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March 5, 2012, 1:38 a.m. EST
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By Satyajit Das
SYDNEY (MarketWatch) "” The ability of China to support the seriously compromised global economic and financial system is overestimated. The unsound foundations of Chinese economic and financial strength have been largely ignored. But then all food tastes good to the starving man.
The NPC will set key economic priorities for 2012 but as the WSJ's Aaron Back tells Deborah Kan, it's often what goes on behind the scenes that's most telling.
In the first phase of the global financial crisis, China was badly hit, with growth slowing and lay-offs of 20-25 million migrant workers in export-based Guangdong province alone. In response to a large external demand shock stemming from rare synchronous recessions in the developed world, Beijing deployed massive resources to restore growth to counter the economic and social impact of the slowdown.
In late 2008, China announced a fiscal stimulus package of renminbi 4 trillion (about $600 billion) over two years, equal to a budget deficit around 2.2% of Gross Domestic Product ("GDP"). But the major response was via the government controlled large policy banks that were directed to extend credit and finance infrastructure projects on a large scale.
New lending by Chinese banks in 2009 and 2010 was around 40% of GDP. New bank loans in 2009 and 2010 totalled around $1.1 trillion-$1.4 trillion, an increase from $740 billion in 2008. Total outstanding loans in the economy have jumped by nearly 50% over the past two years.
According to the World Bank, almost all of China's growth since 2008 has come from "government influenced expenditure". In fact, the Chinese growth story since 2008 is reminiscent of the debt-fueled U.S. economic recovery after the recession of 2001/2002.
In the short run, China's use of rapid growth in credit to restart growth will result in a rise in bad debt problems for the banking sector.
With characteristic hyperbole, James Chanos, a hedge-fund investor argues that China is "Dubai times 1,000 or worse". But predictions of a financial and banking collapse are overstated.
Property loans are conservatively structured and also the government has a variety of policy tools to manage problems. Predictably, in February the Chinese government instructed banks to roll-over $1.7 trillion of loans to local governments, to avoid the risk of default.
But the bad debts will absorb significant financial resources and restrict domestic consumption.
The government will recapitalize the banking system by lowering deposit costs and ensuring a wide spread between their borrowing and lending rates. Just like the Japanese and Americans after the collapse of their respective bubbles, Chinese householders will be forced to pay for the restitutions of their insolvent banks. Savers will pay a disguised tax "” low deposit interest rates and high borrowing rates. In effect, the bailout will entail a large transfer of wealth and income from households to other parts of the economy, amounting to several percentage points of GDP.
The long-term effects of this debt fund investment boom are more complex. Revenues from many projects will be insufficient to cover the borrowing or generate adequate financial returns.
The efficiency of Chinese investment has fallen. It now takes around $6-$8 of debt to create $1 of Chinese GDP, up from around $1-$2 around 20 years ago, well above the $4-$5 debt needed to create $1 of GDP just before the financial crisis in the U.S.
The real issue is whether the specific projects will generate reasonable returns, to sustain growth. High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low. While trophy projects are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may yield higher economic benefits.
China's investment boom may also be exacerbating industrial overcapacity. The greater portion of investment has been in infrastructure, rather than manufacturing. But demand from projects has increased production capacity for basic raw materials, both within China and among overseas suppliers of raw materials, such as Australia, South Africa and Canada.
A 2009 report prepared for the European Chamber of Commerce outlines the overcapacity. In its analysis of six major sectors, the report identified the following capacity utilization rates: steel 72%; aluminium 67%; cement 78%; chemicals 80%; refining 85%; and, wind power 70%.
In 2008, China's steel capacity was 660 million tons against demand of 470 million tons, but the difference is similar to the European Union's total steel output or the combined output of Japan and Korea. China's excess in cement is larger than the total consumption of the U.S., Japan & India. Yet China continues to add capacity.
If China is unable to absorb this new capacity domestically, then it might seek to increase exports, in order to maintain production and growth, increasing a global supply glut.
Driven by spending on unproductive investments, China's growth is economically destructive and ultimately carries the seeds of its own demise.
Satyajit Das is author of "Extreme Money: The Masters of the Universe and the Cult of Risk" (2011)
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