george magnus china

UBS Investment ResearchEconomic Insights — By George

China: the end of extrapolation 22 November 2012

George Magnus, Senior Economic [email protected]

This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 13. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Economic Insights - By George 22 November 2012

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China: the end of extrapolation Sooner or later, economies and the political systems that shape them, evolve to the point where things can’t carry on as they were, sometimes when things are getting better and popular aspirations are emboldened. Traditional economic thinkers from Adam Smith onwards were staunch defenders of the market economy, but also saw the need for societies to nurture strong institutions to deal with economic ills, which they saw as endogenous, not least so that elites could maintain trust and legitimacy. Adam Smith, for example, regarded ‘humanity, justice, generosity, and public spirit’ as essential complements to the market economy. Controversially, Karl Marx put developing social tensions into a unique context, namely the conflict between ‘material productive forces’ and ‘existing property relations’. His predictions are another matter, but let’s just say, for the humbler purposes of this report, that there comes a point in human and economic development where you reach ‘the end of extrapolation’. To sustain progress and prosperity, societies have to adapt and sometimes plump for radical change, or accept the consequences of not doing so. It is widely believed that China, even with its market economy with Chinese characteristics, has arrived at this point.

The consequences will not be trivial for China, or for the world economy and global commodity market.1 They will entail a significant slowdown in economic growth, which need not be catastrophic. While most people still think China won’t grow at 10% per year any more, they argue that it can carry on growing at 7.5-8.5% for years to come. But what if the economic slowdown is only half over? This rather more sober assessment suggests that 5% or so may be a more likely outcome. And the reason lies in the complexity and the maths of the biggest test for China’s new leaders – economic rebalancing. To pass it, the government has to live up to the rhetoric of reform, and demonstrate both its capacity, and importantly, its will to change China’s economic model.

Interesting times: politics cannot carry on as before There is little question that China’s recently concluded 18th Party Congress and the nomination of new leaders have occurred in interesting times.2 Today, China is increasingly complex, sophisticated and developed, but growth is slowing down, partly as a result of its own dynamic, but also under the weight of a model that has developed flaws. This makes the economic transition for China’s new leaders harder and more complicated. And the way in which China deals with it has profound implications also for Asia, the US, and the rest of the global economy.

1 See for example, Andy Cates, The waning influence of commodities, UBS Investment Research, 9th November 2012 2 The phrase expression ‘may you live in interesting times’ is generally attributed to Confucius, as a sort of curse conveying disorder and trouble, but is not actually traceable to anything Confucius wrote. The folklore about the Confucian curse goes back a long way, but may have been encouraged by Senator Robert Kennedy, who was quoted as saying in a speech in South Africa in 1966 that “There is a Chinese curse which says, 'May you live in interesting times’.”


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The leaders now stepping down took office in 2002 when the economy was already on a roll. They inherited an economy that had already slowed down over the prior decade from around 14% to about 8-9%, but the economic model was never really in doubt, and if economic growth was weaker, as in the late 1990s, it could always be supported in familiar ways.

Although the outgoing leaders’ decade of power began with rhetoric from President Hu and other senior party figures about putting people first, creating a harmonious society and addressing income inequalities, and ended with Premier Wen Jiabao’s championing of political reform, China didn’t really live up to this rhetoric.3 Political experts debate why and how the Hu-Wen leadership was distracted and chose instead to soft-pedal these goals in deference to high and vibrant economic growth, led by SOEs and heavy industry, and financed by state-owned banks. Perhaps leaders were anxious to strengthen the foundations of the economy before embarking on politically sensitive polices, perhaps it was the lessons they drew from the Asian crisis in 1997/98, perhaps it was simply hubris. In any event, by the time the Western financial crisis erupted in 2008, it was too late to change course.

If anything, the pursuit of these objectives echoes even more loudly in current political and economic circumstances than in 2002. The clamouring today, not least among many of China’s 500 million or so microbloggers, is for the Communist Party of China (CPC) to become more accountable and transparent, and for the government to attack corruption, pay due attention to the involvement, if not empowerment, of citizens, and strengthen the rule of law.

Rising pressure Social pressures have continued to build with respect to income inequality, corruption, living and working conditions of migrant workers, miscarriages of justice and ‘land grabs’ by local government officials, and air and water quality and environmental degradation. According to one Chinese sociologist, the number of incidents of unrest may have been of the order of 180,000 in 2010.4 Increased social awareness and tension, though, isn’t the only reason why the time for reform has arrived with force.

After a decade or more of turbo-charged growth, the economic model that drove it has led to deep imbalances, especially as regards the investment and consumption shares of GDP, significant increases in both the investment- and credit-intensity of GDP growth, and the distribution of income between profits and wages. A host of institutional, monetary, financial, tax and other fiscal arrangements has been developed to support this economic model. As we will explain below, changing this model has become of paramount importance if China is to avoid a disruptive bust in investment in the next 1-2 years, and lapse into a middle income trap in the medium-term. A change is all the more important as China’s competitive advantages in the global economy are slowly being chipped away by rising wage and labour cost pressures at home, and the

3 See, for example, Kerry Brown, Hu Jintao’s Legacy, Foreign Policy, 7th November 2012 at http://www.foreignpolicy.com/articles/2012/11/07/hu_jintao_s_gamble 4 Sun Liping, China's Challenge: Social Disorder, Economic Observer (English ed), 9th May 2011


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development of cheap energy and new lower-cost, advanced manufacturing technologies in the US, South Korea and other OECD countries.

Earlier this year, as news stories about Bo Xilai were breaking, Premier Wen emphasised the point that the time for reform in China was now pressing. He said, ‘Now reforms in China have come to a critical stage, and without a successful political reform, it's impossible for China to fully institute economic reform, and the gains we have made in these areas may be lost, and new problems that popped up in the Chinese society will not be fundamentally resolved’. Referring to Bo, Wen also said that ‘such historical tragedies as the Cultural Revolution may happen again in China’.5 Strong words indeed, but whatever he meant by the last part, the emphasis on the timing and urgency of political reform was significant.

A date for reform The rumblings about reform in China before and during the leadership change are that things cannot carry on as before and that there is a strong need for political reform. It is not clear yet how and to what extent new leaders will pick up this baton but whatever else happens in the next few years, China’s new leaders will almost certainly address what Lenin called the ‘purity’ of the Party (i.e. anti-corruption, and opposition to those attempting to use the Party for personal gain), and take measures to try and reduce income inequalities, for example, by continuing to expand income and social security arrangements.

But the reform agenda has to go significantly further. And this isn’t a Western rant. In a trenchant appeal for radical reform, a recent editorial in the highly influential Caixin, argued that it was now time to shift the balance away from the dominance of the State in the economy to the private sector. It argued that the dominance of the State was stifling competition, distorting markets (and factor prices, one imagines), encouraging rent-seeking, corruption, the abuse of power, and income inequality, and leading to economic and social fragmentation.6

Further, the Development Research Centre, a comprehensive policy research and consulting institution that is part of and reports directly to the State Council, China’s top policy-making body, has been a vocal proponent of reform. As some readers may know, it was charged last year by Li Keqiang, who has a Ph.D in economics and was then Vice Premier, with the task of co-authoring with the World Bank a defining report, detailing the economic and social agenda that China needs to pursue to fulfill the aspirations that many share about its future.7

5 Wen says China needs political reform, warns of another Cultural Revolution if without, English.Xinhuanet.com, 14th March, 2012 at http://news.xinhuanet.com/english/china/2012-03/14/c_131466552.htm 6 Deng Xiaoping and the Date for Reform, Caixin Online, 31st October 2012 at http://english.caixin.com/2012-10-31/100454595.html 7 The kind of reforms that are considered vital to successful rebalancing were examined in the detailed report ‘China 2030 - Building a Modern, Harmonious, and Creative High Income Society’, by the World Bank and Development Research Centre of the State Council, PRC, 2012, and were summarised in ‘Asia: Is the miracle over?, Economic Insights, UBS Investment Research, 12th September 2012.


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Few people doubt that China’s new leaders will only pay lip-service to reform, such is the need, and the extent of public debate. The issue, hardly unique to China, is not about recognition and understanding, but about political will. If China’s new leaders want to steer the country through a period of successful economic rebalancing, they will have to take on vested interests in the CPC, the military, powerful families, local governments, state-owned enterprises and state banks, all of which have benefited over the years from the privileges conferred by an economic model that worked strongly in their favour. Economic rebalancing means the model has to change, that past beneficiaries will have to give way to new ones, and that any push-back by the former will have to be checked.

Sinologists will doubtless pore over speeches and statements made during the 18th Congress and after to try and assess the leanings of the new Politburo Standing Committee (PSC), and the wider reshuffling of other senior positions, and look for signs of cohesion or division among the new top elite of the Party. The initial responses, certainly as far as reform is concerned, have expressed disappointment.8

Hu Jintao’s final address to the Congress ended with an endorsement of the vitality of the state-owned sector, and a commitment to ‘unswervingly adhere to the basic economic system in which public ownership is the mainstay and economic entities of diverse ownership develop together.’ This didn’t suggest the ground was being prepared for sweeping reform. The subsequent unveiling of the new PSC fulfilled widespread expectations about Xi Jinping becoming Party Secretary and next President, though he will also take control of the Central Military Commission, and about Li Keqiang becoming the next Premier, but those hoping for a stronger reform tilt on the PSC were disappointed that Wang Yang and Li Yuanchao, with proven reform credentials in Guangdong and Jiangsu, respectively, were passed over in favour of members reflecting more Party orthodoxy.9

It seems unlikely that there is a strong consensus for the implementation of rebalancing reform with the new government hitting the ground running from next March. Rather, the composition of the PSC seems more restrained, perhaps fearful of disturbing the primacy of the Party, and limited to internal Party reforms, and incremental changes for example, to social welfare, and financial markets (bank transparency, stock market reforms, corporate and municipal bonds). If the full political implications of rebalancing reforms prove to be a bridge too far, the economic hyperbole about China that passes as prediction is likely to be exposed quite significantly. We shall simply have to wait and see.

8 My former colleague and friend, Simon Ogus of DSG Asia in Hong Kong, has pointed out that all 5 PSC members bar the President and the Premier will be over 68 by 2017. If the current PSC is designed more to sustain the status quo, they could be replaced by younger, more reform-minded people half-way into this decade of new leadership....maybe... 9 The PSC, in order of precedence (and expected positions) comprises Xi Jinping, Li Keqiang, Zhang Dejiang (President of the National People’s Congress), Yu Zhengsheng (Head of the Chinese People’s Consultative Conference), Liu Yunshan, Wang Qishan (Head of the Party’s Discipline Commission), and Zhang Gaoli.


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Interesting times: the economy cannot carry on as before After growing at an average 10% per annum for as long as anyone needs to remember, China’s underlying GDP growth has been slowing down for 10 quarters, registering 7.4% in the year to Q3, 2012.10 Many people think the downswing has now ended, pointing to slightly feistier data in September and October for industrial production, fixed asset investment, retail sales, and exports, continued high levels of total social financing, and a renewed rise in corporate leverage. But the short-term outlook for growth pales into significance against the view that China will continue to grow at 7-8.5% for the foreseeable future. This view rests on three critical but questionable propositions: political will and capacity, the insensitivity of consumption to the investment outlook, and the nature of rebalancing, itself.11

Political will The first proposition, following on from the political economy issues discussed above, is that the government has the political will and capacity to introduce reforms that lead to both a sharp fall in the investment share of GDP, and a roughly equivalent rise in the consumption share by strengthening or introducing important adjustment mechanisms discussed earlier. But we don’t know yet how strong the climate for reform in China is, even though there is a popular feeling that things can’t carry on as before. Some initiatives of political reform, aimed at restoring trust in the Party by curbing corruption and ‘purifying’ the Party so as to prevent the abuse of power for personal gain, certainly seem likely.

More radical political reform, though, doesn’t look likely. Note that the distinction often made between ‘conservatives (hardliners)’ and ‘reformers (liberals)’ is false, and much more nuanced. For example, no one is questioning the primacy of the Communist Party, championing the cause of a market economy (though there has been murmuring about resurrecting the stalled privatisation initiative announced in 2010), or advocating the subjugation of everyone, including Party and State, to an independent judiciary and the rule of law, as commonly understood in the West.

This raises questions about the wider significance of rebalancing, which means reforms that would abandon the key drivers of the ‘old model’, including wage rises significantly below productivity growth, repressed interest rates, a managed exchange rate, and other subdued factor prices, that is, of land, water, energy, and importantly, of capital. There is little question that, over a decade and more, a correction of repressed factor prices, money and capital especially,

10 Or 7.7% for the first three quarters of 2012. Of the two principal cyclical causes of the slowdown in growth, net exports may have troughed, unless there is a new worrisome deterioration in the Eurozone economy and world trade, while the slide in property investment most likely has further to go. 11 A fourth questionable proposition is the denial of historical precedent, articulated by Michael Pettis of Peking University, most recently in a Wall Street Journal debate with Nicholas Lardy of the Peterson Institute (and periodically on his website). See http://blogs.wsj.com/chinarealtime/2012/11/02/lardy-vs-pettis-debating-chinas-economic-future/. The core of the argument is that there are no precedents for a significant downshift in the investment share of GDP without a meaningful slowdown in economic growth.


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would help to generate the resource shift needed to drive a more household- and private enterprise-oriented economy, and strengthen resource allocation, efficiency, innovation and total factor productivity. We can be hopeful that China’s new leaders will reform gradually in this direction. But intent will count for little in the face of inertia or a concerted push-back or resistance from others in the Party and the state apparatus, and it may be prudent to remain cautious. Remember that fundamental economic reforms are all about politics that are highly controversial and could, in some respects perhaps, prove to be of existential significance to the Party.

Consumption questions The second proposition is that while investment spending grows significantly more slowly than GDP over the coming decade, consumer spending will continue to grow at its recent 8% annual clip, or higher.12 There are three reasons why consumption spending can’t do this.

The cyclical reason is that what happens to consumption is most unlikely to be independent of what happens to investment. Keynesian multiplier and accelerator mechanisms work in China too, so if there’s a significant erosion in the pace of investment outlays, there will be some impact on consumption – for a while at least.

The maths are problematic. If investment is 50% of GDP and the growth rate falls from 15% to say, 5% per annum, consumption growth has to accelerate from about 8% to an unprecedented 12% per annum or so if the underlying GDP growth rate is to stay at 7.5%. You can do the maths of alternative scenarios at leisure, but the bottom line is that rebalancing requires investment to grow more slowly than GDP, and consumption significantly faster over an extended period of time. Otherwise the model isn’t changing.13

The more structural reason is that the mechanisms that would allow consumer spending to strengthen further don’t yet exist, and would, in any event, compromise the legacy sources of economic growth that have generated structural imbalances in the first place. For example, higher wages dent corporate profits and investment; higher interest rates and a stronger exchange rate help consumers, but to the disadvantage of companies, whose debt-servicing capacity would be compromised; pro-household tax, income and social security reforms have to be financed, one way or another, by companies, or the government.

12 We are not talking about the contribution of consumption to GDP growth, which has picked up, in fact, by 10% to 57%, comparing the first halves of 2011 and 2012. The issue here is about the chronic imbalance between the investment share of GDP of around 50% GDP, and the consumption share, which is either 33% or closer to 40%, depending on how you measure it. But don’t be fooled by the noise in the largely semantic argument about a few percentage points in the consumption share. 13 Several economists make this argument but some of the more forceful ones can be found at Professor Michael Pettis’ website at www.mpettis.com


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The nature of investment The third proposition, which lies at the heart of this debate, is that the downshift in investment in the economy can be managed in a smooth and non-disruptive fashion. Well, we would like to think so, but this proposition rests on hope alone.

You have to have a proper framework to think about this, because this is about the nature of the capital investment cycle, not about whether China has over-invested, and will stop investing. Notwithstanding the much discussed ghost towns and overbuilding in property, you could hardly argue that China has too much decent quality and affordable housing, bearing in mind, for example, the living conditions of urban migrants and rural citizens. Neither is there a clear case for over-investment in industrial, transportation and social infrastructure, when you think, for example, about the much lower levels of income and infrastructure development outside the existing major urban conurbations, continuing urbanisation, a rising middle class and so on. 14 But, to repeat, measurements of the capital stock tell you nothing of value about whether a country is over- or under-investing at a given point in time.

The issue, specifically in China, is more about the speed of capital accumulation, and misallocation of capital, given that, uniquely, the investment share of GDP has been in a range of 40-50% for about a decade now. Roughly two-thirds of the stock of capital has been built in the last decade, and half of infrastructure investment since 2000, for example, has been in transportation projects, many of which serve the same objectives, and must, for a while at least, be redundant or not viable commercially.15 And while total factor productivity growth, which is a measure of the efficiency of capital and labour utilisation, did rise strongly during the 2000s to about 4% per annum as the pre-imbalances capex boom gathered momentum, it has fallen back to around 2% per annum since.

14 By some estimates, China’s capital stock per capita is about 8% of the US, 17% of South Korea, and less than a quarter of the US in 1930. See, for example, Capital Controversy in The Economist, 14th April 2012 at http://www.economist.com/node/21552555. But where is the economic logic that says that relatively poor countries should have comparable per capita capital stock to much richer ones? 15 See, for example, Simon Rabinovitch, China: the Road to Nowhere, Financial Times, 16th July 2012, which is about the longest sea bridge in the world at 42km at the eastern city of Qingdao. Hatched by the local CPC chief who was sacked for corruption, the bridge carries only a third of the designated 30,000 vehicles a day, and serves an area also served by an undersea tunnel, ferries, and a new highway along the water’s edge. The same goes for airports in, and highways and high speed rail routes to remote or inland locations and so on.


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Chart 1: China: growth contribution (%) Chart 2: The debate over China’s potential GDP growth

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Once you frame the issue this way, it changes because rapid accumulation of capital goes hand-in-hand with the gradual, and then more rapid, accumulation of financial liabilities incurred to finance it. In other words, a rise in the credit-intensity of investment. If you cast your minds back to the publicity in 2007-09 given to Hyman Minsky’s explanations about how and why investment booms lead to instability, you’re in for another treat in China. The essence of instability, by way of a reminder, is that over time, borrowers accumulate debt that becomes increasingly hard to service as returns to investment, profits, cash-flows and asset prices decay.

It is well known that China has experienced strong credit expansion. The growth in regular RMB loans by banks may have slowed down from about 35% in 2009, to a more modest 15% since the middle of 2011, but these loans capture only half of China’s credit creation. Total social financing includes also a number of informal financing arrangements, including commercial bills, trust and entrusted loans, other trust assets and corporate bonds not held by banks. The last item, in particular has been growing rapidly, reaching a record RMB 300bn in October 2012.16 The different definitions of credit creation are shown in the following chart, which comes from a research note by UBS China economist, Tao Wang.17

16 Partly by design as the government seeks to raise the share of direct financing to enterprises 17 Tao Wang, Risks in China’s Shadow Banking System, Macro Keys, UBS Investment Research, 16th October 2012


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Chart 3: China’s rising appetite for credit (as % GDP)

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The chart differentiates between regular bank loans, the total of bank credit and off-balance sheet credit, and total credit in the economy. As shown, the broadest credit share of GDP has grown from about 150% in 2007 to around 200% in the last 5 years, quite unprecedented for a country of China’s size.

The rising credit intensity in the economy is also evident in the changes in the relationship between total social financing and GDP. Between 2002 when the former data start and 2007, credit outstanding grew by RMB17 trillion, compared with a rise in GDP of RMB14.5 trillion, a ratio of 1.2, but since then, credit has soared by nearly RMB61 trillion, compared to a rise in GDP of RMB25.5 trillion, or a ratio of 2.4.18

The biggest expansion in debt financing has occurred in the corporate sector. Chinese companies’ debt ratios have risen to join some of the most indebted corporate sectors in major countries, according to Li Yang, vice-president of the Chinese Academy of Social Sciences.19 At 107%, the ratio is right up there with those of the US, Canada, France and the Eurozone, though the standardised OECD ratios may not accord to Li Yang’s definition. But he noted the recent BIS warning that corporate debt levels over 90% of GDP make companies increasingly sensitive to changes in income and interest rates, financial fragility and default risk. These things are liable to weigh on SOEs and other companies, as GDP growth slows, profits and cash flows weaken and in the wake of expected financial liberalisation. And, inevitably, tougher times for borrowers mean tougher times for banks. Most people doubt the officially estimated 0.97% is a realistic number, and higher loan losses are inevitable. China is better equipped financially than most to deal with banking sector loan loss or

18 GDP in RMB rose from 12trn in 2002 to 26.6trn in 2007 and an estimated 52trn in 2012. Total social financing rose from 13.4trn to 31trn in 2007 and probably to 92trn in 2012 19 See Ryan Kutkowski, Is China Becoming a Debtors’ Prison?, China Economic Watch, Peterson Institute, 7th November 2012 for a discussion, and http://www.china.org.cn/business/2012-08/07/content_26154420.htm for the Li Yang citation. Kutkowski thinks capital intensive firms are especially vulnerable to slowing investment growth, e.g. real estate developers, ferrous and non-ferrous metals smelting, chemical fibre producers, refiners and power producers.


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recapitalisation issues. The point, though, is that someone has to pay: the cost is almost bound to fall on the household sector, one way or another, and so where does that leave rebalancing?

Chart 4: Non-financial corporate debt-to-GDP ratio 2011

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Finally, if you put together the speed of (sometimes dubious) capital accumulation, and the rise in credit creation, you have landed up in the rather pointy-headed world of finance-augmented growth theory. Simply put, this says that when the rate of economic growth, generated by population and labour productivity, starts to slacken, then ever-rising investment intensity becomes untenable, especially as it is increasingly financed by credit to increasingly less creditworthy borrowers. And this is true even though a lot of past investment will unquestionably embody technical progress, and some past credit expansion will reflect benign financial innovation and efficiency. There is then a high likelihood of an ‘investment cliff’ (to coin a phrase).

Unfortunately, it isn’t really possible for us, or more to the point, China’s government, to know precisely where the country stands in this process, any more than people were able to gauge where the West was in 2006, for example. A Chinese Minsky Moment, to coin another phrase, may not be imminent. In a highly managed economy with dominant state industrial and banking sectors, the state can deploy policies, and sources of finance to minimise cyclical fluctuations (as now), helping to sustain the status quo and lowering perceptions of risk. But this is the equivalent of ‘kicking the can’ at the risk of a harsher and more disruptive adjustment later.

Final thought The incremental changes in economic rebalancing, and gradual deceleration in investment spending, which are implicit in the extrapolations of 7-8% GDP growth, don’t stack up for this scribe. A more significant fall to 5% over the coming decade – to pick a number – need not be the cataclysm that springs to mind, unless you’re a dyed-in-the-wool industrial commodities and commodity


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currency bull. 20 Nor need it puncture expectations about China’s GDP overtaking that of the US. A halving of China’s superlative growth rate would still see GDP double by 2027, and continue to converge on the US. And since we can imagine China’s citizens care more about living standards than GDP, a change in the economic model and in its incentive systems need not be threatening, if the process is managed well and in a timely fashion. But there’s an unfortunate truth about changing your development model, which is that when you get to the point of having to do so, sustainable and stable growth and prosperity are about politics, institutions and legitimacy. You have reached the end of extrapolation.

20 China’s share of global commodities consumption in 2010, for example, exceeded 50% in the case of cement, 40-50% for iron ore, steel, lead, copper and zinc, 30-40% for aluminum and nickel, and 20-30% for automobiles, coal and platinum.


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UBS 16

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