achieve its 7,5% target rate of growth. Indeed GDP growth in China has been falling for several years. It is surprising that China managed to keep such a high rate of growth for so long*.

China has had growth rates of over 6 ppa for 33 years starting in 1977 and this data set ends in 2010. - (that's 37 years if the figures were updated to include 2010-14)

But rare is this so-called super-rapid growth?

First, episodes of super-rapid (>6 ppa) growth tend to be extremely short-lived. The method of dating growth episodes doesn’t allow an episode of less than 8 years. The median duration of a super-rapid growth episode is 9 years, only one year longer than its possible minimum. There are essentially only two countries with episodes even approaching China’s current duration. Taiwan had a growth episode from 1962 to 1994 of 6.77 ppa (decelerating to 3.48 from 1992 to 2010). Korea had an acceleration in 1962 to 1982 followed by an acceleration in 1982 until 1991 when growth decelerated to 4.48 ppa so a total of 29 years of super-rapid growth (followed by rapid growth).  So China already holds the distinction of being the only country, quite possibly in the history of mankind but certainly in the data, to have sustained an episode of super-rapid growth for more than 32 years.

Reversion to the mean, by definition, means that the longer something deviates from the mean, the higher the probability of it reverting back to the mean. Betting against China hasn't been a profitable bet for the last 30 years*, but it might change. How far down might a reversion to the mean take China's GDP growth? Based on historical figures, the authors offer this:

Third, the typical (median) end of an episode of super-rapid growth is near complete regression to the mean. The median growth of the episode that follows an episode of super-rapid growth is 2.1 ppa. So the “unconditional” expectation (or central tendency) of what will happen following an episode of rapid growth is a reversion to not just somewhat slower growth but massive deceleration of 4.65 points (more than twice the cross-national standard deviation).  A deceleration of that magnitude takes growth in India from 6.29 to 1.64 and in China from 8.63 to 3.98.   

A slowdown in overall growth is bound to affect some sectors more than others. Investment (think housing, infrastructure and manufacturing capacity) in particular will take a beating. Investment as a share of the economy has reached 50% and most of it was financed with debt. The overall debt-to-GDP ratio went from 153% in 2008 to 243% in 2014 (see this and this). Debt has grown faster than debt servicing capacity and this is bound to end up in tears for investors, as it already has for investors in some of China's ghost cities. Empty apartment buildings, nearly empty high-speed trains and shopping centers only mean one thing - no revenue, thus nothing to service debts with. China's banking system is intoxicated with bad debt and up to a point it was manageable by simply refinancing the old loans. Every speculative bubble finds its limit and looks like China has met its limit at the 240% debt-to-GDP mark. 

Without substantial growth in I, G or NX, the growth has to come from somewhere else. More on that in my next post.

*There is evidence that China has been manipulating inflation, income and spending statistics, see this and this. But even if we assume a quarter or even half of the GDP growth is fake, the China's growth is still unprecedented. Some have pointed to the quality of leadership in China, or the extensive industrialization (China was a rural economy before the 70s), or the size of China which allowed them maintain a high rate of growth by pumping money into less-developed regions as wealthier regions slowed down, or the quality and efficiency improvements of their manufacturing. A plethora of explanations have been offered, but the persistence of super-rapid growth remains a mystery.