Yesterday I spoke at Macquarie’s China conference, on a panel with He Liping of Beijing Normal University and Zhang Ming of the Chinese Academy of Social Science, moderated by Paul Cavey who is Macquarie’s China economist.

He Liping’s comments focussed on the March trade deficit, which was the first for several years and conveniently timed to head of complaints from trade partners about the exchange rate.  He made the comment that cyclical rather than structural factors explained the slide into deficit, which he expects to be a one off. 

He thought that one of the biggest risks to the growth outlook was a fall in consumption of automobiles.  Apparently there was already evidence that growth in auto consumption is slowing, with inventory piling up in dealers showrooms.  If growth slows, then one of the major supports to domestic consumption will be taken away.

Zhang Ming followed up with some broader comments on the outlook for the Chinese economy.  He noted that last year’s massive increase in new lending, combined with renewed inflows of hot money, has laid the basis for a return of inflation.  He expected the CPI to push up to 4% in July and August of this year.

A 4% increase in prices would be beyond the government’s target of 3% for the year, and Zhang expects a response from the government in tightening monetary policy.  He expects a first rate hike in the third quarter, and 2 or 3 hikes over the course of the year, taking the deposit interest rate up 100 basis points in total.

Zhang noted that the government had already moved against house prices.  He said that transaction volume in residential property markets has already fallen and he expected prices to start to come down.  The situation today is similar to that in the first quarter of 2008.  The danger for the government is that a collapse in house prices might precipitate an end to investment in the sector - which would have a serious impact on GDP growth.

Zhang also spoke on the introduction of a property tax - which the government has begun piloting in several cities.  He thought that introducing a tax would be extremely difficult.  Even though a tax would mean a steady flow of revenue for local government, local government officials preferred the massive slugs of cash they received from land sales.  This is because with a short tenure in any particular location, local officials want to increase revenue fast in the years when they can enjoy it, not have a dependable stream of income for the years after they had moved to a new post.

Fiscal Policy, Monetary Policy, Property

How serious a problem is China’s property bubble?  King of the China bears Andy Xie thinks its pretty serious, and on Friday I had the chance to hear him presenting his views.  The main points from the presentation are:

‘The Chinese response to the financial crisis has followed that of the US.  But where in the US a financial meltdown required near zero interest rates to keep the banking system solvent, in China there was no problem with the stability of the financial system.  Very low interest rates were inappropriate for the Chinese economy.  With the Chinese banks motivated to lend to appease their shareholders in Hong Kong, and the property sector motivated to borrow by very cheap rates, a year and a half of very relaxed monetary policy have made the Chinese property sector bubble bigger.

Property in China is a government business.  Many property sector developers are owned by local government.  For those that are not, the cost of land and taxes are so high that they are effectively just middle men for the government.  Property is the most important source of government revenue

The government is caught in a vicious cycle.  Property prices rise, which means that property developers demand more land to build on.  To meet that demand for land, local government has to clear residents away from more and more areas.  Residents see that to buy a new home, they will need large amounts of money.  They demand huge amounts of compensation - Xie mentioned a household in Shanghai that received CNY1mln compensation for being forced to leave a 10 metre square apartment.  The government is now massively in debt as a result of the high cost of compensation, and so needs to sell the land on at high prices to recoup its costs.  Property developers buy the land at high prices, and so can only turn a profit by selling high end property at high prices, and the cycle continues.

Land is now so expensive that only state owned enterprises, that face no real budget constraint, are willing to buy.  With state owned enterprises the only buyer, the property sector is just a series of transfers between different parts of the government.  State owned banks lend money to state owned enterprises who use it to buy land from the state. 

Local governments are waiting for private sector property developers to buy land.  Their attitude is that private property developers only exist with their approval, so their money is really government money, and can be extracted at will.  Private property developers might look big and powerful, but according to Xie they are being squeezed by the government, with profit margins of 50% a few years ago, 25% today, and non-existent if developers are forced to buy land at today’s high prices.

This state of affairs can’t continue for much longer.  In Hong Kong, property is expensive but other taxes are low.  In China, property is expensive and other taxes are high.  The middle class - grauates of the 1990s who are now earning CNY10-15K/month - are getting squeezed.  This is the most able and vocal of China’s social groups.  Xie pointed out that journalists are also in this group, which is why there is so much negative press attention on the housing issue.

Inflation will be the pin that pricks the bubble.  Xie believes that China is entering an age of high inflation.  Xie pointed out that in the 1950’s, Chaiman Mao encouraged families to have multiple children to boost the Chinese population.  ’Hero mothers’ that had 10 children could even meet Mao.  In the 1970s, the children of the resulting baby boom hit their teenage years.  The result was the cultural revolution.  In the 1990s, they entered the labour market and excess labour supply kept wages (and inflation) low.  Now they are leaving the labour market, wages will start to rise and with them inflation. When inflation returns, the Chinese government will be forced to raise interest rates.  When borrowing becomes more expensive, house prices at today’s high levels will not be sustainable, and there will be a sharp correction.  Xie’s intuition is that this will come in 2012.’

Interesting stuff.  I had not heard the argument about compensation for relocation before, and don’t think it is as important as an explanation for high land prices as local government’s need to close the gap in their finances.  But in general, a compelling account of the drivers and motivations of the key players in the most important sector of the Chinese economy.  Also fascinating argument about the role of demographics and Mao’s ‘hero mothers’ in China’s recent social and economic history.

Banking, Financial Crisis, Fiscal Policy, History, Labour markets, Monetary Policy, Property, Social Policy

Local government debt is back in the headlines.  Today, I attended a presentation by Prof Victor Shih, who has just finished some fairly extensive research on the debt taken on by local government investment entities.

The starting point for Prof Shih’s argument is that last year’s massive economic stimulus was massively underfunded by the central government.  Local governments were left with colossal spending obligations but no obvious way to pay for them.  The solution for many local governments was to set up local government investment entities to borrow the money on their behalf.

The process is quite simple.  Local governments set up a financial company and give it some land.  Using the land as collateral, the financial company, which is wholly owned by the local government, borrows money form the banks.  That money is used to fund local government’s investment projects.

Prof Shih’s calculations suggest that money owed by these finance vehicles now adds up to around CNY11trln - or about 1/3 of Chinese GDP.

This money will now have to be paid back.  If, as seems likely, the revenue stream from the projects in which it has been invested are not sufficient, some other way will have to be found.  Land sales, higher taxes, or reliance on a bail out from the central government are the most likely options.

The government might have kept the majority of economic stimulus spending off balance sheet, but the bill will still have to paid.

Chinese economists are also alive to the problem of local government debt.  These are the main points from a recent blog post by Guo Tianyong:

‘Many of the projects funded through local investment vehicles are not commercially viable.  A visit to local areas revealed projects that will not generate revenue for 5 or even 10 years.

That will mean that responsibility for repayment falls back at the door of local government, which has acted as guarantor of the loans.

If the real estate market wobbles and land prices fall, the repayment ability of local government will also come into question.

Properly understood, local government finance risk and bank credit risk are now two sides of the same coin.

A more sensible approach for the future would be for local government to invite bids from the private sector to build local infrastructure.  If projects are commercially viable, there should be no problem.  If the project fails, the private sector is left with the debt, and its no burden for the government.’

You can see Guo Tianyong’s blog post here.  Prof Shih’s research has been getting a lot of play and you can see a summary of it here.

Banking, Financial Crisis, Fiscal Policy, Infrastructure, Property, Regional

One of the many unknowns about the Chinese economy in the year ahead, is whether inflation will rear its ugly head or not.  Pessimists note that growth in money supply of around 30% so far this year has laid the foundation for a return of rising consumer prices.  Optimists note that surplus capacity will keep a lid on price rises.

Sun Lijian of Fudan university economics department weighs the arguments in his latest blog post.  The main points he makes are:

‘The rapid increase in money supply so far this year has led to concerns about inflation.  Private capital is certainly flowing into property and equity markets and inflating asset prices.

One theory is that inflated property prices could drive up costs of accommodation for households and rent for businesses.  Meanwhile, inflated asset prices could contribute to a feeling of wealth that means consumers start to bid up prices.

Personally, I think the risk of inflation from these sources is small.  But what can’t be denied is that the longer the government keeps the liquidity taps turned on, the harder it will be to engineer a soft landing for asset price bubbles.

If we are going to see inflation then, as was the case in the second half of 2007 and the first half of 2008, it will be from imported commodity prices.

If we do see imported inflation from commodity prices, it could be a more serious problem than before, because companies now have stronger price setting power in the domestic market, which means that they will more easily be able to pass their increasing costs onto customers.

At the same time, if the government’s balance sheet doesn’t improve, we will also have fiscal deficits adding to inflationary pressure.

The nightmare scenario would be the bursting of the asset market bubbles at the same time as inflation takes off - leaving China facing the risk of stagflation.

With risks of inflation mounting, we should call on governments in the EU and USA to reign in liquidity.  At the same time, we should recognise that the ability of China to move ahead of the global exit strategy, or to fall behind, is limited by the impact of speculative inflows on our economy - which limit the discretion of monetary policy makers.

What we can, and should, do, is push capital into the real economy, and away from the property and equity market bubbles - guarding against the worst case scenario of simultaneous imported inflation and domestic asset price bubbles.’

I’m not sure I agree on the point that companies now have more price setting power in the domestic market.  I think overcapacity means they have less price setting power, and this is certainly the view companies seem to be expressing in various surveys over the past few months.

You can see Sun’s blog posting here.

Exchange rate, Financial Crisis, Fiscal Policy, Monetary Policy, Property, US-China Relations

For China economy watchers, the Canton fair is a bellweather of the health of the export sector.  With September’s data pointing to the first signs of a recovery in exports, this year’s fair will be more closely observed than many.  Caijing has the inside scoop and this is a few of the main points from their report:

‘The general mood seems to be one of cautious optimism, with agreement that business at this fair is better than the last two (the fair is held twice a year), but uncertainty about how quickly orders will pick up, and whether they will again reach the elevated levels seen in the first half of 2008.

A representative of Midea (home electronics) said ‘we are more optimistic about next year than this year, but it’s too soon to talk about a recovery trend, all we can say is the worst is over.’

One maker of electric cars said that they had been getting lots of questions, but not many orders.  They had noticed a switch from developed markets to the middle east as the main source of orders.  He also said that, in the past, they had not been receptive to customers’ requests for customization, now they are prepared to do a lot more to win orders.

A maker of air conditioners also noted that exports to the EU had fallen considerably this year, where sales to the Middle East, Asia Pacific, and Africa have all increased.

Exporters have become concerned about the potential for the CNY to appreciate.  A representative of Hisense Kelon - a household electrical goods company - said that they were moving to secure finance in the US to insure against exchange rate fluctuations, and trying to lock in orders at the current exchange rate.

A manufacturer of car parts said that they competed with Italian companies for market share.  They currently had a 20% cost advantage, but a shift in the exchange rate could erode that very quickly.

Exporters were united in believing that the government’s export support policies - a rebate on VAT on exported goods and the peg against the US dollar - remained an essential support.  A representative of the Ministry of Commerce is said to have told exporters at the fair that these supports would not be removed lightly.’

The three key points I take away from these various quotes and anecdotes are:

1. Exporters remain cautious - and rightly so - the outlook for consumption in the US and other major markets remains uncertain

2. To a certain extent, other emerging markets have taken up some of the slack left by the US and EU.  But even if growth in these markets is rapid it is also from a very low base.

3. If exporters get their way, there will be no early exit from export support policies - especially the exchange rate peg.

Here’s the Chinese article.

Exchange rate, Financial Crisis, Fiscal Policy, Trade

Every end of quarter, before the economic data for the last three months has been released, the State Council get together to decide what it all means and to realign economic policy priorities for the months ahead.

For the last year that task has been fairly straightforward.  With the world economy in crisis, the focus has been straightforwardly on maintaining growth.  Every three months, and fairly often in between, Wen Jiabao and other senior figures in the government have said that ‘the recovery remains unstable’ and reassured the markets that they will maintain an ‘appropriately relaxed monetary policy and active fiscal policy.’

This month, with the recovery apparently on more solid ground, the message has been subtly realigned.  The language on an ‘appropriately relaxed monetary policy and active fiscal policy’ is still there, but it has moved down the list of priorities.  The headline objective for the remaining months of the year is now to ‘correctly handle the relationship between maintaining the steady rapid growth of the economy, adjusting the economic model, and controlling inflationary expectations.’

In other words, the single minded focus on maintaining growth will now give way to a more balanced set of economic policy priorities.  The markets are expecting tomorrow’s set of economic data - which includes GDP, investment, and retail statistics, to be positive.  This announcement by the highest level of the government, is confirmation that it will be.

The other point I took away from the statement is that there is explicit mention of local government debt, with the promise to ’standardise regulations on borrowing and guarantees of debt by local government’s and local government investment platforms.’

You can see the Chinese here.

Financial Crisis, Fiscal Policy, GDP, Monetary Policy, Regional

One of the sleeper issues for the Chinese economy is local government debt.  With little concept of fiscal responsibilty, and a hand-in-glove relationship with local banks, county and township governments have been racking up debt at an alarming rate. 

The National Development and Reform Commission (NDRC) has announced the results of new research which put the local government debt level at CNY5trn.  2008 GDP was CNY30trn so that puts local government debt at 16% of GDP - lower than some other estimates I have seen. 

Xu Lin of the NDRC points out that according to Chinese company law, a company can’t take on debt that adds up to more than a percentage of its total assets or average annual profit.  This way of controlling credit risk could usefully be applied to local government.

He also says that credit agencies give excessively optimistic ratings to borrowers backed by local government guarantees, which means that they can borrow too easily.

Xu Lin also says that according to the latest estimates there are 3,800 local government investment vehicles managing CNY8trn in debt.  (I assume the point is that this debt is guaranteed by local government and is additional to the CNY5trn they have on their own books).

He also notes that debt issued by local government investment vehicles accounts for 38% of total debt in the first half of the year, vastly more than the 13% of the total in the same period of 2008.  One implication of this is that local government borrowing is crowding out borrowing by the private sector (though a more optimistic reading would be that, in the downturn, government is picking up the slack from the private sector).

Xu concludes that there is a risk that local governments will not be able to repay the money they borrowed.  That’s certainly a conclusion I agree with.  Local governments borrow against the future revenue stream from tax income and land sales, as well as revenue from their investment projects - for example tolls from use of roads or other infrastructure built with the loans.

What we have seen in the fiscal data so far this year is that tax revenue has collapsed and it is non-tax revenue from land sales and elsewhere that is propping up local exchequers up and down the country.  What we have also seen is a massive infrastructure build out which many people believe is running way ahead of demand - a fact which bodes ill for infrastructure projects’ ability to generate the revenue necessary to repay loans.  Land sales have been a mainstay of local government revenue, but they are dependent on the state of the housing market - an area where many people believe the stimulus has only delayed a serious correction in prices.

None of this spells imminent catastrophe, but it does call into question the revenue stream on which local governments rely to repay their debts.  If local governments start to default, first the banks and then, if the problem is sufficiently severe, the national government, will end up footing the bill.

You can see a news report based on the NDRC work here.

Banking, Financial Crisis, Fiscal Policy, Infrastructure, Regional

The collapse in demand in the US, EU and other trade partners from the end of 2008 on threatened to lay waste China’s export sector.  With exporters a major driver of employment and growth the government stepped in with various supportive measures.  The CNY ceased its upward movement against the dollar, the banks stepped forward with financing to meet companies’ cash flow needs, and the Ministry of Finance reintroduced and then increased VAT rebates on exported goods.

Extra cash in difficult times has doubtless helped some of China’s exporters keep their heads above water.  But there are reasons to believe that neither a stable exchange rate nor VAT rebates have been much help.  The reason is that the problem for China’s exporters is not competitiveness (cheaper goods of a similar quality from Vietnam and elsewhere eating into their market share) but rather weak demand (consumers in the US and EU spending less money).

An article in the 21st Century Business Herald takes this analysis one step further and argues that the cost to the Chinese government of export VAT rebates might outweigh the benefits.  The author’s main argument is that the benefits of subsidising China’s exports depend on the elasticity of demand - that is - how much demand changes when prices change.  This is my translation of some of the main points.

‘The elasticity of demand for China’s exports is about 0.65.  That is to say that every time prices fall 1%, the quantity purchased will increase 0.65%. 

So far this year the government has spent CNY800bn on export VAT rebates.  Given the elasticity of demand for China’s exports, that means they have used CNY800bn in government spending to buy a CNY520bn increase in exports (CNY800bn*0.65 = CNY520bn). 

What is more, 50% of China’s exports are produced by foreign firms - that means half of the benefits of the CNY520bn is going to foreigners.

Of course, increasing exports is also good for the rest of the economy - creating employment and demand for raw materials.  Increasing exports has a multiplier effect on GDP which is estimated at 1.2.  So for every 1 unit increase in exports the contribution to GDP is actually 1.2.  Taking this into account, the impact of export VAT rebates on GDP is actually CNY624bn (CNY520bn * 1.2 = CNY624bn). 

Spending CNY800bn for a mere CNY624bn increase in GDP is clearly not a good use of the government’s money.  If the government had spent the CNY800bn directly in the domestic economy, the multiplier effect would have meant a CNY960bn addition to GDP - much more than you get by subsidizing exporters.

Some people might argue that subsidizing exporters is especially beneficial because of its impact on employment - protecting large numbers of jobs in the export industry.  In fact, this depends on the price elasticity of demand for goods in labour intensive export sectors.  In fact, demand for labour intensive export goods does not change much when the price changes, so even from the perspective of protecting jobs, export  VAT rebates are not a good idea…’

It’s actually a rather long article which makes a number of other points - you can see it here.

A couple of points I take away from this.  First, defining the national interest in trade is not easy.  Not only are there different interests between consumers (who tend to benefit more from free trade) and producers (who sometimes benefit in the short term from protectionism), but also between foreign and domestic firms.  China’s export subsidies might hurt firms in the US that have their market share eroded by cheaper Chinese goods, but they help US firms based in China who benefit from the subsidy. 

Second, the author argues in favour of directing stimulus efforts into the domestic economy rather than toward the export industry.  This would be consistent with rebalancing the economy toward domestic demand as a driver of growth and away from excessive reliance on foreign demand.  Unfortunately, as the budget-busting spending on export VAT rebates so far this year demonstrates, it is a message the government is not yet ready to hear.

Finally, it’s interesting how the language of nationalism creeps into what is actually a rather technical economic paper.  The author - who is from the Chinese Academy of Social Science - is not afraid to point to benefits to foreign firms in China of government subsidies as a negative aspect of policies.  Clearly China has benefited enormously from wealth creation by foreign firms, but there is also a popular strain of discontent with their role in the Chinese economy, ranging from a scandal about Japanese businessmen participating in an orgy with Chinese prostitutes, I think in Shenzhen, to the widespread belief that its is foreign factories that are the main source of pollution on the mainland.

Financial Crisis, Fiscal Policy, Labour markets, Trade

China’s coordinated fiscal and monetary response to the slowdown was very effective and enabled the mainland to recover faster and stronger than the EU and US.  But as the focus shifts from funding the recovery to exiting from the extraordinary period of stimulus, co-ordinating fiscal and monetary policy may be slightly more complicated.  I have an article on the subject on the WSJ China website which you can read in Chinese here.

The main points from the article are:

With revenue below expectations and spending above expectations the Ministry of Finance (MoF) has to rely on borrowing money from the bond market to close the gap in the public finances.  Unfortunately, in July, three MoF bond auctions failed as the markets were unwilling to buy bonds at the yield (interest rate) the MoF was willing to offer.

The reason is that as the People’s Bank of China continues to fine tune monetary policy, there is uncertainty about the future direction of interest rates.  Participants in the bond markets do not want to buy a low yielding bond from the MoF today if there is a chance that interest rates will continue to rise and they could buy a higher yielding bond tomorrow.

In its latest auction, the MoF solved the problem by 1) auctioning less bonds and 2) paying a higher yield.  But this does not solve the underlying problem of co-ordinating fiscal and monetary policy as the government moves toward an exit from the stimulus. 

In the short term , uncertainty about the future direction of interest rates will mean the MoF has to pay a premium on market rates if it wants to shift its bonds.  In the longer term, the cost of the extraordinary period of relaxed monetary policy will be the higher interest rates necessary to control the inflation that would otherwise emerge.  As a consequence, the MoF can look forward to higher interest payments on the bonds it will need to sell to plug the holes in the public finances in the months and years ahead.

As a side note, a researcher with one of the government think tanks recently suggested that the MoF would be running a stiimulative fiscal policy (ie borrowing money to fund public spending) for the next three years.  This would mean the future fiscal cost of today’s easy monetary policy would be even higher.

Banking, Financial Crisis, Fiscal Policy, Investment, Monetary Policy

Local government debt is one of the sleeper issues for the Chinese economy and one we have written about on several occasions before.  With a narrow revenue base, rising expenditure, and a devil-may-care attitude to financial discipline, county and township governments were massively indebted going into the current slowdown.  With tax revenue down and spending on stimulus projects up, that debt can only have increased.

One of the reasons why working out how indebted local governments are is so difficult is because much of their debt is taken on through investment vehicles, which borrow money backed by guarantees from their local government masters.  The debts of these investment vehicles are actually the same as local government debt, but they are not recognised on the local government balance sheet. 

There are so many of these investment vehicles, with so much debt, that the issue has taken on a national significance.  Ba Shusong, a researcher with one of the institutes under the State Council, has just published an opinion piece pulling together some of the main facts and figures.  This is a translation of his main points:

‘There are around 3,000 local government investment vehicles around the country, 70% of them controlled at the country level.  At the end of 2008 they had about CNY1trn in debt.  At the end of the first half of 2009 they had CNY5trn in debt (China’s 2008 GDP was about CNY30trn).

Local government’s are reliant on revenue from land sales to pay the debts of their investment vehicles.  This creates an incentive to artificially inflate land prices, which can contribute to the build up of bubbles in the real estate sector.

These investment vehicles also place local government in the driving seat for making decisions about local investment projects, replacing private sector entrepreneurs.   Local governments tend to favour low value added, energy and resource intensive projects.

The financial situation of local government investment vehicles is opaque.  This puts commercial banks at a disadvantage in dealing with them.  In many cases they rely on guarantees from local government that are of dubious legality.  With complex ownership structures, in the event of a default tracing the debt back to the original debtor can be a difficult process.

Lending to local government investment vehicles means that local governments are taking on more and more debt.  If local government’s default, their liabilities will all ultimately be taken on by the central government

From a macro perspective, high lending to long term government projects with long repayment schedules limits the flexibility of monetary policy and constrains commercial banks capacity to lend to other projects.

To address the problem of excess debt taken on by local government through their investment vehicles, we need to move towards standardisation and marketisation of their operating procedures, and apply higher standards of transparency. 

We need to strictly apply capital requirements for loans and deeply analyse repayment capacity before handing out more credit to local government.

Debt from investment vehicles needs to be recognised by local government on the balance sheet.  Where there is defaults they need to be seriously examined and the responsible leaders held to account.’

All of Ba’s suggestions make a lot of sense and I especially like the idea of holding leaders to account for excessive borrowing.  The problem is that the current rash of lending to local government investment vehicles has already quintupled their debts, from CNY1trn to CNY5trn (lending to local government apparently accounting for more than half the CNY7.37 in new loans in the first half of the year).  Even if all of Ba’s suggestions were fully implemented it would be a case of shutting the stable door after the horse has already bolted.

Original article here.

Banking, Financial Crisis, Fiscal Policy, Investment, Monetary Policy, Property, Regional