march 2016 vol. 20 no. 1 economic quarterly - gavekal q1 2016.pdf · ly with japan in the early...

Avoiding The Japan TrapSecular stagnation could be

around the corner

March 2016Vol. 20 No. 1

The Impending Minsky Moment?It could be nearer than you think

Lessons From The Stock Market CrashHow to run a market if you don’t believe in markets

BooksStrong arm of the Chinese law

ChinaEconomicQuarterly

GavekalDragonomics

www.gavekal.com

The Party Line

Powerhouse, Menace, Or The Next Japan? 3 By Arthur Kroeber

Avoiding The Japan Trap

China’s Impending Minsky Moment 9 China’s authorities have given up trying to solve the country’s spiralling debt problem. A financial crisis and severe growth downturn are likely by 2020. By Jonathan Anderson

The Fall Of Productivity And The Rise Of Debt 17 Despite rising debts and falling capital productivity, strong state enterprise reforms could allow economic growth to stabilize at a high level. By Richard Herd

Excess Capacity, Zombie Companies, And Debt Deflation 27 China’s zombie company problems are mainly confined to its steel, coal, and other construction-related industries. A long, slow restructuring is possible. By Thomas Gatley and Rosealea Yao

Vol. 20 No. 1 March 2016

China Economic Quarterly

Miscellany What We Learned From The Stock Market Crash 35 Sacking securities regulator Xiao Gang was the easy task. Now the real work needs to be done if China’s financial markets are to become true allocators of capital. By Charles Horne and Xinling Wang

Books

The End Of Non-Interference 41 As more of its companies and people head abroad, China will inevitably adopt a more interventionist foreign policy. By Tom Miller

EditorArthur KroeberEditor-at-large

Tom MillerDesign & production

Big Brains

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3 China Economic Quarterly, March 2016

Two popular narratives about China are that it will either reform its economy and become the next superpower, or fall

victim to a dramatic financial crisis. There is a third and perhaps more likely scenario: gradual stagnation, along the

lines of 1990s Japan.

As China’s economic growth inexorably slows and its mountain of debt rises ever higher, three main paths to the future present themselves. First is the one implied by current government policy, whose premise seems to be that most economic problems can be solved with a bit of technocratic tinkering.

State-owned enterprises (SOEs)—which account for about a third of output and on average take on nearly twice as much debt as private firms while delivering less than half the returns—just need more financially-ori-ented (state-owned) shareholders and a bit more discipline. The financial sector can right itself, without the need to bring in much more private or foreign competition. Productivity can be pushed up by the government spending hundreds of billions of dollars on technology venture funds and on soft loans for Chinese companies to buy up more innovative foreign firms. Since China’s per-capita GDP is only one-fifth that of the United States, and since Japan kept growing rapidly until it exceeded 80% of US average income, it is obvious that with a few adjustments China can still grow at 6-7% a year, or even faster, for another generation.

This vision is popular with economists on the government payroll and the object of sad incredulity for pretty much everyone else. Most foreign and independent Chinese analysts believe much more drastic reforms are

Arthur Kroeber is editor of the China Economic Quarterly.

The Party Line

Powerhouse, Menace, Or The Next Japan?

By Arthur Kroeber

4 Gavekal Dragonomics

Arthur Kroeber

required to sustain rapid economic growth, defined as 6% or so for the rest of this decade and 5% or so in the 2020s. The SOEs must be slashed back much as they were in the late 1990s by premier Zhu Rongji; private companies must be allowed to compete freely in the many sectors, espe-cially services, where they are now blocked or fettered; and the financial industry must be restructured with a recapitalization of the banks (which could easily cost several hundred billion dollars, to cover unrecognized bad loans to SOEs and local governments).

If these politically unpalatable reforms occur within the next few years, it should be possible to maintain growth at a reasonably fast rate and sta-bilize gross debt at 300% of GDP or less, a high but manageable level. But if policy falls short, then the third scenario emerges, namely that some-thing bad happens. Pessimists generally describe this “something bad” as a financial crisis or a sudden collapse of growth to near zero. Yet this “something bad” could be less dramatic, and more like the long slow slide into stagnation that Japan suffered in the 1990s.

Seen this movie before?China’s most general similarity with Japan is that both are East Asian developmental states that used export prowess to vault into second place in the world economic rankings, and were widely considered to pose a threat to US economic and political dominance. For those inclined to see China’s rise as unstoppable, it is advisable to read the literature on Japan’s rise in the late 1980s (a good starting point is Bill Emmott’s prescient and skeptical The Sun Also Sets) and count the ways in which descriptions of Japan then can be applied word-for-word to China now.

There are more concrete similarities: China today is quite a bit like Japan at several different periods. Developmentally, China lines up rough-ly with Japan in the early 1970s, with a per-capita GDP somewhat less than a quarter of the US, and an eight-year-old high-speed train network. Demographically, China is more like the Japan of 1980, with about six people of working age for every person over 65. For Japan, it took 35 years for this worker/retiree ratio to fall to two. Barring a birthrate miracle, China will accomplish the same transition in just 25 years. In other words, just one generation from now China’s population will have the same age structure as Japan’s today.

Financially, China looks most like Japan circa 1990. A powerful export sector drives large current account surpluses that enable it to be a major buyer of foreign assets—but corporate debt is rapidly escalating, and the leadership is committed to a growth model and forms of corporate orga-


The Party Line

nization that are nearing the end of their useful lives but are politically difficult to change.

Japan’s keiretsu proved admirably suited to the task of creating globally competitive manufacturing enterprises, yet their success was financed by huge debts that ultimately crushed their ability to pursue profit. The firms and the insular society they inhabited also proved ill-suited to global competition in the world of networked consumer services that began to emerge with the internet in the mid-1990s. Ten years after the peak of punditry proclaiming the Japanese century, Japan was lamenting a “lost decade” of virtually zero growth, and its companies were said to embody a “Galapagos syndrome”—strange creatures nicely adapted to the conditions of their home archipelago, but unable to flourish anywhere else.

Beware the balance-sheet recessionSimilarly, China today has a gigantic SOE sector that did a good job on the infrastructural tasks of the past but is ill-equipped to cater to the con-sumer society of the future. Its debts are huge, about 160% of GDP, and growing fast. This enables state firms to expand their balance sheets (and snap up foreign assets), masking their poor returns. There are of course many successful private companies whose debt levels are not scary. But many of them have a Galapagos aura: notably the internet trio of Alibaba, Tencent and Baidu, whose success depends heavily on the protection of the Great Firewall and who have shown little interest or aptitude for com-peting outside their home market.

It is easy to imagine a scenario in which SOEs and overleveraged pri-vate conglomerates, along with debt-ridden and cash-strapped local gov-ernments, push the financial system into technical insolvency: the debts are so large, and generate so little real income, that banks start running out of the ability to fund themselves. As Jonathan Anderson notes later in this issue, on current trends China is at most five years away from hitting the level of financial stress that typically triggers a bank crisis.

As with Japan in the 1990s, the breaking point may not trigger an obvious crisis. Instead, we could see massive government intervention to provide banks with cheap liquidity at near zero-rates. As corporations and banks get absorbed in a long process of deleveraging, the government will

Ten years after the peak of punditry proclaiming the Japanese century,

Japan was lamenting a “lost decade” of virtually zero growth


Arthur Kroeber

have to ramp up its own spending and debt in order to prevent economic collapse.

Richard Koo, an economist at the Nomura Research Institute, coined the term “balance sheet recession” to describe the predicament that arises when companies switch from being profit-maximizers to debt-minimiz-ers. Monetary policy becomes impotent—since companies will not bor-row no matter how low interest rates go—and fiscal policy becomes the only game in town. The consequence in Japan was that its public sector debt ratio rose from the lowest in the OECD in 1990 to one of the highest by the early 2000s.

As Japan’s experience shows, the balance-sheet recession and its after-math can become an inescapable trap. A long period of zero interest rates is deflationary: it entrenches expectations of low nominal returns, which become self-fulfilling because companies, acting on those expectations, decline to invest. An aging population makes things worse, because it gives companies another reason to fear that growth will slow down.

With growth permanently stuck in low gear, the central bank cannot change expectations by raising rates. And the government has a strong incentive to ensure that rates stay low forever: the cost of servicing its mounting debt is bearable when rates are low, but ruinous when they rise. Low growth and high debt can thus become permanent, mutually rein-forcing conditions.

Bigger, more vibrant, more ambitiousThere are also some big differences between the two countries. First, because China is developmentally more or less where Japan was in the early 1970s, its potential growth rate is much higher than Japan’s was when it hit the debt wall: it has plenty of “catch-up” growth left. It is thus plausible that a combination of corporate balance sheet repair, structural reforms, and economic growth could enable China to skirt its debt trap.

Second, the proximate cause of China’s woes is less damaging than Japan’s. In the late 1980s Japan suffered an epic asset bubble which famously valued the land under the Imperial Palace in Tokyo at more than the entire state of California. The popping of this bubble led to equally epic asset price deflation: land and equity prices fell by about three-quar-ters in the next few years. This created Koo’s “balance-sheet recession” whose underlying dynamic is debt deflation: every effort by companies to reduce their debt burden by selling assets makes the overall problem worse, because the resulting fall in asset prices forces up the real value of the remaining debt.


The Party Line

China’s strategic ambitions mean that the Japanese path

of genteel retirement is not an attractive option

China is nowhere near that yet. Its main difficulty is excess capacity in a number of heavy industrial sectors (steel, coal, cement, glass) whose fortunes are directly tied to a construction industry that has peaked and now faces a decade or more of slow decline. In principle, a restructuring of those industries can address this issue without triggering an econo-my-wide debt deflation crisis.

Last, China is a far larger country than Japan, and a fully independent geopolitical actor with its own strategic aims, rather than a US dependen-cy. Its size and decentralization mean it has a greater store of potential domestic demand to draw on, and a greater chance that “animal spirits” bubbling up from the bottom can restore economic vitality when and if the state chooses to get out of the way. The elite’s strategic ambitions mean that the Japanese path of genteel retirement is not an attractive option. The desire to wield more global influence may force the pace of economic reforms, because only greater wealth will make that influence possible.

The sad fate of hubristic control freaksThe similarities and differences are both striking and we cannot know for sure which will prove more important. China’s fate may come down to the basic attitudes of its leaders. And here the echoes of Japan are worrisome.

One is hubris. By the end of the 1980s Japanese officials, and many analysts, thought that Japan had come up with a new economics that was superior to the outmoded Western market capitalist variety. This proved not to be so. Now, most of our foreign corporate and government contacts report that Chinese officialdom has never been so arrogant, unapproach-able, and convinced of the rightness of its model of state-led development. Public discussion of the debt problem is essentially absent (although in fair-ness, Premier Li Keqiang has begun to talk about “zombie companies” in steel and coal, and rumors say the central bank has circulated a discussion paper calling for a US$400bn bank recapitalization). History teaches that when the captain and his mates start congratulating themselves on the superior design of their ship, and ignore obvious icebergs, it is time to haul out the lifeboats.

The other echo is that the obvious solutions to both country’s prob-lems all involve a retreat from state control. Japan could probably have achieved higher growth in the 1990s by deregulating services, opening


Arthur Kroeber

up the financial sector, and permitting much more foreign investment. It chose not to do any of that, because that would have upset the orderly arrangements of the government/corporate elite.

The same unease is now visible in Beijing, where the Communist Party says it will let market forces “play a decisive role in resource allocation,” but in practice has intervened in the equity and foreign exchange markets to prevent prices from falling. The reluctance to reform the SOEs reflects a fear of letting markets, rather than the state, decide who gets to control important assets. China may yet be able to avoid the Japan trap, but only if its rulers learn to lighten up.


The Chinese authorities have given up even trying to get a handle on the country’s spiralling debt problem.

This means that a financial crisis and severe growth downturn are likely by 2020.

As pretty much everyone knows, China has a debt problem. The gross debt of corporations, households and the government has surged to over 230% of GDP, up from less than 140% in 2008. And this ratio continues to rise at a rapid pace, with credit growing at more than double the rate of nominal GDP. The question is, how much risk does this problem pose? Is China heading for a classic emerging-market financial crisis, or can it keep letting the debt pile up year after year as Japan has done for the past quarter-century?

In the short run, China looks quite a bit like Japan. Debt is rising fast, but it is not feeding into the kind of overheated investment activity that typically presages a financial crisis. So it is perfectly possible to ignore the festering debt problem when making projections of China’s economic growth, or investment decisions, on a one- to three-year time horizon.

The bad news is that in the longer run, China does not look like Japan at all. Japan’s debt spiral has gone on for more than 20 years and could well continue for a long while, because the debt is public-sector borrowing that is fully monetized by the Bank of Japan. In other words, the ultimate lender is the central bank, which has limitless ability to fund itself thanks to its mon-ey-printing power. In China, the lenders are commercial banks, whose abil-ity to fund themselves from deposits is gradually eroding. Eventually, banks


China’s Impending Minsky MomentBy Jonathan Anderson

Jonathan Anderson is principal of Emerging Advisors Group, an economic research consultancy.


Jonathan Anderson

will hit a funding squeeze that will precipitate a financial crisis. On current trends, we put the initial crisis threshold at around five years from now.

Grossly distorted debt numbersTo understand China’s debt problem, we must first come to grips with its credit numbers. Most analyses focus on the “total social finance” numbers published by the People’s Bank of China (PBOC), which include bank loans, loans by trust companies, corporate bonds, bankers’ acceptances, “entrusted” (or inter-corporate) loans, and new equity issuance. If you take out the equity item, you have a nice aggregate of traditional debt exposures of the non-financial corporate sectors—we can call it “TSF debt” for short.

The stock of TSF debt is now rising at about 13% a year, or nearly dou-ble the rate of nominal GDP growth. By this measure, China has a rising leverage problem, but the growth of leverage is not accelerating, because growth in TSF debt slowed from the high teens in early 2014 to around 13% since the middle of 2015.

This is bad enough, but the reality is almost certainly worse. This is because there are several kinds of debt and debt-like exposures that appear in the PBOC’s survey of depository institutions, but are excluded from TSF: loans to the government, loans to non-bank financial institu-tions, and all other non-loan/non-bond claims on the rest of the economy. A more accurate gauge of total credit, which I call the “augmented balance sheet,” would include all these extra exposures along with TSF debt, minus non-bank holdings of corporate bonds.

Now, until late 2014, it didn’t matter whether you looked at TSF debt or the augmented balance sheet. The augmented balance sheet yielded a

CEIC, Emerging Market Advisors

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ppNo end in sight

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somewhat higher debt-to-GDP ratio than TSF debt, but the growth rates in the two aggregates were nearly identical for over a decade.

But since late 2014 the two measures have diverged a lot. While TSF debt growth has slowed, augmented balance sheet debt has accelerated, with a growth rate now nearing 20% a year. On this measure, the debt-to-GDP ratio exploded upwards by almost 25 percentage points in 2015—just as big an increase as during the 2009 stimulus boom.

What is driving this acceleration in debt? All three categories of credit excluded from TSF. Loans to the government zoomed from 8% of GDP to 13% in 2015. Non-loan claims on non-bank financial institutions have risen even more, from 10% of GDP at the end of 2013 to 25% of GDP at the end of last year. And non-loan claims on the rest of the economy jumped from 8% of GDP to 12% in the second half of 2015.

In essence, the closely-watched TSF numbers have fallen victim to Goodhart’s Law, which holds that “As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.” The PBOC has told banks and other financial institutions that it will closely monitor the exposures measured by TSF. Banks and other institutions have responded by increasing the flow of financial assets in the areas that TSF doesn’t cover.

Purists may raise various technical objections to including the non-TSF numbers (for example, that some of these claims are more like equity than debt). But this misses the crucial point: China’s financial-sector balance sheet is expanding at a rapid and accelerating pace. At the current rate of expansion, it is only a matter of time before some banks find themselves unable to fund all their assets safely. And at that point, a financial crisis is likely.


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Jonathan Anderson

If China stopped its credit insanity tomorrow, it could probably

manage to keep growth at 2-3%

On to the next question: is there any sign the government will move to stop this galloping leverage? The answer is a resounding “no.” The authorities have clearly shown that they have no intention of addressing the leverage problem, and it no longer makes sense to look for aggressive tightening scenarios. Rather, the new base case is that the Chinese gov-ernment will indeed simply let the debt party go on until it eventually collapses under its own weight.

One reason for this is that the eye-popping explosion in overall main-land debt has had a surprisingly small impact on the real economy. There’s been no overheated demand: growth in industry and construction has ground down to almost zero, with falling materials usage and contracting imports. China doesn’t have spiraling foreign funding liabilities or a bur-geoning external deficit; its current account surplus is actually increasing. There’s very little sign of “abnormal” excess productive or property capac-ity relative to what one would expect given the demand slowdown.

It is therefore easy to pretend that there is no financial emergency right around the corner. This means there is little pressure to tighten monetary policy today, and no official wants to bear the political cost of the growth

slowdown that would be required to get the leverage problem under con-trol. This is a shame, because the rel-atively healthy state of the real econ-omy means that if China decided to stop its credit insanity tomorrow, it could probably still manage to keep

growth at 2-3% through the tightening process, rather than suffering an out-right recession as is typically the case in the unwinding of financial excess.

Instead, at the March session of the National People’s Congress the authorities reiterated a public target of 6.5% average annual growth over the next five years, with adamant language about maintaining the mone-tary and fiscal stances “necessary” to deliver on this goal. In other words, they are kicking the can down the road. And that means that when the inevitable financial unwind does finally come, the impact will be far more severe than it would be if credit were tightened today.

China as Japan? Not quiteIn short, official China will let the debt bubble inflate. No one wants to bear the cost of turning off the taps; the credit boom hasn’t done that much damage to the real economy or to financial system balance sheets; the government still has decent liquidity buffers and has taken steps to



reduce risky lending at the margin. There are a number of domestic voices who argue that the debt run-up really doesn’t matter at all.

Sound familiar? It should. This is quite similar to the situation in Japan. There, the government is stuck running extremely large fiscal deficits, and can’t withdraw stimulus for fear of sending the economy into sharp reces-sion. As a result, it has run up the gross public debt ratio by nearly 200% of GDP since the early 1990s.

But rising fiscal debt loads haven’t seemed to matter at all; the private sector continues to deleverage, and has a very high saving rate. And in the past few years the Japanese central bank has actually been a net buyer of public debt from the private sector, buying up not only all of the new issuance flow of government paper but also part of the outstanding stock in the rest of the economy as well. It does so by printing excess reserve money to the commercial banking system, which never gets lent out as the private sector is, again, deleveraging. This process could go on forever—or at least until the private sector stops building up savings.

At the end of the day, though, China is not Japan, in one key respect. Japan may actually be heading further away from a debt crisis, since the central bank is effectively nationalizing an ever-greater share of public lia-bilities. China, however, is heading steadily towards an eventual financial crisis in a few years.

In Japan, the entire annual increase in economy-wide debt is now accumulating on the books of the central bank, offset by large-scale base money creation. In this situation, what could trigger a crisis? Not a run on commercial banks: they have massive excess liquidity balances and a shrinking portfolio of loans. Not a run on the central bank: this is impos-sible in a fiat money system with a floating currency. Not a blowout in


Return of the shadowMonthly credit �ows, % of GDP

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Jonathan Anderson

sovereign yields: the central bank can set the price at every point in the curve by monetizing debt wholesale. Not an exchange rate depreciation: a falling yen does nothing to affect the sustainability of a debt stock that is fully denominated in local currency.

The only sure-fire way to generate a crisis in a country that is fully mon-etizing its own public debt is through a run on money itself—that is, high inflation or hyperinflation. This is how emerging-market fiscal crises have always played out, from Latin America in the 1980s to the former Soviet Union in the 1990s to Turkey in the early 2000s and Venezuela, Argentina and potentially Egypt today. This has not happened in Japan so far, because the private sector is mired in a deleveraging process with almost no appe-tite for new spending and investment—and may remain so within the investible lifetime of most readers. But if you extend Japan’s current policy ad infinitum, high inflation remains the most likely end game.

Slouching towards ArmageddonIn China, however, credit is being issued not by the central bank but by commercial banks and non-bank lenders. One might ask what difference this makes, given that virtually all of China’s lenders are state-owned and much of the credit they issue is quasi-fiscal in nature. But it makes a big difference. A fiat money central bank can never run into funding pressures, because it can simply print the money it needs to fund itself. Commercial lenders cannot do this, even if they are state-owned, so they can hit a funding squeeze.

This means that China today is in the same camp as the Asian crisis econ-omies of the late 1990s, and the United States and central and eastern Europe in the 2000s. In none of these cases did financial crisis hit because of high fis-


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cal deficits or public debt spirals. Each crisis was preceded by a private sector lending binge, and was triggered by a shortfall in bank funding.

To see how close China is to the financial crisis precipice, therefore, what we need to monitor is not the level or quality of bank assets, but financial-system funding ratios—spe-cifically, the ratio of total domestic credit to bank deposits, and net exter-nal liabilities. The higher these ratios, the greater the risk. Both ratios are still moderate, but rising relentlessly.

China does not face an imminent external liability crisis: its banking system is a net creditor to the rest of the world, to the tune of 2% of finan-cial system assets. (This is, however, quite a bit lower than the 5% net creditor position China enjoyed as recently as 2007.) The domestic funding situation is more worrisome. The ratio of total credit (including all off-balance-sheet activity) to deposits is 110%, up from 86% in 2008. This level is not necessarily dangerous but the big rise in the ratio since 2009 implies a steady increase in systemic risk.

To measure just how close China is to the crisis cliff, we combine these measures of domestic and external funding liability, and present them for the years in which 10 major emerging-market countries hit financial cri-ses, as well as for China in 2009 and in 2015. (See chart, “Heading toward the crisis frontier.”) The conclusions are as follows: • The average EM crisis economy had a credit/deposit ratio of 140%

and a net foreign liability position of 15% of total assets. • The minimum crisis threshold (represented by the dotted line)

seems to be a credit/deposit ratio of 115% and net foreign exposure of -5% of bank assets.

• With a credit/deposit ratio of no more than 110%, and a net foreign creditor position, China, is not yet at the crisis threshold. But it is heading in that direction. Between 2009 and 2015 it moved from a very safe financial position halfway to the crisis threshold. So anoth-er three or four years on this same trajectory would put it in very dangerous territory indeed.

Emerging Market Advisors

Heading toward the crisis frontierFinancial vulnerability indicators,

China and emerging market crisis countries

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Jonathan Anderson

What would a crisis look like?At the moment, the government seems determined to muddle through at all costs, maintaining credit growth in the high teens in order to keep the property market stable, investment stable, and real GDP growth around 6% through the end of the decade.

If Beijing persists in this policy, then by 2020 credit in the formal finan-cial system will rise to at least 320% of GDP. The credit/deposit ratio will be 130% for the system as a whole and much higher at individual small banks. Banks’ gross liabilities to the non-bank financial sector will be a multiple of total precautionary reserves held at the PBOC. Foreign liabil-ities will still be moderate, but the net balance may have turned negative. China will decisively cross the crisis frontier.

The huge increase in debt, and the rising reliance on non-deposit, inter-bank funding, will raise the risk of a “Minsky moment” where defaults in the non-bank financial sector could overwhelm smaller banks and cause a run that freezes up the interbank market. The wave of financial bankrupt-cies would also trigger a wave of capital outflows, making it much harder for the PBOC to stabilize the banking system and the currency.

The PBOC could, of course, backstop larger institutions by provid-ing emergency liquidity—but not before credit flows are disrupted. The property market would tank, construction would halt, and consumption spending would get whacked hard. There would be widespread corporate illiquidity and sudden bankruptcies on highly-geared enterprise balance sheets, with a big drop in investment activity as the corporate sector is forced to hoard funds to pay down debt.

Overall, industrial production would fall by up to 15%. Real GDP could contract by up to 5% initially, followed by a long, slow, grinding recovery retarded by deleveraging pressures. Five years after the initial crisis shock, the economy would be growing at a 3% rate at best.

The bottom line: by avoiding a painful but moderate adjustment today, China’s leaders greatly increase the risk of a major financial crisis in five years or so, and of a “lost decade” of sluggish growth thereafter—at a much lower level of income, and with a far less cohesive society, than Japan enjoyed when it hit its lost decade in the 1990s. It is not a pretty prospect.


Productivity of capital is falling, and debt is rising. Does this mean China is headed for low-growth, high-debt stagnation? Not necessarily. Economy-wide returns on

capital remain solid; the biggest problems are an inefficient state enterprise sector, and excessive infrastructure debt. Strong state enterprise reforms could enable growth to

stabilize at a high level.

In the past decade, the share of China’s GDP devoted to investment, or gross capital formation, has risen sharply to just under 50% of GDP, the highest rate ever recorded for a major economy. The investment-to-GDP ratio has stayed high even as growth decelerated from nearly 11% in 2010 to under 7% in 2015. Since each dollar of investment evidently delivers a lower contribution to growth each year, it seems that the productivity of capital is falling. In addition, the nation’s gross debt has steadily risen from 140% of GDP in 2008 to 240% in 2015. This implies that businesses and the government are piling on ever more debt to finance ever less produc-tive investment. If so, China’s economy is clearly on an unsustainable path.

A close look at capital productivity trends reveals a more mixed pic-ture. The rise in China’s capital-output ratio since the early 2000s mainly reflects huge increases in investment in housing and infrastructure. The return on investment both in agriculture and in the non-farm business sector remains strong. Within the business sector, private companies


The Fall Of Productivity And The Rise Of Debt

By Richard Herd

Richard Herd headed the OECD’s China Desk for over a decade. He now works for consultancy firms, banks and the Guangdong Development Research Center.


Richard Herd

deliver a high return on equity, maintain prudent debt ratios, and are steadily picking up market share. The biggest problem lies with the indus-trial state-owned enterprises (SOEs), where productivity growth has fallen virtually to zero and debt burdens are rising.

The overall conclusion is that the continued use of debt to finance non-productive infrastructure, and failure to restructure SOEs, could lead China into much slower growth and debt sustainability problems. But a move away from debt-financed public works spending, and resolute restructuring of the SOEs, would enable sustained GDP growth around 7% and a stabilization of leverage.

Taking stock of China’s capitalThe best indicator of capital productivity is the trend in the marginal product of capital—the additional output that arises from the use of an additional unit of capital. Looking at the marginal product of capital across different sectors can help us determine where capital is being mis-used and where it is productive.

The first step is to set a baseline by estimating the capital stock and its distribution across the economy. I divide the economy into five sectors: agriculture, the non-farm business sector, infrastructure, government and housing. This division is chosen because Chinese national accounts assume that there is no real return either from the government’s physical assets or from housing. So lumping them in with business investment might give a misleading impression of the returns on capital deployed by business.

Data limitations mean any attempt to measure investment by sector must be approximate. I base my estimate for housing on the formulae published by the National Bureau of Statistics for housing investment; figures for the gov-ernment sector are taken from the flow of funds. These data on annual invest-ment flows are combined with an estimate of the capital stock in 1952 by the economist Gregory Chow. Depreciation is assumed to average just under 5%.

The main findings from this exercise are that the business sector’s share of total investment has steadily declined for the past two decades, and that the speed of this decline has accelerated in the last five years. Correspond-ingly, the investment shares of other sectors have risen, at varying speeds in different periods. From the early 1990s, infrastructure spending grew rapidly under policies of the Eighth and Ninth Five Year Plans (1991-2001), while capital formation under the government budget recovered markedly after the 1994 tax reform.

But the biggest change in the investment shares came with the privat-ization of the housing market in the early 2000s. Once the private residen-



tial market was firmly established a decade ago, housing’s share of total investment rose steadily. Housing investment now comfortably exceeds total capital spending by the business sector.

The large rise in housing and infrastructure investment has pushed up the size of the capital stock relative to annual GDP (that is, the capital-out-put ratio). Nearly all of the increase in the overall capital-output ratio from 2.2 in 1995 to 3.2 in 2015 has come from sectors that produce little or no economic return, as measured in the Chinese national accounts.

However, the capital stock in the business sector (including agricul-ture) has risen only slightly faster than output. Most of the rise is due to the increasing mechanization and modernization of the agricultural sector, which has seen a massive drop in the available workforce. The non-farm business sector capital-output ratio actually fell slightly until 2010, but since then has been rising slowly, to 1.7 in 2015.

By international standards, this is not abnormally high. In most devel-oped countries, business sector capital-output ratios are between two and three. In less developed countries, capital-output ratios tend to be lower and rise steadily as a nation modernizes. Between 1965 and 1975, Japan’s business-sector capital-output ratio rose from 1.3 to 1.9. China’s business sector capital-output ratio now is about the same as Japan’s in 1968.

Returns on capital are fallingSo much for the capital stock. To assess the marginal productivity of cap-ital, we must determine what proportion of each year’s increased output represents increased income from capital. This is not a straightforward task, in China or anywhere else. A key problem is deciding how much of the income of the self-employed and of very small enterprises represents

CEIC, author calculations

An epic housing boomShare of gross �xed capital formation by sector

%

10

20

30

40

50

60

20152010200520001995

Government/ infrastructure

Business/ agriculture

Housing


Richard Herd

a return to capital, as opposed to labor income. Chinese national accounts assigned all of this “mixed income” to labor before 2004, and split it between labor and capital thereafter. All income in agriculture continues to be allocated to labor. My estimates correct for the 2004 statistical dis-continuity, and also allocate some agricultural income to capital.

These estimates suggest that there has been an unprecedented fall in capital’s share of national income since 2010. This fall in the capital income share is also visible in financial data from the industrial sector, where the earnings of companies before interest, tax and depreciation showed no growth between 2013 and 2015.

The two large facts that we have established so far—the rise in the economy-wide capital-output ratio and the fall in the capital income share—imply a marked decline in the gross rate of return on capital since 2011. This contrasts sharply with 2003-08, when gross returns to capital in the business sector rose rapidly, thanks to earlier reforms that deregulated manufacturing and integrated China into the world trade system. Returns stayed high for an additional couple of years thanks to the 2009 stimulus program. But since 2011 they have fallen, and hit an all-time low of 22% in 2015, compared to rates of 25-30% that prevailed between 1992 and 2011. Despite this decline, the gross return on capital in China’s business sector is still similar to those of other emerging economies, and much higher than in the United States and Europe.

For the economy as whole, the rate of return on capital is much lower than in the business sector, and has fallen considerably to about 11% in 2015. This is due to the increased share of public sector and housing assets within China’s overall capital stock. Part of this decline would disappear if the return to housing were correctly measured in the Chinese national


Business e�ciency is not the big problemIndex of capital-output ratios by sector*

1995

= 1

00

*Capital in each sector is measured relative to total GDP.

100

120

140

160

180

200

2015

Government/ infrastructure

Business/ agriculture

Housing

2010200520001995



accounts. When China first adopted GDP accounting in the early 1980s, virtually all urban housing was provided by the government or state-owned work units to their workers at low rents; the true value of housing services was not accounted for and continues to be left out of China’s national account. Recent estimates suggest that GDP would be 4.4% high-er if the contribution of the housing sector were adequately measured. This would raise the return on capital in the whole economy to slightly over 12%.

A widening gap between the state and private sectors The fall in the business sector rate of return on capital mirrors a drop in the rate of return on equity across many sectors. In industry, state firms have suffered a sharp decline in equity returns, with the result that the average return on equity in private companies is now 2.5 times that of SOEs. The same pattern holds in real estate. Only in retail and wholesale trade have SOEs and private firms shown similar returns, achieving an average rate of return on equity close to 20% over 2010-14, though returns dropped for both groups in 2014.

The changing pattern of rates of return has been accompanied by a marked reallocation of capital within industry, from the state to the pri-vate sector. In 2010-15, the shareholder equity of private firms rose by Rmb14trn, compared to just Rmb4trn for SOEs. In the same period, pri-vate firms also increased their borrowing by Rmb16trn, against Rmb10trn for state companies.

Despite their big increase in debt, private companies reduced their liability/equity ratio to 1.1, slightly above the average for OECD firms. Meanwhile SOEs’ liability/equity ratio rose back to 1.6 in 2015, after a


Returns are falling, but still highGross return on capital

%

10

15

20

25

30

35

20152010200520001995

Whole economy

Business sector


Richard Herd

momentary improvement following the late 1990s SOE reforms. Falling returns on equity and an increased debt burden have rendered state indus-trial firms’ cash flows more precarious: interest payments have risen faster than pre-tax profits. Interest payments as a share of earnings before inter-est and tax (EBIT) have nearly doubled since 2008, to 21%—although this is still far below the life-threatening levels of the late 1990s, when interest payments devoured nearly three-quarters of state industrial firms’ EBIT. Private firms, in comparison, are in much better shape: interest payments have been stable at around 10% of EBIT since 2008.

For the median listed SOEs, the risk from debt is limited, as liability ratios are lower than for the whole universe of SOEs. But there is a tail of listed SOEs that must be considered financially distressed, with debt to equity ratios of over 3 in 2013. These firms—which comprised more than one third of all listed enterprises in 2015—are concentrated in the real estate, construction, mining and utility sectors, and most are controlled by local governments. This group of highly indebted firms pushes the overall SOE debt-equity ratio up to 1.6, a level associated with financial crisis in several OECD countries.

The combination of falling return on equity and high debt service makes life difficult for SOEs overall. In order to grow at the same pace as the economy they would need to further increase their debt. But this would put further pressure on their solvency, unless they can raise their rate of return on capital. A continued decline in SOEs’ share of business sector output thus seems likely.

OECD, CEIC, author calculations

Leverage is a state-sector problemCorporate debt/equity ratios, selected countries

%

*Industrial companies only**Unweighted average for all OECD countries

0

50

100

150

200

US

FranceSpainUK

OECD**

China private*

Netherla

nds

Germany

Italy

Korea

Greece

China SOE*

Portugal



We find a similar pattern in real estate, where the equity of state-con-trolled firms fell by 27% in the four years to 2014, even as the equity of private firms doubled, leaving private firms with a 96% share of total equity in the sector. The difference with industry is that in real estate, all firms (both state and private) have seen a rapid rise in leverage. In 11 of 31 provinces, the real estate sector’s interest payments as a share of EBIT have risen to an uncomfortably high 45%. In the worst provinces (Yunnan and Inner Mongolia) the ratio is 70%.

To sum up our findings on capital productivity:• Economy-wide returns to capital fell by a third between 2008 and

2015, largely because of an increase in housing’s share of total investment.

• Return on equity in state-owned industrial and real-estate firms has fallen by more than half since 2008. Returns in private sector firms have held up much better; and private industrial firms are much less indebted than SOEs.

• Rising leverage is a problem for industrial SOEs and for both state and private firms in real estate. Yet for the most part the interest burden is nowhere near the crippling levels of the late 1990s.

To get a more complete view of economic efficiency, we need to move beyond the marginal productivity of capital to total factor productivity (TFP), which measures the economic returns of capital and labor combined.

Here the story is that economy-wide TFP growth has fallen from its 2006-07 economy-wide peak of nearly 5% to less than 2% in 2015. Business-sec-tor TFP growth is somewhat higher (2.6%) and has fallen markedly less than for the economy as a whole—again reflecting the economy’s increased reliance on low-productivity housing and infrastructure since 2008.


State sector pro�tability plummetsReturn on equity for industrial �rms

%

0

5

10

15

20

25

2015201020052000

State

Private

Total


Richard Herd

Within the business sector, agriculture has shown remarkable TFP growth in the past decade, as its labor force fell and production became more mechanized. Even so, agricultural productivity remains well below that of the non-farm business sector, so the transfer of labor out of agri-culture continues to raise economy-wide average productivity.

The other noteworthy pattern is that TFP growth in the state-owned industrial sector has collapsed, from a high of 14% in 2002 (when SOEs were reaping the benefits of a massive restructuring) to about zero in 2015. Meanwhile, TFP at private industrial firms declined between 2006 and 2011, but it has since recovered and now stands at about 3%. The fact that SOEs’ TFP growth has deteriorated far more than their return on cap-ital suggests that their labor productivity is abysmal, and in turn implies that large-scale layoffs are required to restore industrial SOEs to health. In fact at the beginning of March, Reuters quoted two senior government officials as saying that layoffs of over 6mn—out of total SOE industrial employment of 37mn—will be necessary.

Adding it all up, should we conclude that China’s economy is in immi-nent danger of crumbling due to falling capital efficiency and rising debt? The short answer is no, but the capital-efficiency and debt problems require strong policy response.

Clean up the SOEs, and clarify government debtOne finding is that—despite fears that the government-controlled banking sector was starving the private sector of funds—both the equity and lia-bilities of private firms have grown faster than those of SOEs. As a result, private sector fixed assets grew by 21% in 2009-14, compared to 11% for state-controlled companies. There has thus been a significant reallocation


Interest burden: not as bad as the ’90sInterest payments

% o

f EBI

T

0

20

40

60

80

201420122010200820062004200220001998

State Private



of capital away from the state sector. The private sector has achieved this result without interest payments rising significantly as a share of profits.

A second conclusion is that because of their deteriorating balance sheets (thanks to lower returns on capital and labor and a higher debt load), SOEs will find it ever harder to keep up with private companies. There is pressure for them to pay bigger dividends to the government, which will reduce the growth of their retained earnings. Banks may become more reluctant to lend to them as their balance sheets deteriorate. One key to stabilizing economic growth is vigorous SOE reform: reducing the role of the state and party in enterprise management, shrinking the workforce where necessary, and permitting some defaults on SOE liabili-ties to encourage adequate risk management by banks.

Third, the rise in debt to finance housing, infrastructure and govern-ment assets could at some point become unsustainable. The surge in hous-ing investment between 2008 and 2015 caused a doubling of household mortgage debt as a share of household disposable income, to 32%. This level is still relatively low and could continue to rise substantially without endangering the solvency of the household sector. But the government’s debt position is less favorable than that of households. The exact level of government debt is uncertain, because of the lack of transparency about the debt of off-budget entities owned by local governments, and about the financial flows between local governments and these off-budget entities. Most likely, the consolidated effective debt of the government is around 60%-65% of GDP in 2015.

This is not high by international standards: OECD countries average 100% of GDP; and among emerging economies, both Brazil and India have public debt in excess of 70% of GDP. But the official budget deficit is


Productivity’s rise and fallTotal factor productivity growth

%

1

2

3

4

5

6

20152013201120092007200520032001

Whole economy

Business and agriculture


Richard Herd

likely to rise above the 3% of GDP projected for 2016, as the government comes under greater pressure to bolster growth through fiscal support. Moreover the true deficit, including the financial flows of local-govern-ment off-budget entities, has been estimated by the IMF to be as high as 7% of GDP, and even higher if revenue from land sales is counted as a financing item. Finally, the really crucial element in debt dynamics—the spread between the interest rate and nominal GDP growth—has narrowed significantly, making debt stabilization more difficult.

These are stiff challenges. Yet the positive message from this analysis is that over-investment does not appear to be generalized in the business sector. The business sector capital-output ratio has only risen modestly and rates of return, though falling, are still high. The private-sector cor-porate debt burden does not now seem excessive except in parts of real estate. But debt is growing rapidly among industrial SOEs, and is now at the level that has been associated with banking crises in some OECD countries. Even though growth of TFP has slowed and there will be little growth in China’s workforce, the business and agricultural sectors should be able to support GDP growth of around 7%—if there is a determined reform of SOEs that goes well beyond the current strategy of pushing profitable firms absorb the loss-making ones.


Testing the zero boundTFP growth by business ownership

%

0

3

6

9

12

15

201520132011200920072005200320011999

SOE

Total

Private


The story goes that excess capacity and debt-ridden ‘zombie companies’ will drag down China’s economy. But the problems are mainly confined to steel, coal, and other construction-related industries—and are less dire than in the 1990s. A long, slow restructuring is possible, though

perhaps not ideal.

A popular story about China goes something like this. Numerous indus-tries are swamped in excess capacity, but the government keeps unprof-itable and debt-ridden firms on life support. They thus become “zombie companies” that add nothing to the economy and whose continued exis-tence prevents a re-allocation of capital to more productive uses. More-over, the persistent excess capacity pushes prices down. Falling prices mean that the real value of companies’ debt burden rises, making it even harder to restructure them. China is thus skirting a debt deflation trap similar to the one that engulfed Japan in the early 1990s, when (arguably) a failure to put debt-ridden zombie companies out of their misery led to a “lost decade” during which the economy failed to grow.

This story contains many elements of truth. Several industrial sec-tors—notably coal, steel, non-ferrous metals and cement—suffer from severe excess capacity. A rising number of firms qualify as potential zombie companies by virtue of having sustained negative operating profit margins. And the producer price index (PPI), which measures the wholesale prices of industrial and agricultural goods, has been in deflationary territory since 2012, with an average annual fall of -2% in the last four years.


Excess Capacity, Zombie Companies, And Debt Deflation

By Thomas Gatley and Rosealea Yao

Thomas Gatley and Rosealea Yao are respectively the corporate and investment analysts at Gavekal Dragonomics.


Thomas Gatley and Rosealea Yao

Taken as a whole, however, the story exaggerates the scale of China’s problems. Excess capacity is not generalized: it exists mainly in a set of heavy industrial sectors tied closely to construction cycle. These same sectors account for most of the PPI decline, whose root cause is the sharp fall in commodity prices in the last few years. And although the number of potential zombie companies is on the rise, it falls far short of the disastrous late 1990s, when over a quarter of all industrial firms were hemorrhaging red ink. China faces a serious and difficult restructuring challenge, but a debt deflation trap is not necessarily imminent.

Blame it on the housing boomThe starting point for our analysis is the end of China’s great housing boom. Between 2000 and 2012 annual construction of housing doubled, from 875mn to 1.75bn square meters. This explosive growth, combined with infrastructure development, drove dramatic increases in China’s con-sumption of basic materials. Steel consumption quintupled, from 150mn to 750mn tons a year, and cement output quadrupled, from 600mn to 2.5bn tons. Coal consumption more than tripled, from 1.4bn to 4.3bn tons, with most of it going into the electric power plants that fueled the production of steel, cement and other basic materials. Prices of these com-modities rose accordingly.

It was a great party while it lasted, but the party is now well and truly over. Housing construction volume began to decline in 2013, and over the next decade we project it will fall by 15-20% from the peak. Coal, steel and cement use all started to decline in 2014-15; steel industry researchers are now talking about a 20% decline in steel demand by 2020. Coal consump-tion will probably fall by about 10% over the same period.

The passage of peak China demand, along with global over-investment in mining capacity, has driven commodity prices down by half or more since early 2014, and materials prices have also fallen. These price dynam-ics are important: although there were complaints about excess capacity in steel, coal and cement for years, the market reality was that for most pro-ducers prices were high enough that it made no sense to cut production.

The turning point for the coal and steel industries arrived in early 2015. Profits and prices had been falling in both sectors since 2012, but most producers were still generating enough cash to cover their variable costs if not their fixed costs (that is, they had positive gross margins but negative net margins). Many gambled that it was still worth staying in business, even if they had to dip into their capital to cover their fixed costs, in case the cycle turned and prices and profits picked up later.



That gamble was generally a good one in the boom years of 2000-12, but it turned sour in 2015 when prices and industry profits fell low enough that gross margins turned negative and firms found themselves unable to cover either fixed or variable costs. At that point it became economically irrational to continue producing, without substantial outside assistance.

Coal and steel are the worstThe inflection point is clear for coal. When the coal price fell from over US$100/ton in 2011 to US$85 in 2013, the industry’s gross margins fell by 10pp to 20%, but that did not cause many firms to reduce production. But as the price dropped to US$60 in early 2015, the number of firms with nega-tive gross margins suddenly jumped. With more firms unable to cover their operating costs, output fell. Extrapolation from historical data suggests that if the coal price falls to around US$50, then the industry as a whole will have negative net profits, and the proportion of firms with negative gross margins will rise to more than 20%.

The situation in steel is more complex, since falling input prices (for iron ore and coal) offset some of the pain from weaker steel prices. But the general picture is similar: aggregate net profits for the sector are now neg-ative, and by September 2015 five of the 48 domestically listed steel firms suffered negative gross margins. Again, this translated into production cuts: domestic crude steel output fell 2% in 2015, the first annual decline since 1981.

In short, market forces are driving the pace of closures in excess capacity industries. This pace is likely to accelerate in the next year or two as finan-cial pressures mount. Two factors could slow things down: foreign trade and local government support. But there are constraints on the impact of both.

Gavekal Data/Macrobond

The end of an eraHousing completions, actual and projected

bn s

q m

eter

s

0.0

0.5

1.0

1.5

2.0

2025202020152010200520001995199019851980

ModelActual completions



Steel producers can offset weak domestic demand by exporting more, and in 2015 they did just that: crude steel exports rose 28% to 115mn tons. But global demand is also soft, and several countries are stepping up anti-dumping actions and other import restrictions to curb the flood of Chinese steel. Most likely, China’s steel exports are at or near their peak. If so, domestic production will probably need to decline another 5% in 2016.

For coal, the key swing factor is on the import side: weaker demand can be accommodated by cutting imports rather than domestic produc-tion. Coal imports fell by 30% in 2015, to 200mn tons, and another steep drop is likely this year. But even if that occurs, domestic production will probably still need to fall by 3-4%; and once coal imports fall to zero, all further adjustment will need to come through domestic production cuts.

Local governments, obviously, are not keen to see large employers and taxpayers shut down, so they find various ways to help troubled firms keep producing even at low prices and minimal profits. But they are cash-strapped too, and their ability to subsidize loss-making enterprises is clearly eroding. The steel and coal industries have already shed 1.4mn workers since 2014. As more producers hit the wall of negative gross mar-gins in 2016, the pressure to shut down the weaker ones (or more likely, merge them with stronger players) and lay off workers will intensify.

How many zombies?Our discussion has so far centered on steel and coal, for a reason: despite the talk about “excess capacity throughout Chinese industry,” evidence of large-scale excess capacity and severe financial stress is pretty much lim-ited to these sectors and a few others whose fortunes are directly tied to the construction industry.

CEIC, Gavekal Data/Macrobond

bn to

ns

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Past the peakKey commodity production and consumption

0

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2

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4

5

20152010200520001995199019851980

Steel use(right scale)

Cement production(left scale)

Coal use(left scale)

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200

400

600

800

1,000



To generate an estimate of how many potential zombie companies there are in the whole economy, and which sectors are most troubled, we turn to data from the 1,077 companies listed on the Shanghai stock exchange. In 2015, 15% of these firms reported a net loss. This figure in itself is not obviously troubling: in any given year, 10-15% of the compa-nies in the S&P 500 report net losses. And today, the share of loss-making firms in the US index is around 20%, thanks to the severe downturn in the energy sector.

Of course, it is not really credible that the Shanghai index has fewer loss-making firms after a prolonged industrial downturn than does the relatively healthy and diversified US index. Some Chinese firms are only able to report profits thanks to direct and indirect subsidies, which take two main forms: non-recurring profits (often reflecting government infusions of some sort) and lower-than-av-erage interest rates paid on debt. Adjusting for these two items, the share of loss-making firms on the Shanghai index rises to 28%.

Loss-making rates are much higher in the energy and materials sectors (55% and 45% respectively), and lower in consumer discretionary and healthcare (25% and 10%). About two-thirds of loss-making firms are state-owned enterprises, as one would expect.

One cannot leap to the conclusion that all loss-making firms are potential zombies. Some are run-of-the-mill unprofitable firms such as would be found in any market. Others are companies caught out by the commodity-price downturn, whose performance may improve once com-modity prices recover. Even companies successful at leveraging subsidies and low interest rates may not all be zombies; they may be opportunists that will figure out some other mode of survival once government support is cut. A stricter test would identify companies with operating profit mar-gins in or near negative territory: at present, 7.5% of Shanghai-listed firms have operating margins of 5% or less.

Better than the bad old daysAnother important caveat is that the Shanghai index is unrepresentative of the national economy. The energy and materials sectors, for instance, account for about 10% of GDP but nearly a quarter of Shanghai-listed firms. Non-financial services, by contrast, account for nearly half of GDP but less than a third of listed firms. So a purely stock-market based esti-mate of zombie companies will almost certainly be too high. Once we

State-owned enterprises account for two-thirds of loss-making firms



adjust for the under-representation of services in the Shanghai index, our estimate of potential zombie companies falls to 3-11% of all companies.

Is this a lot or a little? For this we need a time series. Stock market data is only comprehensive enough to take us back to 2009, and no strong trend is visible. For a longer-term view, we can count up the proportion of loss-mak-ing firms in the government’s industrial survey, and then adjust for indus-try’s share in the overall economy. This yields an estimate of 10% of firms as potential zombies, about the same as the high end of our stock-market based estimate, but less than half the figure in 1998, when 28% of industrial companies, and perhaps 21% of all types of firms, were in the red.

The details are somewhat messy, but two large conclusions clearly emerge. First, while corporate losses have mounted in the last three or four years, the proportion of firms that can plausibly count as zombie candidates is far less than in the dark days of the 1990s. This helps explain why the central government has moved less aggressively on industrial restructuring than did premier Zhu Rongji two decades ago: the situation is just not as dire. And second, the major problems are concentrated in a handful of heavy industrial sectors, meaning that a relatively targeted set of policies can address the problem.

The question then becomes whether Beijing will in fact do anything to speed up the process of forcing excess capacity to exit the market. Until recently the answer seemed to be no. Recently, however, there has been a clear rhetorical shift. Since late December, official media have headlined denunciations of the evils of zombie companies. Premier Li Keqiang chaired a meeting in January with provincial and corporate leaders on

Wind, Gavekal Data/Macrobond

Heavy industry fares the worstShanghai-listed companies running a loss

% o

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tor

0

10

20

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Healthca

re

Utilitie

s

Consumer

discretio

nary

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Consumer

staples

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Energy



excess capacity in coal and steel, and said the central government would help pay for benefits and retraining for laid off workers. In March, Reuters published a report, based on conversations with central government offi-cials, that Beijing was anticipating 5-6mn job losses in the coal and steel sectors, and had earmarked Rmb150bn to cover the costs.

That report has not been formally confirmed, and in any case, official-dom has made clear its hope that the resolution of excess capacity will be a matter of “many mergers, few bankruptcies.” This points to a continua-tion of the past preference for poorly-performing firms to be absorbed by stronger ones, rather than a suddenly higher tolerance for corporate clo-sures. Whether this muddle-through method will prove adequate remains to be seen.

One risk of this approach is that the considerable debt of loss-making firms does not get retired or written off, but is simply shuffled on to the balance sheets of bigger firms, and remains a drag on bank profitability and economic growth. This is especially worrying for industries that get caught in a “debt deflation” cycle, in which companies struggle with a fixed debt burden while falling prices drag down their revenues and operating profits. When a debt deflation dynamic becomes generalized throughout an economy—as it did in the United States in the 1930s and in Japan in the 1990s—it can turn into a quagmire, since every effort by companies to escape their problems by selling assets to pay down debt simply pushes prices down further, causing the real value of their debt to rise even more.

So far, it seems that debt deflation could be a problem in the coal and metals industries, but not elsewhere. In coal, falling prices have caused industry revenues to fall 27% from their 2012 peak, and operating profits to tumble by 57%. As a result, interest costs eat up 22% of coal sector gross

Gavekal Data/Macrobond

Not as bad as the 1990sPotential ‘zombie companies’

% o

f all

�rm

s

0

5

10

15

20

25

201520132011200920072005200320011999

From industrial survey

Listed firms (high estimate)

Listed firms (low estimate)



profits today, compared with just 5% in 2011. Metals smelters also face debt-service burdens of over 20%. This is textbook debt deflation: falling prices have increased the real debt burden.

Broader evidence of debt deflation is hard to find. Debt service costs in most other industries hovers around 10% of operating profit. And almost all the deflation in the economy comes from lower commodity prices: consumer price inflation has been steady at around 1.5% for several years, and the entrenched PPI deflation is mainly attributable to commodities. Other producer prices, for machinery and consumer goods, are seeing price declines of less than 1% annually, mostly thanks to productivity gains rather than weak demand.

In sum, the end of China’s long housing boom precipitated a huge, per-manent fall in commodity prices, and this has resulted in severe financial stress in the country’s commodity and materials sectors, especially coal and steel. Excess capacity and debt burdens in these industries are high, and while market pressures will inexorably squeeze much of this excess capacity out of the market over the next several years, the process will be long and slow. The central government has little interest in accelerating the closures, and will try to spread out the inevitable job losses and debt write-downs by forcing weak firms to merge with stronger ones, rather than crystallizing the problems through bankruptcies. This approach may not be ideal, but can be justified on the grounds that China’s industrial problems today are much less serious, and far more narrowly concen-trated, than the mess that prompted the great state-enterprise industrial restructuring of the late 1990s. China does not face a general debt defla-tion trap—at least not yet.


The mess that are China’s stock markets cost securities regulator Xiao Gang his job in early 2016. Sacking him

was the easy task. The real work remains to be done if the country’s financial markets are ever to fulfil a real role as an

allocator of capital.

In March 2013, after a successful decade running the Bank of China, one of the country’s “big four” behemoth banks, Xiao Gang took over as head of the China Securities Regulatory Commission (CSRC). His job was to shepherd China’s fast-growing but chaotic stock markets into a more important role financing the nation’s economy. Armed with a reputation for effectiveness and a strong mandate from president Xi Jinping’s mar-ket-oriented reform agenda, Xiao seemed to have a good shot at success.

Less than three years later, the reputation of China’s securities markets lay in ruins and Xiao had been fired, shortly after making a public apology for an effort to restore market stability that had exactly the opposite effect. Apologies by public officials are rare in China, and sackings of high-level bureaucrats for incompetence just as rare: the last notable example was Meng Xuenong, the Beijing mayor cashiered for bungling the SARS crisis in 2003. What went wrong? And what does Xiao Gang’s story tell us about the prospects for China getting a stock market worthy of the world’s sec-ond biggest economy?

The main lesson from this dismal episode is that no amount of admin-istrative skill can overcome the contradiction at the heart of president Xi’s economic program, which simultaneously affirms a “decisive” role for

Miscellany

What We Learned From The Stock Market Crash

By Charles Horne and Xinling Wang

Charles Horne is senior research manager at Beijing-based advisory firm China Policy. Xinling Wang is lead analyst for financial and fiscal policy at China Policy.


Charles Horne and Xinling Wang

markets and a “dominant” role for the state. Xiao failed in part because of flaws in character and vision, but more because of the incoherence of the Communist Party’s twin desires for more markets and more stability.

A hard act to followXiao came to the CSRC job with a fine bureaucratic pedigree and a rep-utation as a skillful operator. He spent the first two decades of his career climbing the ladder of the People’s Bank of China (PBOC), mostly in its research and monetary policy offices. In 2003 he was named chairman of Bank of China. He moved aggressively to get the bank an internation-al listing; its 2006 IPO in Hong Kong was the second for a big Chinese bank. He also spearheaded an impressive upgrade of the bank’s IT systems and pushed it to bulk up both its domestic and its international market position. He did not hesitate to fire senior bank officials who performed poorly, and guided the bank through China’s post-stimulus credit bubble of 2009-2012 with a relatively clean balance sheet.

In March 2013 Xiao took over CSRC from Guo Shuqing, a well-regard-ed financial reformer with a similar career track: several years at PBOC, followed by a six-year stint as chairman of China Construction Bank. A key difference between the two was that Guo spent the better part of a decade cutting his teeth at the State Commission for Restructuring the Economy, the main policy planning hive for premier Zhu Rongji’s swarm of reforms. Other notable graduates of this office include Politburo stand-ing committee member Wang Qishan and PBOC governor Zhou Xiaoch-uan. Xiao, a PBOC lifer, displayed far less skill than Wang, Zhou and Guo in pushing through a complex agenda.

Guo accomplished a lot in a short tenure at CSRC. His aim was to destroy CSRC’s approval system for IPOs, which bred corruption. The system favored state-owned enterprises over more dynamic private firms, encouraged collusion between the companies queuing for approval and the IPO reviewers in CSRC, and fostered the under-pricing of IPOs, which ben-efited insiders who could reap spectacular profits when share prices rose in their first day or two of trading. His ultimate goal was to switch to a simple registration system for IPOs, freeing up CSRC’s resources for monitoring and sanctioning listed firms. He did not hesitate to launch mass audits to scare companies into compliance with disclosure standards. Perhaps because of the toes he trod on, he was shuffled out of his job after serving less than two years and sent to Shandong as governor.

Xiao promised “policy continuity” with Guo’s work, and kept his word for a while. Within his first weeks on the job, he cited eight prominent


Miscellany

companies for fraudulent disclosure, and ramped up prosecution of insid-er trading. But in October 2013 Xiao took a populist turn which proved to have fatal consequences. Guo rightly thought the stock market too dan-gerous for small investors, and actively discouraged retail activity. Xiao reversed this policy, pledging in a widely read interview in the Securities Times to make the market safe for small players. By the end of 2013 this vision took form in a State Council opinion which became known as the “National Nine Points.”

Within six months Xiao’s nine points were superseded by another State Council document (creatively nicknamed the “New National Nine Points”). This built on Xi Jinping’s Third Plenum economic reform agenda and called for a vast expan-sion of China’s equity and bond mar-kets to move the country beyond its traditional reliance on bank finance.

In short by the end of his first year in office, Xiao’s remit had expanded from making technical changes in a confined space to helping orchestrate a grand restructuring of China’s entire financial system. He found himself pursuing three agendas at once: Guo’s aim of a cleaner market, his own plan for a market more accessible to small investors, and Xi’s vision of national financial transformation.

What Xiao got right…At first, Xiao made substantial progress. By the end of 2014, he had fulfilled two of the New National Nine Points’ key items: launching the Shanghai-Hong Kong Connect program, which enabled investors in the two cities to access each other’s stock markets; and creating a mechanism for stock delisting.

Xiao then returned to the task of making the market more law-abiding. Cases against insider trading picked up, and procedures for prosecuting fraud were streamlined. In March 2015, CSRC launched an insurance fund to reimburse investor losses from illegal activity, proposed measures to strengthen blacklisting procedures, and issued the first delisting warn-ing. When markets overheated in April and May, Xiao launched a crack-down on insider trading, information fraud, and market manipulation.

The crash in June destroyed the illusion that China’s markets were safe for retail investors. Xiao Gang then turned with renewed vigor to IPO reg-istration reform, Guo’s original priority. Here he was deft and successful,

By the end of his first year, Xiao’s remit had expanded to helping

orchestrate a grand restructuring of China’s entire financial system



getting this reform placed on a fast track, separate from the slow-moving amendment of the Securities Law to which it was originally tied. When he left office, Xiao had laid down a roadmap for the abolition of the old IPO approval system by March 2018 (although this process was put on hold at the latest National People’s Congress meeting in favor of policies supporting market stability).

..and what he got wrongDespite these achievements, Xiao proved inept at balancing technical reforms with the management of market confidence. In other words, he was a progressive technocrat with good ideas for reforming the markets—but as a lifelong bureaucrat, he was utterly clueless about how markets actually operate. This cluelessness was evident in the cascade of policy failures that led to his dismissal: the ramping-up of the stock market bubble in late 2014 and early 2015; the ill-timed and ham-fisted effort to control margin borrowing, which triggered the crash; and finally the misguided “circuit breaker” that was supposed to cut market volatility but instead induced panic selling in China and in stock markets around the world in January 2016.

Whereas Guo made plain his view that China’s markets were unsafe for small and medium-sized investors, Xiao declared strong capital markets a manifestation of the “China Dream” shortly after taking over CSRC. Despite this rhetoric, Xiao remained relatively reticent in talking up the stock market, but he is still culpable for standing back while state media and other officials urged inexperienced investors into the market. Worse still, just days before the market crashed, Xiao asserted to a gathering of party officials that the bull market was unequivocally a result of confi-dence in economic reform.

Having allowed unauthorized channels for leverage to flourish for months and push up stock prices to unreasonable levels, Xiao then moved belatedly and hastily to close them down, with disastrous results. The bull market of 2014-15 was driven by unprecedented levels of borrowing. In the first half of 2015, outstanding margin loans from securities firms doubled to Rmb2trn. Worse, “outside-the-market financing” via trust companies and peer-to-peer lending platforms—which regulators could not easily monitor—also soared.

CSRC did investigate unauthorized channels of margin finance in late 2014 and early 2015, but punitive actions were mild in comparison to those against disclosure fraud and insider trading. In March 2015 Xiao declared to the People’s Daily that leverage was “in general…still under control.”


Miscellany

As the market continued to heat up in April, CSRC re-issued a warning against “financing outside the market.” Given CSRC’s lax attitude until then and the high volume of borrowed funds in the market, most domes-tic observers expected CSRC’s measures to address risks gradually and carefully. But CSRC moved abruptly on June 12, in a multi-pronged move that probably triggered the crash. Brokers were required to thoroughly review and report any instances where their clients might be trading with borrowed funds from unauthorized sources. Share prices fell 40% between June 12 and July 8, with the sell-off halted only after blanket trading freez-es and a massive share-buying program by state agencies.

Electrocuted by the circuit-breakerRegulators initially stood back during the first weeks of the crash, but this changed abruptly with multi-agency intervention orchestrated by Li Keqiang over the weekend of July 4-5. Although Li was the figurehead leading the charge, Xiao oversaw the bulk of the intervention, including organizing a group of brokerages to prop up share prices by buying and holding shares of blue chip companies, pushing the two exchanges to allow several hundred companies to suspend trading of their shares, and forbidding senior managers and large shareholders from selling shares for a period of six months.

The state share purchases stabilized the market, but created another problem: how to enable the state to unload its holdings without caus-ing another collapse in prices. The now infamous “circuit-breaker” rule imposed by CSRC at the beginning of 2016 was designed to solve this problem. It also aimed to ease the task of introducing needed regulatory reforms without triggering market panic each time. A final motivation was to impose market stability so that the National Social Security Fund could safely increase its equity investments.

The circuit-breaker rule automatically suspended trading for 15 min-utes once the main market index moved 5% from its opening level. After trading resumed, the market would shut down for the day if the cumula-tive movement in the index hit 7%.

This completely ignored the dynamics of the Chinese market. First, the permitted volatility was extremely low. The New York Stock Exchange’s circuit-breaker, adopted in 1987, only stops trading once share prices fall by 20%. An inspection of trading data in Shanghai and Shenzhen for 2015 would have revealed that the main index had an intraday move of at least 5% on 25 occasions, and a 7% move in 11 sessions. Properly designed, a circuit-breaker should trip once in a few years, not biweekly.



Second, the circuit-breaker ignored elementary investor psychology. Xiao assumed it would dampen volatility, but in practice it magnified neg-ative sentiment. Once the 15-minute pause ended, traders rushed to sell their shares before the second limit was hit, for fear of being caught out when trading was suspended for the day. After a week of plunging share prices—which spread contagion around the world as global investors feared the stock market turmoil presaged an economic implosion—the circuit-breaker was abolished. A month later, Xiao was dismissed, and replaced by another PBOC lifer, Liu Shiyu.

Fear only government efforts to stop volatilityWhatever his personal limitations, Xiao does not deserve all or even the bulk of the blame for China’s stock market turmoil. He was a competent technocrat with an impossible mandate: free up the markets while guar-anteeing stability of market prices. This in turn points to a fundamental contradiction in Xi Jinping’s reform program. The Third Plenum Decision called for “allowing the market to play a decisive role in the allocation of resources,” yet also reaffirms the “dominant role of the state.” Fearful that unfettered market forces will lead to social instability, state agencies are instructed to guide market outcomes to achieve pre-determined goals and ensure stability.

Capital markets are seen as a panacea for a number of pressing policy problems: corporate fundraising, valuation and restructuring of state-owned assets, and ensuring stable returns on China’s household wealth and retirement savings. Xiao sought to remold CSRC so that it could guide market behavior to facilitate these objectives. When that failed, Xiao had no choice but to restrain markets with sharp administrative controls, even as he continued to work on institutional reforms.

On the surface, policy makers seem to have learned some lessons from the disasters of the past year. They are working to improve coordination and information sharing among the various financial regulators and improve macro-prudential supervision. These moves should deepen the market, improve oversight, and ultimately lead to lower volatility. But there is an enduring risk that the party leadership will always favor an illu-sory stability over real reform, falling back on administrative intervention when markets deliver unwelcome outcomes. Investors have less to fear from China’s natural market volatility than from an endless succession of stopgaps designed to prevent it—which will only exacerbate the market’s casino-like nature and delay its maturation.


China’s Strong Arm: Protecting Citizens and Assets Abroad by Jonas Parello-Plesner and Mathieu Duchâtel

(International Institute for Strategic Studies, 2015)

Do countries march towards great-power status by design, or slip into it by necessity? Usually, it is a bit of each. In China’s case, a moment of necessity that overturned a decades-old design came in in the spring of 2011, as turmoil engulfed Libya. China evacuated more than 35,000 Chi-nese workers from the country by plane, ship, bus and truck. It voted in the UN Security Council to sanction Muammar Gadhafi for mistreatment of his people, and agreed to a second resolution that eventually led to NATO-sponsored regime change.

All a day’s work in the rough-and-tumble arena of international pol-itics, one might think. But for China it signalled a big change: a break with its long-standing principle of “non-interference” in other countries’ internal affairs. Beijing’s uncharacteristic intervention in Libya reflected a hard-nosed reality: 75 Chinese companies had invested an estimated US$18.8bn in the troubled north African state, and it had to protect both its citizens and its assets. Overthrowing another country’s authoritarian leader is not something that China’s authoritarian leaders take lightly, for obvious reasons. But the events in Libya gave them no choice.

As ever more Chinese companies invest abroad and millions of its people move overseas, China is being inexorably pulled, rather against its will, into the messy reality of foreign politics. The inevitable result is a more interventionist foreign policy, as Jonas Parello-Plesner and Mathieu

Tom Miller is editor-at-large of the China Economic Quarterly and author of China’s Urban Billion (Zed Books, 2012).

Books

The End Of Non-InterferenceBy Tom Miller


Tom Miller

Duchâtel argue in this short, clear and useful book published by the secu-rity think tank that convenes the annual Shangri-La Dialogue. China’s greater assertiveness under Xi Jinping is not just an ideological shift under a thrusting leader looking to restore national glory: it is a necessary con-sequence of China’s expanding commercial interests.

Where the companies go…President Jiang Zemin first instructed Chinese firms, led by state-owned enterprises, to “Go Out” into the world in 1999. Since then China’s com-mercial footprint has spread across the globe, with an estimated 5mn nationals living abroad (though Beijing has no clue what the exact number is). Its three national oil companies—Sinopec, CNPC and CNOOC—are the largest overseas investors, often attracted to fragile states where there is less international competition. They are followed by miners and con-struction firms, frequently operating in remote and dangerous regions. The appetite for risky investments, often with explicit state backing, has taken thousands of Chinese laborers to some of the world’s most volatile states: Sudan, Libya, Syria and Pakistan.

No capable or serious state can sit back while its citizens are killed or kidnapped. Chinese policy caught up this reality at the 18th Party Congress in 2012, when “protecting nationals abroad” was finally made a political priority. Earlier that year, 29 Chinese road workers had been held hostage by secessionist rebels in southern Sudan—just one of 33 major attacks on Chinese nationals in 2004-15, according to the authors’ tally. President Xi Jinping has promised to use the power of the Chinese state, including mil-itary force, to keep Chinese citizens safe. A defense white paper published in 2013 stated for the first time that the People’s Liberation Army (PLA) must provide security support for Chinese interests abroad.

The evacuation from Libya during the Arab Spring was by far the most impressive show of China’s strong arm overseas, but it was unusual only in its scale. China has conducted 17 non-combatant evacuations in the past decade. In 2015, two Chinese frigates evacuated 629 Chinese citizens and 279 other foreign nationals from war-torn Yemen—the first time the PLA Navy had conducted such a mission.

…the PLA is sure to followChinese security forces and soldiers have also intervened on foreign soil. The Ministry of Public Security led the hunt for the killers of 13 Chinese sailors in the jungle of southeast Asia’s Golden Triangle in 2011, even though the murders were committed outside China. The investigation


Books

resulted in the extradition, prosecution and execution of a Burmese gang leader in Yunnan, and in Chinese patrols down the Mekong River. In early 2015, Beijing dispatched 700 soldiers to join UN peacekeepers in South Sudan—the first time it had sent combat troops on such a mission. “We have huge interests in South Sudan,” explained the Chinese ambassador in Juba, “so we have to make a greater effort to persuade the two sides to stop fighting and agree to a ceasefire.”

Rather than reflecting a conscious shift in grand strategy, the authors argue, growing Chinese intervention is mostly a reaction to unfolding events. It is in China’s interest to protect its assets abroad, whether it seeks strategic involvement or not. Beijing also feels obliged to respond to vociferous public demands for action, often prodded by nationalis-tic voices on social media. The Min-istry of Foreign Affairs has even received calcium tablets in the post from critics lamenting its failure to show more backbone. President Xi’s shift to a proactive foreign policy is designed to project China as a great power, but it is also a reaction to the reality of what being a great power entails.

Guns along the Belt and RoadThe security risks faced by Chinese workers will only expand as China pursues Xi’s Belt and Road Initiative. Pakistan, where China has pledged to fund US$46bn of investments, is one obvious example. Dozens of Chinese workers and engineers have been targeted in previous terrorist attacks there. Islamabad is training a special security division of 12,000 guards to protect Chinese nationals working on the “China-Pakistan Eco-nomic Corridor,” one of the biggest projects connected to the Silk Road Economic Belt. But Beijing also fears insecurity will spill over the border into its own restive region of Xinjiang. In Pakistan, as in neighboring Afghanistan, China has found it impossible to separate economic and security issues.

China’s economic diplomacy is based on the promise of mutual benefit (“win-win,” as its diplomats never tire of saying). Yet this policy comes under strain when state power breaks down and Chinese interests are threatened. If a massacre of Chinese workers occurred in Pakistan or else-where, Beijing would feel domestic pressure to intervene more directly. History shows that “trade follows the flag”, but also that “the flag follows trade”: British India was a trading colony under the auspices of the East

Growing Chinese intervention is mostly a reaction to

unfolding events


Tom Miller

India Company until the violent uprising of 1857 persuaded the Crown to impose direct rule.

No one is predicting a Chinese Raj, but Beijing’s promise to defend the rights of its citizens abroad means that non-interference is increasingly no longer an option. As economic realities push China towards superpower status, China will have to project political and military muscle across the globe—whether it wants to or not.

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