2014-08-01 By Harald Malmgren
There is unspoken, but growing apprehension among central bankers that the Chinese financial market is vulnerable to serious, potentially systemic shocks. To put the measureable scale of debt exposure in perspective, China’s total debt to GDP ratio was 147% at the start of the Great Financial Crisis in 2008.
The debt to GDP ratio is now about 250%, and growing as official support for banks continues to rise.
Most world market analysis of China’s economic growth continues to be based on China’s officially published GDP growth rates.
Lowered Growth Expectations
However, inside China’s upper levels of government (Central Committee, Politburo, and Premier Li Keqiang) growth expectations are gradually being lowered. It seems to be admitted among higher level officials that the latest official growth rate was deliberately devised as 7.5% to assure the public that Xi Jinping’s publicly proclaimed target is being met. Inside the higher levels of the Chinese government a 6.5% growth rate is thought to be more realistic for the next year or two, and that this slightly lower rate of growth is “politically manageable.”
Chinese official national economic data are compiled from data generated at the local and provincial level, and adjusted according to a methodology not publicly available for review. Local and provincial data are often manipulated to assure the central government that its economic plans are being achieved. The components of the deflator used to set “real” GDP growth vary from quarter to quarter.The aggregate national numbers are built upon flawed or deliberately distorted reporting.
Other published indicators can be called upon to assist in evaluating the official economic growth numbers. Typically, world markets give close attention to the ISM manufacturing index. The government generates its own ISM figure, and HSBC publishes a different index which is usually lower than the official number. The ISM is determined via surveys, but the reliability of the surveys is questionable. Various other indicators watched by markets include inventories of coal, iron ore, copper and cement. Yet inventories of raw materials may not be good indicators of economic activity.
Some years ago, when Premier Li Keqiang was in a subordinate role, he publicly suggested that alternate measures might sometimes be better indicators, such as electric power consumption or power output, rail cargo, automotive sales, and excavator sales.
Recently most of such indicators suggest deceleration of growth.
Chinese Financial Stress
Turning to China’s financial market, there is growing high-level worry inside China about potential financial stress from now through the next two or three years. The pileup of nonperforming debt in the banks, particularly local banks, is well understood. The exposures of the rapidly expanding “shadow banking system” (non-bank financial intermediaries) are far less understood. With minimal oversight, there is little data by which exposures to nonperforming debt and counterparty risk can be measured – or even estimated. Recently, two of the so-called “Trusts” have declared insolvency, but little evidence exists to suggest the scale of how many more might fail.
The government says it is trying to rein in the shadow banking system, but officials seem unsure about how much restrictiveness could be tolerated without a systemic breakdown. In essence, Chinese investors have been emulating the behavior of US “financial engineers” in the late 1990s and first decade of the 2000s, firing up leverage through hyper-hypothecation of assets, minimal documentation and custody mechanisms, and “friendly” toleration or even encouragement by local and regional government officials. The level of corruption is simply not known beyond the localities of funding.
Many of the Chinese financial intermediaries rely heavily on short-term funding provided by European and US megabanks. Futures contracts and other derivatives provide the connectivity for much of the non-bank financing, opening potential for systemic collapse if individual links in elaborate collateral chains were to break.
The real estate market has become so heavily leveraged that officials openly acknowledge the existence of commercial and retail real estate bubbles. Residential values have been falling in some areas recently, threatening to trigger social unrest from families whose savings are being eroded.
As in many other nations, the government official measures of inflation are usually adjusted downwards so as to conceal or obfuscate household impact. The official deflator used in calculating real GDP rate of growth is continuously adjusted without regard to any coherent methodology, but normally is set significantly lower than what might be considered by ordinary households as the “real” rate of inflation.
China was able to grow extraordinarily rapidly in recent decades by reliance on its export engine which accounted for more than 40% of GDP. At the time of the Lehman collapse, world trade finance came to a halt, and world trade began its longest, deepest contraction since the Great Depression of the 1930s. In 2011 and 2012 world trade recovered and slightly surpassed the peak of world trade which had been reached in August, 2008.
The Need to Rely More on Chinese Domestic Growth
However, more recently the pace of world trade has slowed markedly, rising at a rate of growth somewhat less than the rate of growth of the world economy. It should be recalled that before 2008, world trade had risen at an average rate of almost twice as fast as world production. Now, instead of double world production, it is rising less than world production.
In this context of slow world trade growth, China is experiencing rapid decline in manufacturing competitiveness. As the Chinese economy grew, wages have had to be raised. At the same time, China’s export products gradually moved up the value added ladder, to more complex products embodying technological innovations. Chinese manufacturing quality control suffered during this transition, discouraging foreign businesses from using Chinese parts, components, and sub-assemblies for global markets.
Gradually, foreign manufacturers that had been involved in local manufacture inside China shifted their production expansion to other countries like Vietnam. As a destination for overseas production, China is no longer choice number one, unless a foreign company wishes to focus on the Chinese domestic market.
In recent years Europe passed the US as China’s biggest export market, but Europe is still suffering from the consequences of the Great Financial Crisis and mired in slow growth, on the edge of slipping into negative growth. The US economy and most other markets around the world have also suffered economic slowdown, and in 2014 the outlook for world growth appears to be weakening, not strengthening.
Thus, China is now faced with weakening global competitiveness and weak foreign markets. It is in growing need of stronger domestic-led economic growth.
As the Chinese population is no longer growing, the labor force in future years will gradually shrink as a share of total population, and the aging population will have need for a growing share of economic output. The transition to domestic-let growth will not be easy. One of the most obvious examples of the many challenges is that to raise domestic consumption wages must rise at a faster rate, but this will put upward pressure on inflation.
The Impact of the Political System
At the pinnacle of the Chinese economy is a centralized planning system managed by the Communist Party Central Committee, Politburo, and the Standing Committee of the Politburo and the National Security Committee (encompassing the PLA military leadership and other ministries and agencies).
To the outsider, the Chinese governing structure looks coherent and orderly, but behind the formal structure are various groups vying for power with varying ideas of how policy should be made, what policies should be followed, and how to enforce policies once agreed, while maintaining acquiescence of the wider population.
Even within the Politburo there can be found elements of two separate factions that emerged following the death of Deng Tsao Ping: The Shanghai bang, led by China’s former leader Jiang Zemin, and the Youth League Faction, led by former leader Hu Jintao. The present national leader, Xi Jinping, is from the Shanghai bang, but when Jiang Zemin passes on, that faction potentially might break into different segments. In the background are the New Left, which promotes return to more disciplined management of the economy and society, and the Princelings (sons of the families of former Party leaders).
The now disgraced Bo Xilai used Princeling status to build a widespread personal power network among the New Left but also with the State Security apparatus and the military leadership. He also established a powerful personal political base in Chongqing province. At present, it would appear that Xi has set in motion a persistent effort to wind up and eliminate from power the entire network built by Bo Xilai, mostly using allegations of corruption, but with intent to destroy an alternative personality power cult which might potentially evolve into a challenge to the Jiang-Hu structure.
Xi has essentially completed reform of the Central Committee, the Politburo, and the Standing Committee of the Politburo. He has also set in motion a broad crackdown on the State Security hierarchy, with its former head Zhou Yongkang already held under house arrest for charges of corruption.
Xi has also begun a methodical reconfiguration of the PLA leadership, but that, left to the last, may be more difficult.
China’s PLA functions in 7 distinct military districts. Of these, the northeastern Shenyang Military District is perhaps the most powerful, with greater mechanized mobility than other districts, and standing by the border with North Korea. The connections between the PLA in this District and Zhou Yongkang and Bo Xilai are said to have been intricate and strong. The generals in this military district are also thought to be directly involved with managing relations and business with North Korea.
One of the steps taken under Xi has been to shift a greater share of military spending to the Navy and Air Force sections of the military, gradually squeezing spending in the domestic land-based military and giving larger roles to a new cadre of senior navy and air force officers.
Why this all matters is that the sustainability and strength of the new national leadership under Xi has not yet been tested.
A nationwide anti-corruption drive has begun, but hardly any Chinese citizens expect all corruption will be eradicated. Instead, selected segments of Chinese wealth and authority are expected to lose power and greater wealth and authority will be attained by other segments. Since 2010 many wealthy families have been eagerly seeking to move some of their family wealth abroad, in anticipation of unknown reallocations of power and wealth that might follow the ascent of Xi and his new Standing Committee.
The recent surge in outflow of capital is not readily measureable, but its scale is reflected in huge demand of Chinese citizens for high-end residential properties in London, New York, Toronto, Sydney and other cities around the world. Most wealthy families with sons or daughters press them not only to be educated abroad, but to remain abroad to manage family wealth from other legally protected jurisdictions in nations strong enough to resist pressure from Beijing.
The Impact of Politics and the Military
Why does this all matter to the Chinese economic outlook?
Many central bankers, private bankers, and finance ministry officials in other countries are wondering whether the Chinese power-based political decision system can cope with the challenges of reconfiguring the Chinese economy and prevent its financial market crashing.
This is not a question of the capability of the Peoples Bank of China (PBOC) but rather the capability of consensus decision making in Beijing and the regional governments at a time of maximum financial stress. When looked at in this way, the apprehensiveness felt by many central bankers about the financial challenges facing China’s enormous, bubbly economy can be understood.
During this complex transition and reconfiguration of political power the government’s highest priority is to prevent excessive social unrest or disorder.
Efforts to ramp up national sentiment against neighbors, particularly Japan, are part of an effort to maintain loyalty to a single flag and a seemingly uniform leadership structure.
This emerging new power structure may be able to manage reforms of shadow banking, or housing bubbles, and injection of additional liquidity to an insolvent banking system, but successful management may result in damage to foreign interests, including the interests of foreign lenders who would likely be given low priority in financial crises.
To keep its military structure acquiescent, Xi will likely let his navy explore further blue water reach, through the Arctic, the Indian Ocean, and certainly across its own neighborhood of the South and East China Sea.
Gradually, the government is likely to begin to control its newly declared Air Defense Identification Zone (ADIZ) not only to protect itself, but to push other military forces, especially those of the US, further away from China (and further from Taiwan).
Occasional provocations of neighboring nations, and even sometimes of US forces, will be cheered by the PLA and perhaps by the people of China.
Given that the present Administration in Washington has clearly demonstrated domestic political issues take priority over global security challenges, and that the Administration is “disinclined” or hesitant to take action when talking or sanctions can be substituted for force, China may tend to feel safe in probing possible US responses to an increasingly assertive China.