Debating a “Hard Landing”
This Thursday, March 22, The Guardian (of the UK) published a friendly email “debate” between Andrew Batson, of Gavekal Dragonomics, and me over whether China’s economy faces a “hard landing” in 2012 — with me arguing that it does, and Andrew that it doesn’t. You can read our exchange below, or access the original here.
Should China be bracing itself for a hard landing?
The China bears grow ever gloomier, while the bulls maintain their confidence. So will the world’s second largest economy see a hard landing in 2012 or can its leaders steer a steady course? Patrick Chovanec of Tsinghua University and Andrew Batson of Beijing-based consultancy Gavekal-Dragonomics debate.
There really are two related but distinct things people have in mind when they talk about a “hard landing” for China. The first is a rapid deceleration of GDP growth – below, say, 7%. The second is some kind of financial crisis. I think we’re already seeing some signs of the first, and the second is a bigger risk than most people appreciate. For the past several years, most of China’s GDP growth has come from a massive investment boom fuelled by easy credit. Unless China sees a major increase in export demand – highly unlikely – or a huge shift towards domestic consumer spending – a lot easier said than done – the only way to hit 8-9% growth is to keep that investment boom going like gangbusters. The problem is, all that easy credit is generating bad debt and inflation. The state banking system can brush bad debt under the rug, but the more bad debt gets rolled over, the less capital is available to fund new projects. The only way to keep the investment boom going is to dramatically expand credit. That would spark inflation and further distort the economy, which China’s leaders know they can’t do. They’ve painted themselves into a corner, and something has to give. Even though the money supply is expanding at a fairly generous rate it’s still not enough. That’s why real estate is collapsing and ambitious public works, like urban subways, are hobbled by lack of funds. Last year, out of China’s 9.2% real rate of GDP growth, five percentage points came from investment in fixed assets. If China builds all the roads, bridges, ports, airports, high-speed rail lines, condos, villas, etc this year that it built last year – an absolutely astounding amount of construction – but NO MORE, GDP growth would fall to just 4.2%. That’s a “hard landing” by anyone’s definition, and from what I can see, it’s already under way. Best, Patrick
You are right to identify a crunch in investment as the main risk that could cause a sharp slowdown in GDP growth. It is true that about half of China’s economic output is investment, so if there is zero growth in investment then overall GDP growth will be cut sharply just as a matter of arithmetic. The question is then whether investment growth in China is really going to go to zero, and here I do not think you have presented a convincing argument. Investment in China is not driven simply by the supply of loans from the state banking system, but also by the very strong demand for investment opportunities. China has an enormous urban housing shortage (on the order of 70m units), regional electricity shortages and one of the world’s most crowded railway systems – not to mention thousands of manufacturers busily automating to offset rising labour costs. In short, there are plenty of things China can usefully invest in. Secondly, it is simply not true that investment is collapsing despite the best efforts of officials desperately trying to keep credit growth going. The investment cycle in China is clearly correcting after the huge stimulus in 2009-10: real growth in fixed asset investment slowed to 15% year-on-year in the last quarter of 2011, from a peak of over 40% growth in mid-2009. But this slowdown is happening precisely because the government is pulling back. The wave of new stimulus projects in 2009 was a one-time event that is not being repeated, and bank regulators have clamped down on credit growth because of worries about inflation and financial risk. Money supply growth has come down from a peak of nearly 30% year-on-year in mid-2009 to 12% in January 2011. In short, this looks to me like a cyclical downturn brought on by tighter monetary policy, and not a “hard landing” or crisis. Best, Andrew
A developing country like China has plenty of things in which it could profitably invest. But I could name any number of countries, over the years, all at a lower development level than China, which nevertheless made wasteful investments and ended in trouble. We know already, from the collapse in the property market and the rising loan rollovers at banks, that many of the investments made over the past few years are not paying back. The last time China saw this kind of lending binge, in the 1990s, 35% of the loans ended up going bad. The problem isn’t China, it’s the inefficiency of its state-run banks and the state-run companies they lend to. I agree that some Chinese policymakers recognise this problem, and have tried to rein in runaway credit. But that led to two problems. First, the burden of tighter credit fell disproportionately on the private sector, the most productive part of the economy. Entrepreneurs paid exorbitant interest rates or got cut off entirely, while politically driven projects continued to get money on preferred terms. Second, while Chinese regulators did succeed in reining in formal lending, banks and speculators – often working together – cooked up all kinds of ways around these constraints. Last year saw an explosion in off-the-books “shadow” banking, including the repackaging of questionable loans into risky investment products that were then marketed and sold to the general public. We’ve already seen people commit suicide or flee the country in a few cities, like Wenzhou, where this house of cards has taken a tumble, but the same practices are pervasive all across the country. There’s a greater risk of financial instability than most people realise. Best, Patrick
Of course there are problems in the Chinese economy that need addressing. It is clearly true that China’s state-owned enterprises are less efficient than private-sector companies, and that private companies have real difficulty getting loans from the state banking system. To the extent that China can fix this problem, it will only improve its prospects for future growth. While this inefficiency may well be a drag on China’s growth, is it such a burden that growth must come crashing to a halt this year? I think this is implausible. In the key industrial sector, corporate profit margins are now steady around 6%, the same level they have maintained for years. If Chinese companies were really burdened with lots of investments that “are not paying back,” shouldn’t they be losing money? Similarly, housing sales are now falling mainly because the government has put in place policies that prevent many people from buying houses; this is hardly evidence that investments in housing are massively unprofitable. This does not mean there will not be bad loans resulting from the huge amount of stimulus lending. Clearly, China’s government has accepted some bad loans as a price it was willing to pay to keep growth going during the global financial crisis. (The “shadow” lending explosion took place in 2009 and 2010, and was curbed in 2011.) Banks and the government will have to work off the burden of these bad debts in coming years. All this is a good reason to expect China’s growth rate to be lower in the next few years than in the past few years. It is not a good reason to expect growth to collapse right now. Best, Andrew
We both agree that China’s high rates of GDP growth, these past few years, have been mainly due to an investment boom and that an abrupt end to that boom could spell a sharp slowdown. We agree that the big surge in lending that propelled this boom has created a bad debt burden for banks. We also agree that Chinese regulators have now (as you put it) “clamped down on credit growth” and that investment growth has fallen off as a result. But while you see this as a deft (and ultimately successful) balancing act by Chinese policymakers, I see it more as a wild juggling act, an increasingly desperate effort to keep way too many balls in the air at once. Real estate is a prime example. You credit the recent fall in the market to the government’s restrictions on multiple home purchases. If only it were that simple. Those curbs were put into place nearly two years ago and to the extent they worked at all, merely shifted speculative attention to (unrestricted) second and third tier cities. Developers kept expanding investment by 30% a year, piling up nearly a year’s worth of unsold inventory, confident that the government needed them – and would ultimately support them – to maintain growth. In the meantime, the central bank was reining in credit to counter rising inflation, including spiralling home prices. When developers finally ran out of financing options, they had to start dumping their unsold inventories to raise cash – and the market tanked. Drop one ball and others follow. Land sales – which local governments are relying on to fund basic services, as well as repay their stimulus bank loans – are at a standstill, and some analysts expect private housing starts to fall by 20% this year. I wouldn’t take too much comfort in the reported profits of Chinese firms. Lehman, Bear Stearns, and AIG – not to mention Fannie and Freddie – were all rolling in profits as long as credit was cheap and property prices were rising. That’s the nature of boom/bust cycles: it’s easy to make money when they’re printing it, and nobody’s pressing to be paid back. But as Warren Buffett says, “It’s only when the tide goes out that you learn who’s been swimming naked.” Chinese companies I’ve been talking to, across many different industries, say they’ll count themselves lucky if they can just match last year’s sales in 2012. Sounds to me like the tide’s going out – and I’m betting there are a lot of folks in China who figured they’d never need a swimsuit. Best, Patrick