Faltering China carries global risk....

Faltering China carries global risk....


By Francesco Sisci



BEIJING - Is China's recent, still-minuscule, slowdown signaling the end of the magic decoupling of Asia in the economic crisis engulfing the world since 2008 and is it indicating the possibility of an imminent deeper dip in the economic crisis? The questions have huge implications, and many extremely qualified economists are working on them, yet a few systemic considerations, not properly of macro economics, from China could be helpful as they seem to point in this direction. [1]

Chinese banks' current difficulties are not new. For nearly two years, a group of economists inspired by former premier Zhu Rongji have warned of problems in the financial system, which he had reorganized in the 1990s. However, these difficulties are the result of combined systemic problems and emergency measures

taken during the current economic crisis. (See China's misread property 'bubble', October 7, 2010.)

In 2009, China launched a financial stimulus plan worth about US$600 billion (some estimates have put it at more than US$1 trillion) which jump-started the country out of the crisis and decoupled Asia from the problems of the rest of the world for a couple of years. Yet now, as the financial crisis lingers on in the rest of the world, China is facing new difficulties of its own.

The 2009 funds had to be used quickly, and banks therefore gave them to state-owned enterprises (SOEs) for one simple reason: if a state bank lends to a state firm and the investment goes bad, it becomes a problem of the SOEs, and the bank has just fulfilled its institutional duty; that is, to lend to state companies.

If the bank lends to a private company and the investment goes bad, it can create the suspicion that the bank officer and the contractor may have agreed to defraud the institution. So private loans are much more complicated and cumbersome, while within the state, the money is quickly and simply passed from one hand to another.

However, SOEs are inefficient almost by definition, and the country's growth over the past 30 years has been largely driven by non-state enterprises. The result of this wave of money being placed in the hands of state companies has been waste on a scale still difficult to calculate.

Certainly, hasty investments in infrastructure are the cause of the recent accidents on the railway in Wenzhou, which resulted in dozens of deaths, and in the subway in Shanghai (no deaths, but at least 200 people injured). But the most wide-ranging problem is that SOEs simply did not invest enough money in actual industrial and productive projects; instead, they put that money into financial transactions, such as real-estate investments and "triangular" loans to private companies at a rate of 20%, 30%, or more.

The first phenomenon is the origin of the present "housing bubble". Land sales in 2010 had a total value of about $500 million, more than double the figure from a year earlier. Also in the first six months of 2011, real estate investments increased by 32% over the same period in 2010.

This was not matched by an explosion in apartment sales or a doubling of migration from the countryside to the cities.

According to a trade publication [2], the total apartment flooring in cities at present is 43 billion square meters. Put another way, if we optimistically think of an urban population of 800 million (actually more than 50% of the total population of China and more than the official rate), this gives an average space of 53.75 square meters - or 570 square feet - per person.

A family of three on average should now have an apartment of 160 square meters, more than its US or European counterparts who live in more modest spaces. These calculations are not precise, but as Chinese people on average do not live in 160 square meter apartments, they give a sense that there is an oversupply of housing in the market.

Moreover, another trade publication [3] claimed there are now over 3 billion square meters of apartments under construction. Assuming they will be all finished for 2012, it will take almost 60 million more people migrating to the cities next year to occupy them with the same large space we had assumed. But there are not so many people moving to the cities in a year, and these apartments are going to remain empty.

Many are going to be bought with cash and used as some kind of safe-deposit boxes for the rich who do not know where to invest their money. Many others, however, will just remain empty, weighing on the banks for years. Eventually they will be absorbed by the market, as China over the next 20 years will have more than 1 billion people in the cities, but in the meantime the rate of new constructions will have to practically halt.

In addition, this housing bubble fed another bubble, an increase in the tax revenues of municipalities, so that today more than 50% of tax revenue in many cities comes from the sale of land. This has thus created a de facto collusion between property developers and local administrators to blackmail the state and citizens.

A sudden halt in property development would damage the soundness of banks that have lent to property developers, and it touches the interests of people who bought a house at 10, and then after a year may find it's only worth only seven or five. Even if they paid in cash, as many Chinese do, people will still not be happy with their investment gone bad.

Therefore (a) a further stimulus re-boosting the construction boom would further drug the market - it would make a few people linked to the real estate sector richer, and many wage earners poorer, and leave even larger holes in the banks, and (b) the accidents in Wenzhou and Shanghai prove that it is very difficult to rush infrastructure projects without proper study, and timely controls. Then even if the state wanted to throw extra money in building more roads and railways, despite the financial burden (China has still a lot of money to throw around), its economic impact would have to wait to have the proper control system in place, something bound to be slow.

Alongside this, there is the associated issue that non-state enterprises are often exporters, with double pressures in the face of the increasing real cost of money (20% or more) and the revaluation of the yuan against international currencies, which hurts their competitiveness.

Finally, there is the most immediate result - higher inflation, which is affecting an ever-wider stratum of the population. To pull down inflation and deflate the housing bubble, the government is putting the brakes on financial transactions, but this affects the ability of firms to repay banks.

In such a situation, China is moving to support small and medium-sized enterprises in difficulties, as is happening in Wenzhou, where Premier Wen Jiabao has ordered local banks to support businessmen on the verge of bankruptcy because of the sudden tightening of credit. These are positive signs but short-term measures, and China should be moving toward a long-term solution, such as the one applied in the 1990s.

This time, it would require a restructuring of the banking system so that it can service the more efficient private firms. It would also need to promote a reorganization of private companies, which are born in a gray area of the law, and often operate in situations that are not crystal clear to cover their past faults. Some kind of financial amnesty should be granted to them so that in the future they can operate fully within the law.

In addition, China should privatize and break up the powerful SOEs, a major source of "pollution" of the market. This takes time and political effort, because the SOEs are a state within a state, capable of promoting their own interests even at the expense of national ones. This could be one of the important issues to be discussed at the party congress next year.

In the short term, the situation may become less stable. In recent weeks, Premier Wen has warned of possible failures of private companies. Some estimates suggest that among Chinese banks, 23% of loans to projects supported by the municipalities will be total losses, while another 50% will be at risk. An international bank reported dramatic news in the past days:

Loan losses at Chinese banks may climb to levels equivalent to 60% of their equity capital as real-estate companies and local governments fail to repay debts, according to Credit Suisse Group AG. Nonperforming loans will probably increase to 8% to 12% of total debt in the "next few years", causing losses amounting to 40% to 60% of Chinese banks' equity, Hong Kong-based analysts led by Sanjay Jain at Credit Suisse wrote in a research report dated Oct. 12. [4]

Of course, China is not in danger of collapse. Stringent administrative regulations prevent capital flight, the accounts of the state are strongly positive, and over $3 trillion in reserves can be partly used to avoid any impending trouble.

Econometric studies by Paolo Savona and scholars at the Chinese Academy of Social Sciences also indicate that the rate of use of bank capital to deposits in China is 2 while it is 9 in Europe. That is large room for improvement of the efficiency of the financial services and better use of the existing capital.

But these accounts have to be brought back in order, and this could be quite a burden for the state. Between 1998 and 2004, over $500 billion worth of loans were classified as non-performing and transferred to different vehicles. Today, the bill could be much more significant and even result in a decline in growth in China, which this year if forecast at 9% - and a reduction in that growth could be disturbing news for the global situation.

In 2010, China accounted for 19% of global growth, and that could rise to 24% this year, making China the world's single biggest growth factor.

In fact, China's exports slowed in September because of weakening external demand, particularly in Europe, China's overall main export market. Then imports also slowed, although without so far suggesting a very fast slowdown in China's economy. Meanwhile, the official inflation index remained perked at around 6%, a level demanding further government intervention to cool down the economy.

Then the current combination of the international and domestic situation is not conducive to China's growth, which will reflect on other parts of the world. The risk is of a vicious cycle: if there is not soon a squaring of the circle, China's problems could have an impact on present European and American problems, which could in turn then become more serious. Here the shadow of the second dip in economic recession looms larger, as people are pointing their eyes on Italy: will it default, or not default? And will it be the trigger of all?

Here economics turns into social factors and politics. The recent wave of Jasmine revolutions in the Middle East is also a byproduct of the ongoing economic turbulence; the 1997 Asian financial crisis changed the face of Asian politics. One wonders whether ongoing protests in Wall Street or a recent riot in Rome, almost a contagion of Athens' tough demonstrations, are harbingers of something bigger and more radical as prospects of a second dip mount.

Notes
1. Official data for third-quarter GDP are due to be released on Tuesday, October 18. China's GDP grew 9.3% year on year in the third quarter, according to the official China Securities Journal, citing forecasts in a Tsinghua University report. The economy grew 9.5% in the second quarter and 9.6% during the first half. It grew a revised 10.4% last year.
2. "Zhongguo chanye bao", August 3, 2011.
3. "Zhong zheng wan", March 9, 2011.
4. "China Bad Debt May Reach 60% of Bank Equity, Credit Suisse Says", Bloomberg News, October 12, 2011.