The unravelling of China’s exceptionalism

MARKETS across the world were given a boost yesterday when the Chinese central bank pumped tonnes of liquidity into the country’s banking system for the second time in a fortnight. The People’s Bank of China injected 265bn yuan (£26bn) into the money market via reverse purchase agreements, adding to the 2.418 trillion yuan offered since the end of June.

This move came at the same time that mining giant Rio Tinto trimmed its growth forecast for China, bringing it to just below 8 per cent, in line with the International Monetary Fund’s (IMF) recently revised forecast. “Significant stimulus efforts have been announced in China, the US and Europe, but it’s uncertain exactly when we will see the impact of these on our markets,” said Rio Tinto chief executive Tom Albanese, as the miner downgraded its outlook.

CHINESE SUGAR DADDY
But the reaction in the world’s markets shows just how much investors are looking to China for salvation. After all, with the US in an economic slump and Europe in turmoil, isn’t the unstoppable growth and strengthening of China the saviour for global markets?

So is China truly exceptional? There is no shortage of high hopes for the People’s Republic. It has been predicted that the renminbi will be completely free floating within a decade, that Hong Kong will overtake New York as a financial centre within two decades, and at the same time, Chinese companies will dominate the Fortune Global 500. But as Michael Pettis, a professor at Peking University’s Guanghua School of Management points out: “The reasons for saying that the Chinese economy will be much stronger than many people currently expect consist largely of citing a series of earlier predictions.” Pettis adds: “Unfortunately, expert predictions are notoriously unreliable, and we seem to be especially bad at predicting turning points.”

HOUSEHOLD TRANSFERS
One of these turning points was supposed to be the Chinese debt crisis of the late 1990s, (which some believe the Chinese simply grew out of). But of course it didn’t. It moved the debt burden to the household sector through local government financial vehicles (LGFV). Though it may have averted a banking crisis, it stamped out already meagre household consumption. Chinese economic data is notoriously unreliable. However, taking a median between the China Regional Financial Operation Report and the National Audit Office’s estimates put the LGFV’s debts, along with other local government debts, in the 12-13 trillion renminbi range (in excess of £1.2 trillion) at the end of 2010 (latest figures).

The Chinese government has done some creative accounting with these numbers. Since these debt programmes are in place to provide better transport infrastructure and better schools, the view is that they will later lead to increased consumption. Therefore, the government justifies that these outlays should be classified as consumption in the first place, boosting Chinese figures, and rebalancing its lopsided growth and investment figures.

MALINVESTMENT
Bulls argue that the Chinese growth model, which has encouraged savings by constraining consumption, means that domestic savings can cover investment. But this misses the point. Crises and severe slowdowns are not created by countries running a current account deficit. Japan did not have a problem meeting external debt when its asset price bubble burst. Nor did its domestic savings exceeded investment.

Rather than financing these infrastructure investments outright, one of the biggest problems at the heart of the Chinese model is malinvestment. At some point, the state-directed investments – whether via LGFVs or other mechanisms – need to pay for themselves. Under China’s creative accounting system, a 10m renminbi investment in a road would be classified as consumption, as it is predicted that it will then increase economic consumption. If it only brings in 5m renminbi of increased economic activity, then this consumption number has been overstated. But due to the predictive, rather than retrospective nature of the Chinese consumption reporting, this shortfall is unaccounted for. And as long as this imbalance is sustained, it will be maintained by further transfers from households via taxation, exacerbating the Chinese growth imbalance.

Whether or not this malinvestment can be supported in the short term, wasting resources is always destructive. If China wants to avoid the twentieth century fates of Japan, Russia, Brazil and Latin America, it needs to find a mechanism, whether market-driven or state-directed, to allow these investments to create wealth, rather than build household debt, flatten consumption and create more ghost cities. And as long as the global economy continues to look to China as the driving force for its recovery, let’s hope that it achieves this economic miracle sometime soon.