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CFR Interview

August 4, 2012

Earlier this week, I was interviewed by the Council on Foreign Relations (CFR) for their website, about the current state of the Chinese economy.  You can read what I had to say below, or check out the original post by clicking here.

Silver Linings in China’s Slowdown

China’s gross domestic product for the second quarter declined to 7.6 percent (WSJ) in July, its lowest level since the height of the global financial crisis in 2009. At the same time, the International Monetary Fund reduced its 2012 growth forecast (CBS) for China by 0.2 percentage points to 8 percent. While China has been adversely affected by external factors like the eurozone crisis, its current slowdown is mainly the result of internal structural issues, including a suppression of domestic consumption, says Tsinghua University’s Patrick Chovanec. “The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis,” explains Chovanec, “and this investment boom is buckling under its own weight.”

What are the main causes–internal and external–of China’s worsening economic slowdown?

A lot of people compare this slowdown to what happened in late 2008, early 2009. The main difference is that what happened in 2008 was primarily due to external causes–a fall-off in exports caused by the economic crisis in the United States. What’s happening now in China is mainly due to internal reasons. The main growth driver of the past several years has been an investment boom that was engineered in response to the global financial crisis, the last slowdown, and this investment boom is buckling under its own weight. It’s not sustainable, and it has given rise to inflation and now to bad debt, and that bad debt is dragging down Chinese growth. And, of course, people pay attention to whether Chinese exports are rising or falling. It’s relevant because if Chinese exports are very vibrant, that creates something of a cushion for the Chinese economy.

If the causes of the slowdown are more internal, and not just a response to outside factors like the eurozone crisis, should we expect a more long-term slowdown?

It really depends on what the Chinese leadership chooses to do. China is due for correction. That correction will be good for China in the sense that a lot of the growth we’ve been seeing over the past several years is not sustainable and in many ways does more harm than good. So in some ways, slower growth, if it’s part of an adjustment toward a more sustainable growth path, is actually good. That doesn’t mean it’s painless, so there is a lot of resistance, even though in principle China’s leaders know that China needs to make this economic adjustment away from dependence on exports and investment-driven growth toward more domestic consumption-driven growth. If they resist a meaningful adjustment and if they try to pump up the economy even more–try to push this growth model to its limits and beyond–then the repercussions could be more damaging and painful than embracing any economic adjustment, painful as that might be.

I would add that there are lots of areas of potential growth in the Chinese economy–in agriculture, in services, in healthcare, in retail, in logistics. The problem is that that growth is not as easily achieved as pumping money and boosting investment. Unfortunately, that more sustainable growth is not where the focus has been these past few years. But there is nothing to say that the Chinese economy has to be doomed to slow growth.

What are some policy responses China should take to boost domestic consumption and diversify sources of growth?

They have to realize that it is a structural issue. Part of China’s export-led growth model was to suppress consumption in order to maximize investment and then make up the difference through selling abroad. The Chinese economy is geared toward channeling resources away from the household sector –Chinese savers and consumers–toward investors and producers to boost production and basically turbo-charge GDP growth. To re-balance the Chinese economy, you have to channel those resources back to the household sector through changing exchange rate policy, interest rate policy, the tax policy.

The problem is that if you channel resources back to the household sector, you knock the legs out from under the growth that you’ve got, and nobody wants to do that. That’s the biggest challenge–that these are deep reforms that change the way the Chinese economy works, and it takes some foresight and some vision to pursue that.

What of the short-term measures the Chinese central bank has taken by cutting interest rates twice since the beginning of June? Should we expect further measures along this line?

Unfortunately, the short-term response we have seen is to fixate on GDP growth. Even though they talk about the need for quality GDP growth over quantity, whenever GDP starts to look like it’s falling–even slightly–the immediate response is, “We have to shore it up.” The easiest way to shore it up is through more lending, more investment. You get a situation where any movement toward meaningful reform or meaningful re-balancing is put on a shelf. A lot of people have been critical of the efforts to re-stimulate the Chinese economy for precisely that reason. There is a broader recognition that what the Chinese economy needs is not more stimulus, but reform. I don’t think there is a full appreciation for just how constrained the Chinese government really is, even if it chooses to go down that path of re-stimulating the economy. They are actually quite limited in their ability, in the tools they have available to continue pushing down this path.

The conventional view is that China has a debt-to-GDP ratio of about 30 percent and that they have all kinds of resources to throw at boosting growth. I would draw a comparison to Japan in 1990. Japan had many of the same qualities that would lead you to think they could stimulate their way out of any dilemma. They had a high savings rate, almost no foreign debt, and they had a strong fiscal position because of all the taxes raised during the boom of the 1980s. But when the Japanese turned on the fiscal tap, the money went primarily to socialized losses and to counteract a contraction in private investment. They were able to prevent GDP from collapsing, but they were not able to sustain high levels of GDP growth in the 1990s; the fiscal resources that Japan had went to fill a hole, to pay for the growth of the 1980s.

With the lending boom that took place in China in the last three or four years, it was fiscal spending in disguise, and now the bill is coming due. Once the fiscal taps are open, the money released will go to pay for the growth of the past four years, not the next quarter, not the next year, not the next decade. You start to see that already, with the bailouts starting to take place in China–local governments, even the national government, devoting resources to bailing out property developers, bailing out state-owned enterprises, bailing out companies that have run into trouble, bailing out local governments.

What are the implications of the economic slowdown for the Chinese political situation, particularly given a once-a-decade leadership transition this year?

There’s been little political capital for anyone to spend on meaningful reform or any kind of resolute action on the economy, because if people did have political capital to spend, it was going to be devoted to ensuring their seat at the [leadership] table. What happens after the leadership transition [is] hard to say. The slowdown we are seeing, and particularly the pressures that it has created in the financial system and the credit system in China–the danger of default and the danger of a domino effect rippling through the Chinese economy–has pressed some difficult choices on [the] leadership at a point where they are least prepared to make decisions. The economic situation is not waiting for the leadership transition to work itself out before demanding some kind of response.

What are the potential repercussions of China’s economic situation on the U.S. and global economies?

It depends where you sit relative to the Chinese economy. There are countries and companies that have been riding this investment boom that has been driving Chinese growth, but I would argue that is not sustainable and is now collapsing under its own weight. And for those countries–like Australia selling iron ore, Chile selling copper, Brazil selling iron ore, Germany selling machinery–they’re very exposed to this economic adjustment that’s taking place, this correction.

But if your goal over the long term is to sell to the Chinese consumer, and if you have an economy positioned to do that–if you’re a producer of finished goods or a producer of food–then this economic adjustment could be a good thing if it unlocks the buying power of the Chinese consumer. For any economy around the world that wants to sell more to China, that wants to have a more balanced trade relationship with China, a meaningful economic adjustment that resulted in a more balanced domestic economy in China would be a very positive thing.

If you have lower GDP in China, that doesn’t necessarily mean that China’s consumption has to fall. In fact, China has $3 trillion in reserve; that’s buying power. China has produced more than it has consumed for many years; China could afford to consume more than it produced. That would be a major growth driver for the rest of the world. It would provide a cushion for China to undertake this kind of economic adjustment that otherwise could be extremely painful.

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17 Comments leave one →
  1. Jeff permalink
    August 5, 2012 12:21 am

    I do not understand your last paragraph. In pieces you wrote in the past, you said that the 3 trillion in reserves had been invested already and therefore was not available, that it is a paper illusion. So, which is which?

    • prchovanec permalink*
      August 5, 2012 7:24 am

      The $3 trillion FX represents real global buying power in the Chinese economy, it is not a paper illusion. But it does not represent fiscal resources of the Chinese state that could be injected into the domestic Chinese economy to bail out banks or re-stimulate domestic growth. The money is already in the Chinese economy, in the form of RMB. But holding FX reserves means that those RMB could be transformed into real claims on foreign goods and assets. Does that clear things up?

      • Jeff permalink
        August 5, 2012 2:19 pm

        Yes, thank you for the clarification.

  2. August 5, 2012 12:52 am

    As I’ve said for years: China might sit on the money box; but the USA holds the lunch box.
    All the savings of China will go into consumption of what people need: Food.

    The interesting thing about Germany is that they are very well aware of the limitations on exports to China. Germany is apparently swinging their immensely strong industry around to make energy cheaper in Germany (Europe) AND start exporting to Russia – Russia that really needs investment in infrastructure – just to keep the country running.

  3. August 5, 2012 2:43 pm

    Very interesting and informative – thanks. Even if China does adopt the correct policies to rebalance, the sluggish growth we are witnessing in both the euro zone and the US means that there will be no growth driver? With all the pain that this scenario will bring.

  4. andao permalink
    August 6, 2012 1:08 pm

    Professor,
    I believe it was Victor Shih who said if only a tiny fraction of the wealthiest in China were to move 30% of their assets overseas, the foreign exchange reserves would take a $1 trillion hit. The rest of your interview points I think are very valid, but I’m skeptical how long those reserves will truly hold up during the required transition you mention. The political and business elite in China have huge incentive to maintain the dominance of infrastructure-linked SOEs. If wealth starts to move from these SOEs to private companies or the consumption sector, I think it’s very plausible to see the ruling families sell their stakes and move money abroad.

    The reserves could also take a hit while trying to buoy the RMB. Several newspapers today reported that the RMB is headed strongly towards depreciation, but the reserves might be used to ensure a glide rather than a sudden drop. I believe this has been the case lately, with the RMB reaching it’s “low limit” in the daily trading band a few times in the past weeks.

    Anyway, $3 trillion is a huge chunk of change. But the assets of the wealthiest Chinese are also enormous, and if those start to shift, the reserves could drop rapidly. If the PBOC wants to support the value of the RMB, this would accelerate reserve depletion. I don’t think this type of massive capital flight is imminent, but I also wouldn’t bank on the $3 trillion being a sure thing now and forever.

  5. Hua Qiao permalink
    August 7, 2012 6:31 am

    i see the cause of China’s slowdown as a commercial version of the West’s over leveraged consumer. Companies have little borrowing capacity right now. The massive capacity build up by large and medium sized Chinese companies from 2009-2011 is coming online and there is no concommitant cash flow generated to support that capacity.

    Chinese banks may pay lip service to cash flow. But the reality is they will lend to anyone as long as total liabilities to assets are under 70%. shortterm debt was used to fund industrial exapansion projects. Interest expense was capitalized on the balance sheet, which made the already thin income statement look better. Now those projects are finished and the companies must begin to run the interest expesne through their income statement. This is contributing to losses. Inventories are building since companies are under pressure not to lay off workers and so they continue to produce product. Those employee costs get capitalised into inventory. Customers cannot pay their bills and so suppliers end up carrying the receivable, causing a ballooning of working capital needs. So even in a downturn when balance sheets ought to be shrinking, Chinese companies need for debt is expanding.

    I see company after company barely making profit such that one has to question whether there is profit at all. It seems as if the 70% leverage benchmark and profitability of any amount have been the criteria for continued financing support. The problem is that even these targets are now problematic. So, while the US had overleveraged consumers in 2008, China has overleveraged companies.

    I would not want to be an auditor in China.

    • August 8, 2012 10:59 pm

      I did an analysis of some developers for another professor at Tsinghua, who shall remain unnamed…I was proud of myself for going beyond the D/A ratios he had called for – steady around 70% – and looking at debt to cash flow ratios, which were pointing towards the sky. The professor, very strongly on the sell side, was not too happy. He pointed out that debt to cash flow is not one of the basic financial ratios. But maybe it should be…

      • prchovanec permalink*
        August 9, 2012 6:17 am

        Debt to EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization – a rough measure of cash flow) most certainly IS a basic financial ratio in evaluating debt sustainability. I’m curious what you found, if you’re willing and able to share it.

      • Hua Qiao permalink
        August 9, 2012 6:45 am

        @maofucious
        Cash flow for developers may be a bit problematic since most companies are project oriented and therefore historical cash flow would not be recurring. But your professor’s comment is quite strange. Even most of my banker colleagues would say cash flow is important. The problem is their analysis and understanding is superficial.
        What matters in their mind is policy risk.

      • prchovanec permalink*
        August 9, 2012 8:54 am

        Hua Qiao is right, Debt/EBITDA can be problematic for a longer-term project or when a company is undertaking a major capital investment that will pay off years down the road. That being said, it should not be ignored.

  6. Charlie permalink
    August 9, 2012 10:33 am

    So once China corrects, gets on the path to a consumer driven economy and connects each province with satisfice infrastructure, what is it going to cost to clean up?

  7. Andrea puccini permalink
    August 10, 2012 1:48 am

    Good evening professor:do you think that real estate prices correction and the following wealth effect could cause a slowdown in the luxury sector/brand products?thanks for your help

  8. LPM permalink
    August 10, 2012 8:55 pm

    When is part 4 in this series going to be posted? I have actually been waiting for that for a while.

    • prchovanec permalink*
      August 10, 2012 9:00 pm

      I’m on a vacation with my family in Hong Kong this week, I’ve tried to set aside time to write but with a young child it’s difficult. I’ll follow up ASAP.

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