China Is Slowing Down – Old Model Not Working Anymore

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WASHINGTON – We all know that the Chinese economy is slowing down. But we do not know all the facts. The picture may be much darker than what we can get from official statistics. It would seem that recent growth has been financed by large debts. Much of this debt will not be paid back because the money went to pay for ill-conceived projects. Local governments created large liabilities in order to finance development projects for which there is no market.

The Chinese economy is losing altitude

In order to shed some more light on these issues I reproduce here excerpts from a longer article that appeared in the English language version of Caixin, a Chinese publication, (Will Slow and Steady Win China’s Economy Race? By Yu Hairong, Xing Yun, Wu Hongyuran, Zhang Yuzhe and Wang Liwei, March 18, 2015).

 “The government said the gross domestic product growth rate sank to a six-year low 6.8 percent in January and February. Figures for those months came in far short of the average 7.7 percent forecast by economists from 14 financial institutions previously surveyed by Caixin. Fixed-asset investment growth and lending growth slowed as well during the period.”

“Early-year GDP growth also came in below the 7 percent target for 2015 set by the government, as spelled out in an annual report on the government’s work delivered by Premier Li Keqiang on March 5 to the opening session of the National People’s Congress.”

“Officials have acknowledged this year’s slow start in the context of what Li and others have called the “new normal” for China’s economy. GDP growth for “the first quarter will be below 7 percent,” said Zhu Baoliang, director of the economic forecast department of the State Information Center (SIC), a government research agency. The government is pressing forward with transformational economic reforms, but pressure to modify the official approach to these long-term changes has been building as slowing growth affects banks, the overall business climate and local government finances.”

“Pressure is building as the real economy turns downward,” said Xu Gao, chief economist at Everbright Securities. Zhu said how quickly the government is able to strike a balance between the slowdown and economic stability will largely depend on the ability of policymakers to maneuver and adjust fiscal policies.”

“Only in recent months has the Chinese business sector started to feel the full impact of a reform-related campaign to reduce the economy’s heavy reliance on what used to be ever-higher levels of fresh investment.”

“One sign of this impact is reflected in industrial value-added output, a measure of industrial production, which increased 6.8 percent during the January-February period compared to 8.6 percent for the same period last year. Nationwide, fixed-asset investment growth also slowed, increasing just 13.9 percent, down 1.8 percentage points compared to the first two months of 2014. A macro-economic analyst at Haitong Securities, Jiang Chao, predicted industrial value-added growth would fall to 6.5 percent in March. Other recent indicators of a changing business climate since the beginning of the year include reports of declining consumption of coal by power plants and slipping prices for manufactured steel.”

 “A Shandong Province city official overseeing local business investment who asked not to be named said that many small and medium-sized companies decided to suspend or delay investment projects earlier this year. These companies, which contribute significantly to local economies, have had tight capital chains.”

“Banks, which finance four-fifths of the country’s economic growth, are lending more cautiously. Credit is still available, but more thought is going into credit-issuing decisions. “The most important questions revolve around finding assets with good prices and controllable risks,” said the president of a commercial bank who asked not to be named. Risk control has become increasingly important in light of increasing numbers of bad loans. The China Banking Regulatory Commission (CBRC) said that as of December 31, the nation’s commercial banks were saddled with 842.6 billion yuan worth of non-performing loans. That amount was up 42 percent from the beginning of 2014.”

“Bad loan ratios are higher in some regions than in others. Government data show that for banks in the coastal provinces of Zhejiang and Shandong and in the interior provinces of Sichuan and Henan the average bad loan ratios are around 2 percent. The figures for banks in Shanxi Province and the Inner Mongolia region, both in the north, are about 5 percent. A manager at China Merchant’s Bank said that its Sichuan branches are seeing an increasing number of bad loans. He blames the rise on the area’s private lending network, heavy investment climate and the government’s anti-corruption campaign. Yu Xuejun, chairman of the Supervisory Board for Key State-Owned Financial Institutions at the CBRC, said that bad loan rates are rising at a faster pace than in the past, “regardless of the region and bank.”

“Moreover, loans to businesses in the commodities sector have been drying up due to risks tied to slumping prices for a variety of basic commodities, said a source at a joint-stock bank.”

“Local governments are also facing credit pressure. Since last year, several governments, including those in Shanxi, Heilongjiang and Liaoning provinces, have reported declining revenues due to sluggish business for coal and steel companies crucial to their economies. Liaoning’s government reported a 4.6 percent decline in 2014 revenue from the previous year. A bond market source said that the Inner Mongolia government’s financial position is quickly deteriorating due to declining coal prices. In February, the local government in Yijinhuoluo Qi, near the city of Ordos, had to borrow 20 million yuan from the central government to pay employees working on government-backed projects.”

“A nationwide review of government debt ordered by the Ministry of Finance found that as of January 5 local governments had a combined 40 trillion yuan in liabilities. But that figure may be low because in late January the ministry found some data was falsified by local governments. [Bold added] A revised report was expected to be released in March. Local government platforms that borrowed money for infrastructure and other projects are a particular concern. In the eyes of a Shanghai bank executive who asked not to be named, the “local financing platforms’ default risks are much greater than imagined.” One reason, he said, is that “many governments repackaged old projects into new ones in order to obtain bank loans.”

“The Ministry of Finance also set a quota of 1 trillion yuan in debt that local governments are allowed to convert from expensive loans into low-interest rate municipal bonds. The move was designed to help the governments finance new projects.”

The glitter is gone

So, here is the picture. China’s GDP is growing less than official forecasts had predicted. Industrial production is down. In all this, many local governments need to be bailed out because of bad economic development decisions that led to “malinvestment” and high debt. That financial hole may be a lot bigger than early figures had indicated.

What do we make of all this?

A safe conclusion is that China’s golden moment is over, because much of it was fake. GDP growth was spurred by a construction boom that turned out to be a bubble, because there is no real demand for all this debt-financed development. In the meantime, the country created an absurd level of over capacity in all the industrial sectors that support construction and infrastructure development. Many local governments got into big debt to finance big projects that have no economic rationale.

Beijing will pay all the bad debts

As bad as this looks, China is not Greece. We can rest assured that Beijing can manage all this. The Chinese state has gigantic cash reserves that can and will cover all the existing bad debt. But this is a small consolation.

The bad news is that the current scenario indicates the end of an era. The old economic development strategy does not work anymore. A new model that will see a shift from capital investments to more consumer spending has been talked about, but is not operational.

The best I can think of is that, absent huge economic gains stemming from truly innovative sectors, China will go down to average emerging market growth rates of 4 to 5% a year. This is China’s “new normal”. And it does not look that great.

 

 

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