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Imagine a country where a sector has dominated that nation's economy and is deemed to be "systemically important" to growth. Insiders of that sector have made obscene profits from the growth. One day, we wake up and find that that sector has gotten in over its head. The "logical" free-market solution is the let that sector go down and allow the economy to re-balance, but sector insiders have a cozy relationship with the government. If leading companies in that sector goes down, the collapse will surely take many in government down with them. What country am I referring to? What sector? What is the most likely course of action for the government?

One obvious answer to the first two questions is the finance sector in the West (see my last post Another test of the banking lobby's powers). It's a good guess, but I am referring to State Owned Enterprises (SOEs) in China.

The roots of China's growth
The China miracle was fueled mainly by two factors:

  1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and

  2. The CNYUSD currency peg.

While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America's monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called A Model of China's State Capitalism (h/t Michael Pettis) that shows that the dominance of SOEs and their superior growth is largely attributable to their monopolistic or semi-monopolistic positions in the Chinese economy, e.g. telecom, oil refining. etc. John Hempton called this arrangement a kleptocracy because Party insiders have become enormously wealthy at the expense of the ordinary citizen.

Negative interest rates also meant very low or negative cost of capital. As Japanese companies found out in the late 1980's, it's easy to make money when your cost of capital is that low. You borrow as much as you can and invest in something, anything with a positive real return. If you are positioned properly, you can make obscene profits - and they did.

Currency peg = Financial repression

The biggest loser in China, on a relative basis, was the household sector. The ordinary Chinese who worked hard and managed to squirrel away savings had few places to put their money other than the banking system. The Chinese bond market is not sufficiently large. The stock market is very small and undeveloped compared to major industrialized countries and is regarded mostly as a casino. The household sector was forced to put money into the banking system at negative interest rates. Carmen Reinhart calls that financial repression:

Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:

  1. Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).

  2. Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.

  3. Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.

  4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:




For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money, and savings poured into it. In effect, the CNY/USD peg was indirectly responsible for China's property boom.

Where we are today

Fast forward to today. China's growth has hit a slow patch. One of the objectives in the Party's latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector).

Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

SOEs, the vehicle of wealthy Party insiders, have been hit hard:

State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.

SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.

Xie also echoed Hempton's kleptocracy claims, though in a less dramatic fashion:

Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.

In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment Ominous signs from China). Left unchecked, it could have the potential for a crash landing, i.e. negative GDP growth, which is not in anybody's spreadsheet model.

What will the government do?

In the face of the cracks exposed by a slowing economy, what should the Chinese authorities do?

The textbook answer is that growth has been overly unbalanced towards large infrastructure projects and to tilt growth toward the household and consumer sector. The Chinese consumer needs to rise. The latest five-year plan specifies this objective in a clear fashion.

The problem with that solution is that it gores the SOE and Party insiders' ox. For the household sector to rise, household income needs to rise. Wages need to rise. Returns to household savings need to rise. For this to happen, financial repression needs to end.

Ending financial repression would mean that real interest rates would need to rise, which would squeeze the cost of capital of Chinese enterprises - SOEs in particular. Would the Party cadres go along with that? This may be a case of where the leadership dictates a course of action but the bureaucracy doesn't go along.

The good news: A soft landing

Under the circumstances, the most likely course of action is a "more of the same" stimulus program. Already, we have seen a surprise rate cut, which does nothing for the returns of the household sector. We are likely to see more infrastructure stimulus. Already, we have seeing signs of a growth revival and signs of a real estate revival.

The good news is that such a policy course will mean a soft landing in China. The bad news is that it will mean more unbalanced growth and it just kicks the can down the road. The next time the economy turns down, it will be that much harder to revive.

Bad news: End of the commodity supercycle

What's more, such a growth path would mean the end of the commodity supercycle. The principal argument for being long-term bullish on commodities (which I have made before here) is rising household income in emerging market economies like China's mean rising resource intensity. Greater household income mean that consumers want more stuff, e.g. cars, TVs, etc. This is shown by this analysis from the Council on Foreign Relations.

Click to enlarge:

If financial repression continues and the household sector continues to get repressed, then where is consumer demand coming from? Moreover, there are indications (via FT Alphaville) that resource intensity may not rise despite greater infrastructure spending:

Nomura analysts Matthew Cross and Ivan Lee looked at China's urbanisation rate and concluded that it can keep progressing at its current pace for years without needing an increased rate of steel consumption. In fact, they argue that China's annual steel needs won't increase at all in 2012 and 2013 - and that's with new government stimulus.

Also see this chart (via FT Alphaville): (Click to enlarge)

This is where I depart from commodity bulls like Jeremy Grantham. Even long-time commodity bull Jim Rogers has become more cautious on China.

More importantly, while the world focuses on the China hard vs. soft landing debate, I am thinking about the longer path for Chinese growth. They will slow down. When the next downturn hits, we could see a classic negative GDP growth recession.



Source: China: Beyond The Hard/Soft Landing Debate
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