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China's Coming Great Deleveraging

Posted: 07/15/2012 7:11 pm

This past week's release of China's second quarter GDP growth number - at 7.6% - was viewed as an ominous sign of the future direction of the global economy by some pundits, while others see the Chinese government's stimulus measures as a hopeful sign that its economic growth will be higher in the second half of the year. It is important to understand that the root cause of the decline in China's economic growth this year is not the trouble in Europe or funk of the global economy, but rather the unsustainable economic bubbles that have been created by the government, and the collapsing demand that has accompanied it. The central bank's latest tap dance won't fix that.

Central banking maneuvering can at best serve to sustain the over-leveraged economy and avoid a systematic short-circuit of debt financing for now. There won't be much liquidity invested in lending capacity or job creating projects, since there is insufficient demand, so the economic return on credit will deteriorate. If these structural deficiencies aren't properly addressed by the central government - and soon - the longer term deterioration of the Chinese economy can only continue. The inevitable chain reaction will accelerate, and China will face its economic end game.

To gauge how just how far the health of China's economy has deteriorated, look no further than how aggressive China's central bank - the People's Bank of China (PBOC) - has been acting of late. On 5th July, the Bank cut benchmark interest rates for the second time in less than a month. In December 2011, the PBOC cut the reserve requirement ratio (RRR) by 50 basis points (bp), to 21%, followed by a further 50 bp cut in February and another 50 bp cut in May - to the current 20%. Apart from all the rate cuts, the PBOC also made its biggest injection of funds into the money markets in nearly six months, injecting a net 225 billion yuan (US$34.5 billion) through the reverse-repurchase operations (repo) last week, which followed a combined injection of 291 billion yuan in the previous four weeks.

Why the Floodgate of Liquidity?

So why is the PBOC in such a hurry to open the floodgate of liquidity? Because however high it aims, its actions are in practice merely a monetary band aid for the hemorrhaging economy. The central bank's aggressive pro-liquidity actions at best serve to sustain the over-leveraged economy and avoid the systematic short-circuit of debt financing, but in the long term, this is unsustainable.

The main drivers of China's debt financing (China's state-owned banks) are starved for cash. According to Citigroup estimates, in 2011 seven of the largest Chinese banks raised 323.8 billion renminbi (US$51.4 billion) of new funds. Several financial firms are expected to raise another US$17.7 billion in the next few months, with China's fifth-biggest lender - the Bank of Communications - accounting for US$9 billion. The unprecedented lending binge, encouraged by the central government, the increasingly rigorous requirements over regulatory capital, and the continuation of excessive dividend payouts have placed the most-profitable banks in the world (the Chinese banks) in a rather precarious position.

GaveKal's data from 2010 shows that China's five biggest banks -- the Big Four plus the Bank of Communications -- paid more than 144 billion yuan in dividends while raising more than 199 billion yuan on the capital markets. The ballooning balance sheet - driven by the lending frenzy and strict capital requirements - have in reality made China's banks' cash starved, and burning the candle at both ends. In March of this year, China's big four banks had a combined 14% increase in total assets, to 51.3 trillion yuan - this is roughly the size of the German, French and British economies combined.

Under a new set of rules, the country's biggest banks will need to increase their capital levels to 11.5% of assets by the end of 2013. Their core Tier 1 capital ratio will need to be at least 9.5%. These requirements are more stringent than the rules applied to American and European banks. Therefore, it is no surprise why the world's most profitable banks are in the dire need of cash. And right on cue, the PBOC has come to the rescue.

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An Over-Leveraged Economy

According to Ray Dalio's principles, China's credit-fueled economy is so over-leveraged that a great deleveraging is the only way out. The pyramid of debt and credit is cracking and will ultimately collapse, since underlying economic conditions are deteriorating and are unsustainable. No amount of monetary band aids that can change that.

According to Fitch's data, the ratio of total financing/GDP in China rose from 124% at the end of 2007 to 174% at end of 2010, and rose by another 5% to 179% in 2011. In 2012 the growth of broad credit will slightly decelerate but will still outpace GDP. China is not suffering from a liquidity crisis so much as diminishing economic return on credit. According to Fitch, in 2012, each CNY1 in new financing will yield ¥0.39 in new GDP, versus ¥0.73 pre-crisis. Returns would have to rise above ¥0.5 for domestic credit/GDP to stabilize at 2011's 179%.The dilemma is that business entities will need more and more credit to achieve the same economic result, therefore they will become more and more leveraged, and less able to service the debt, more prone to insolvency and bankruptcy. It will reach a turning point when the increasing number of insolvencies and bankruptcies initiate an accelerating downward spiral for underlying asset prices, and drive up the non-performing loan (NPL) ratio for the banks. Then the over-stretched banking system will implode and a full blown economic crisis will come in full force. The chain reaction is clearly set in motion now. The question is when we will reach that turning point. What the PBOC has done is only adding fuel to the fire because it is unable to tackle the root causes of China's economic ills.

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Unsustainable Economic Bubbles and Collapsing Demand

According to Société Générale, in 2010 China spent more than US$1 trillion on construction (including residential and non residential real estate, and infrastructure), representing around 20% of its nominal GDP - almost twice the world average. That year the Chinese construction market surpassed that of the US and became the largest construction market in the world, with accounting for approximately 15%. China's construction binge push its investment/GDP ratio to 48.5% in 2010, a record unprecedented in the recent history of China or any other major economy. Suffice it to say that China is a construction-led economy.

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In 2010 China's cement consumption surpassed 1,800 metric tons, which is around 55% of global consumption and about 25 times more than US consumption. With average consumption of 1,400 kilograms per capita, China stands well above the world average ex-China of 300 kilograms. History shows that such high consumption is hard to sustain and ultimately leads to a construction crisis.

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Two years ago China built about 1.8 billion square meters of new residential floor space, which is the equivalent of Spain's entire housing floor space stock. This construction provided accommodation for 60 million people while the urban population, but the population increased by only around 20 million. If China were to keep its current construction pace over the next five years, then 9 billion square meters of new housing would provide accommodation for 300 million more people by 2015. The available floor space stock in China will then be able to accommodate an urbanized population 65-70%.But according to the IMF, China's urban population will not reach that percentage until 2030.

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For a glimpse of what may happen next, China should look at what happened in Spain. For many years Spain had a high consumption rate per capita before it crashed in the financial crisis. Spanish annual cement consumption topped off at nearly 1,300 kg per capita in 2007, ahead of the financial crisis. Four years later, Spanish consumption stands at around 500 kg per capita, down 60% from its peak. If China's cement consumption per capita continues at its current momentum, sooner or later China's construction bubble will reach its end game.

Simply put, economic bubbles are unsustainable, and are little more than Ponzi schemes. When they first start, the excess liquidity unleashed by central banks drives asset prices higher and higher. More and more people spend more and more money buying into the game, assuming the price will only keep going up. At that point in time, leverage seems to have no ceiling, but when the great de-leveraging begins, there will be a stampede toward the exit. That's when any Ponzi scheme collapses. China's investment-fueled growth - including the construction binge - is just such a Ponzi scheme.

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Busting the Myth of China's Transition Towards a Consumption-Led Economy

China can't rely on excessive investment to propel its growth for much longer. Is demand-led growth the answer? In short, no. China's export growth is clearly decelerating, with the EU and US on the edge of a double-dip recession, and much of the rest of the world relying on China for their own export-led growth. The EU and US are unlikely to bounce back any time soon, and the fortunes of many natural resource exporting countries ultimately depend on China. Brazil, for example, has become highly dependent on China for the majority of its iron ore exports. According to a recent UBS Wealth Management Research report, the great deleveraging will likely play out through 2020, so China will have to look elsewhere for salvation. With the Ponzi scheme of investment growth and the export growth both collapsing, what's left for China?

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Contrary to what many choose to believe, China's trade surplus is not caused by Chinese consumers' high saving rate, but has much to do with their deteriorating disposable incomes, which far lag behind GDP growth and inflation. According to the All China Federation of Trade Unions (ACFTU), workers' wages to GDP ratio have gone down for 22 consecutive years, since 1983. It goes without saying that the consumption to GDP ratio has been shrinking all the while.

In the meantime, the aggregate savings rate has increased by 51%, from 36% in 1996 to 51% in 2007. But Chinese consumers have not tightening their purse strings. According to the Development Research Center of the State Council's report, that increase is mainly driven by government and corporate spending - not by the households. For the past 11 years, the Household Saving Rate has only increased from 19% to 22%. The government and corporate saving rate has increased from 17% to 22%, which accounts for nearly 80% of the increase in Aggregate Savings Rate. For the past decade, the government's fiscal income has been growing faster than GDP or Household Income. In 2009, the fiscal income was 688 billion yuan, and achieved an annual growth of 11.7%, while GDP growth was 8.7%, Urban household disposable income growth was 8.8% and agriculture household disposable income growth was 8.2%. The state and corporations have taken too much out of national income and therefore continue to weaken consumers, rather than empower them.

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State enterprises and crony capitalists heavily dominate the income distribution. The deteriorating income inequity makes it harder for GDP growth to trickle down to the overall population. In 2010, net profits from two large state-owned enterprises (China Mobile and Petrol China) outstripped the net profits from the top 500 private enterprise combined. Meanwhile, government-owned enterprises only contribute 30% of GDP, and provide 20% of national employment, while private enterprises contribute 70% of the GDP and provide 80% of the national employment. Adding fuel to the fire, SOEs also account for 55% of national wages and salary. The widening income gap will skew more and more national income towards corruption, rent seeking, capital flight, asset investment and speculation. Thus the consumption-side of economy will be continually weakened.

The End Game

China's biggest problem is that the state, SOEs and crony capitalists wield too much power over national economy, have too much control over wealth creation and income distribution, and much of the GDP growth and vested interest groups' economic progress are made at the expense of average consumers who are stuck in a spiral of relative poverty. Faster GDP growth will in the end not mean much since Chinese consumers are unable to support the overcapacity in the housing market and lending markets. China will try to create more export momentum in an effort to sustain its growth, but this is a vicious circle of imbalance that even a revaluation of renminbi cannot break.

Unsustainable economic bubbles and collapsing demand are the root causes of China's slowing economy. If these structural deficiencies are not properly addressed by the government, things will get worse. More frivolous rate cuts and other central banking maneuvering are sure to come, but to no avail, as the chain reaction will only be accelerated. China will eventually face its end game - the dark side of a great deleveraging.

The Chinese juggernaut cannot possibly sustain 9 or 10% growth rates forever. In the longer term, we should come to expect sustainable growth rates of 5-6% from China, just as was the case after earlier great economic success stories in countries such as Japan and South Korea in the 1970s and 1980s. If that kind of growth rate can be sustained based on a healthier economic dynamic, it will be a great achievement.

*Daniel Wagner is CEO of Country Risk Solutions, a cross-border risk consulting firm based in Connecticut (USA), and author of the new book "Managing Country Risk". Dee Woo is Standing Director of the Beijing New Century Research Institute.

 
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