China's Faustian Bargain: First of two Parts
China’s 135 percent corporate-debt-to-GDP ratio is the highest among the world’s major economies. Together with the country’s pro-cyclical fiscal structure and 30 percent overcapacity across the board in manufacturing, the country’s GDP could slow to below 4 percent as early as 2017, despite promises by the leadership to maintain a target of 7 percent.
That corporate debt ratio is now a whopping 81 percent larger than that of the US. Figures released by Standard & Poor show that in mid-2014, debt amounted to US$14.2 trillion. In comparison, US corporate debt is US$13.1 trillion, about 75 percent of estimated 2014 GDP.
The country owes such gargantuan corporate debt to the profligate over-leveraging predicated by systemic unaccountability, an institutional insidiousness intrinsic to the largely state-owned banking sector, the mammoth state-owned enterprise sector, and an altogether unsound system of financial markets.
The magnitude of China’s existing property glut and industrial overcapacity proportionate to its GDP are unprecedented in world economic history. From all the colossal amounts of vacant properties everywhere in China and the overcapacity that has brought corporate profit margins down to perilous levels, a sizable portion of China’s high GDP growth figures, in the past, were procured by hugely wasteful investment.
But all this waste actually achieved one thing: success in fooling people across the globe to to picture China’s past double-digit GDP growth as a miraculous economic accomplishment. In truth, much has been a Faustian bargain that brought about dazzling short-term gains at the expense of long-run, sustainable growth.
In recent years, a sizable portion of GDP derived from China’s hugely oversupplied properties, superfluous infrastructure and idle manufacturing facilities constituted a vastly wasteful component of GDP, a sort of “Empty Calorie” GDP. Not only does this not contribute to improved economy, it constitutes “negative equity.” It is not only that there is no revenue generated from all these idled assets, the investor entities need to pay interest expenses for them every day. A prevalent risk-dyslexic mentality of the past decades has impelled the system to now strain at the seams.
A multitude of information is hidden in the layers of China’s economy from materials published only in Chinese, in print and on Chinese-language websites, and previously not accessible to the English-speaking world.
For instance, Xia Bin, a former director at the Center for Development Research of China’s State Council in Beijing, in November 2014 revealed that overcapacity is about 30 percent across the board in China’s industries. Thus, on average, capacity utilization is only about 70 percent, resulting in shockingly low profit margins for most manufacturing industries. Xia said one tonne of steel gives a profit of less than one renminbi (US16¢). The profit on one tonne of coal is not enough to buy a bottle of mineral water. Ominous drops in corporate profit margins necessarily feed into future drags in consumer spending, and economic growth in general.
Numerous China studies in the English-speaking world have failed to investigate these problems. Vacant properties and idle capacity are so vast that it is estimated that 75 percent of all commercial properties already built are now vacant, and will stay vacant for an extended period of time.
What caused the pervasive, grave problem of overcapacity? It is the institutional insidiousness in China’s contorted semi-market system: Xia Bin noted that it is an outcome stemming from the fact that almost every one of China’s local governments in the past decade engaged in an array of blind pursuits in what was seen as the “strategic industries.”
Local governments pushed forward enormous amounts of expansion in those industries and ended up with wasteful overcapacity nationwide. For decades, China’s mammoth State-Owned Enterprise (SOE) sector was being fed with negative real interest rates – lower than the actual inflation rate of the time – on loans from state-owned banks. The SOEs’ blind expansion was fueled by ultra-low-cost funds, together with local government’s blind pursuit to boost short-run GDP. Now the consequences are surfacing.
In his speech Xia Bin also acknowledged that as overleveraging in the past resulted in huge indebtedness, the current practices of debt roll-over that China’s banks have played for the SOEs and local governments are actually equivalent to Ponzi schemes.
All this may lead to continued cuts in China’s GDP growth to an extent unimaginable to most observers in the west. For years, obscured by comparisons made with the other major economies, in terms of total debt (that is, both corporate and non-corporate debts), a majority of observers have not been able to visualize the relevance of China’s corporate debt in its size and its ratio to GDP, as to the probable impact on the country’s economic future.
This lack of awareness of how China’s mounting corporate debt may play a crucial role in negating prospects for the country’s economic future is also consequential to the lack of understanding of the untoward designs in China’s systems. China’s fiscal fragility is prescribed in an intrinsic institutional peculiarity. How this may contribute to a circular causation in economic downturns is now due for a closer look.
Another pivotal factor that will also greatly contribute to lowering economic growth is China’s peculiar fiscal structure. Anyone who grew up in the more developed countries in the world will be startled to learn that, in China, only about 24 million people, 1.76 percent of the entire population, pay income taxes. Failing to recognize this institutional peculiarity is to fail to see how China’s fiscal structure is uniquely fragile in economic downturns (as government revenues are disproportionately pro-cyclical), and the nation’s economy is prone to destabilization in economic downturns.
Unfortunately, hitherto economic research done on China almost invariably has failed to take into account the country’s inversely skewed fiscal structure. That fewer than 2 percent of the population pay income tax is, among other things, data not accessible to people who do not read Chinese. Being bilingual, this author has access to much vital information about China’s systems not being made available to the English-speaking world.
Arguably numerous studies about China have not been able to recognize the primacy of this peculiar institutional feature intrinsic to China’s system, and hence (with many of them) the parameters they established and their outlook thus formulated, may prove fundamentally erroneous.
The Fiscal Reality that China now faces, is the combination of a disproportionately pro-cyclical fiscal structure (a meager income-tax base, and overly reliant on sales and corporate taxes) that necessitates drastic decrease in tax revenues in this economic downturn, plus the inescapable, hiatus reductions in local government revenue from state land (user rights) sales. These are the combined pivotal factors that numerous China studies in the west have actually entirely overlooked, or failed to identify.
Such is the double whammy now starting to impact China’s economy. Corroborating this is a comment made in early 2015 by the chief China economist at Deutsche Bank, who warned that China is likely facing the worst fiscal challenge in three decades.
The second factor is that state land sales have contributed to about 60 percent of local government revenues in the past five years. This key revenue source is now fast shrinking with the set trend of a slumping property market. The Faustian consequences stemming from how the monetizing of state lands were being done in longer than the past decade are now starting to surface.
First of two excerpts from “China’s Economy: The Hidden Truths”, available on www.createspace.com/5391811. For the e-book version the book is live on Google Play and Google Books. . The author, trained in economics, accounting, and business law, has for 25 years worked in international business/finance relating to Asia, and China specifically.
See part 2 of this series: Will China Inc. Fall Victim to Accounting Fraud?