Monday, February 13, 2006

China: What Next?

Andy Xie (Hong Kong)

*****Overcapacity is causing investment slowdown: I estimate that fixed investment in industries that are experiencing overcapacity contributed 40-50% of GDP growth in 2005. Without other components of the GDP accelerating, China’s economy should slow in 2006.

*****Spending more on infrastructure won’t reverse the trend: The infrastructure areas that can justify more investment account for 4% of total investment, I believe. Spending more there won’t reverse the trend.

*****Stimulating property again could lead to another wave of bad debts: Giving property a second wind is a popular proposal for stimulating the economy. Cutting mortgage rates could boost sentiment. However, it would mostly encourage more speculation. The industry is already swollen and highly speculative.

*****Lifting consumption is hard to do: The main problem for consumption is the low income and wealth of the household sector. To solve the problem, the government could securitize its assets for distribution to the population, which could create a consumption boom for several years. However, vested interests may prevent such a policy change.

Summary & Conclusions

China is running into serious overcapacity. On the demand side, I estimate fixed investment accounted for 58% of China’s GDP growth over 2000-05 and the current account 9%, using revised-up GDP as a benchmark. Of course, on the income side, export growth has accounted for most of the increase that has funded the fixed investment expansion.

Overcapacity is likely to force China to slow down fixed investment. In addition, I expect export growth to slow down to 15% in 2006 from 28% last year due to deceleration in factory relocation. What could sustain China’s high growth rate in 2006?

Property is widely discussed as the best option. China has vast overcapacity in steel and cement. Property is the primary user of both. This is why pushing property has become an attractive option. This sort of planning mentality could create another wave of bad debts, I believe, and cripple China’s economy for years to come.

The signal for a property push would be a cut in mortgage rates. If this were to occur, the market could become euphoric again. I doubt that it would push up physical demand significantly. The disconnect between price and supply is too big to overcome simply via a reduction in mortgage rates. Prices need to come down substantially to clear current supply and support more supply to boost GDP. I think another wave of bad debts would be inevitable from such a bubble push for GDP growth.

Infrastructure is considered an alternative. In terms of its fiscal situation, the government has ample room to stimulate. Infrastructure is overbuilt in most areas already, though. I believe a big push in selected areas (e.g. water and environment) would be worthwhile, but the potential boost from such areas would be insufficient to offset the overcapacity-induced investment slowdown or export deceleration.

Consumption is the alternative that receives the most coverage, but rarely receives serious attention when it comes to policy changes. China’s relatively weak consumption is due to demographics, skewed income and wealth distribution, arbitrary healthcare costs, and high property prices. The government could securitize and distribute government-owned assets to boost consumption quickly. Fixing the healthcare system and maintaining affordable property prices would boost consumption over the long term.

Accounting for GDP Growth

China’s national accounting data are very confusing. The latest revisions make it even more complicated. My suspicion is that the revised total value of GDP is closer to reality than the old value, but is on the high side of the potential range. Rmb18.2 trillion of 2005 GDP no longer underestimates China’s GDP, in my view.

China compiles production data most diligently – a legacy of the planning economy. Demand side data are woefully inadequate. The income side data are missing. I have roughly estimated the various components of China’s national accounts on the demand and income side. In the text below, I provide a breakdown of my methodology in deriving these ‘guesstimates’.

China keeps the most detailed information on production side data. Such data are the most difficult to verify. There are millions of business units in China. The market can check only the accuracy of trends by following selective corporate production data. For example, the decoupling of electricity and industrial production in 1998 was cited as the main evidence of overstatement of GDP growth at that time. On aggregate production data, we have to use whatever is available from the National Statistics Bureau.

On the demand side, China keeps detailed data on fixed investment. Since central or local government has to approve virtually all significant investments, I assume that the data largely reflect reality. I suspect the main inaccuracies relate to the extent to which funds for investment are diverted for consumption. I would not be surprised if this sort of double counting represented as much as 10% of the investment amount. To allow for this, I assume Rmb8.1 trillion for fixed investment in 2005, compared with Rmb8.9 trillion in the monthly fixed investment data series.

I derive a net export figure from my current account (CA) balance estimate. The differences between net exports and the CA balance have been erratic in recent years. The CA surplus was 40% higher than net exports in 2004. This is attributable to hot money inflows disguised as CA items. I estimate the CA surplus reached around Rmb 1.3 trillion in 2005. Considering that hot money inflow slowed substantially in 2005 compared with the year before, I consider a figure of Rmb1 trillion reasonable for net exports in 2005.

The difference between GDP and fixed investment plus net exports is consumption. This number is also relatively simple for most people to estimate – we all have a reasonable feel for our own consumption, and how this compares with the average. Multiplying that by the population is consumption. Rmb9.1 trillion for China’s national consumption feels about right to me. I use the 2004 distribution shares of consumption among urban, rural, and government to divide Rmb9.1 trillion among the three sectors.

The revised production data show that nominal GDP rose from Rmb9.9 trillion to 18.2 trillion between 2000 and 2005. I estimate that fixed investment rose from Rmb3.3 trillion in 2000 to 8.1 trillion in 2005 (accounting for 58% of the GDP growth), while net exports rose from Rmb 224 billion in 2000 to Rmb1 trillion (accounting for 9% of the GDP growth).

On the income side, I identify Rmb3.1 trillion of household savings in household savings deposits, a rise in mortgage downpayments and principal paydown, life insurance and pension assets. Added to household consumption, this implies total household income of Rmb10.2 trillion in 2005. It suggests 30% of household savings deposits, which seems not unreasonable.

Government income is the proceeds that the government uses to consume and invest, of which consumption is Rmb2 trillion and investment about Rmb0.5 trillion. This item is not big in other economies, but is very large in China due to the dominant role of the government in the economy.

Monetization of natural resources is a big part of China’s GDP. Oil, coal, and land are the three big ticket items. The income from these sources usually goes into investment through local government or SoE accounts. I estimate that the profit component through the production chain in monetizing such resources was about Rmb1 trillion in 2005.

Other sources of profits are primarily from state-owned monopolies (e.g., banks, telecom companies, utilities, etc.), export companies, property companies, and foreign owned businesses in the consumer sector. Based on profitability trends in companies’ reported data, I derive very rough profit estimates for these segments in 2005, as follows: the state-owned companies ex-the resource sector probably earned Rmb500 billion last year; exporters saw a net profit margin of about 3% on US$762 bn of exports (i.e. Rmb 185 bn in net profits); property developers probably earned Rmb200 bn, foreign companies in China’s domestic market probably earned Rmb 200 bn, and all other companies probably earned another Rmb200 bn. This produces a total of Rmb1.3 trillion.

The residual of Rmb 3.2 trillion is assigned to depreciation. China invested Rmb27 trillion between 2001 and 2005. The total capital stock for productive purposes is probably over Rmb50 trillion now. On this basis, Rmb3.2 trillion of depreciation would represent about 6% of the productive capital stock. Considering how low the returns on capital are on most investments, 6% seems a reasonable level.

The above estimates are really one man’s efforts. The true data could be off by 5% or even more. However, considering the opaque state of affairs, I think it is better than nothing.

The Growth Gap from Overcapacity

China may have over-invested in manufacturing, electricity generation, highways, ports, and property. These sectors accounted for about three-quarters of growth and 60% of total fixed investment in 2005. Under normal circumstances, overcapacity would lead to price and profit decline, which triggers investment decline. However, as local governments have strong influence over investment funding and are motivated by growing GDP at any cost, overcapacity may cause fixed investment stagnation but not decline.

Stagnation of investment in sectors with overcapacity could still have a serious effect on GDP growth. I estimate that growth of investment in such industries accounted for 40-50% of demand growth in 2005. Without acceleration in other GDP components, China’s economy could experience a significant slowdown, deflationary pressure, and a surging trade surplus.

Various ideas are being mooted as to how to sustain high GDP growth. I discuss three popular ideas below.

Pump-Priming Again

The government’s finances have improved tremendously; the fiscal balance bottomed at 2.6% of GDP in deficit in 2002 and was probably balanced in 2005. The actual improvement is much bigger. Many previously outstanding arrears, such as VAT rebates for imported components and equipment for export production, have been paid off. Fiscal incentives for purchase of domestic equipment have been increased. In short, China is in a good position to engage in fiscal stimulus.

Because personal income tax is quite small in China’s tax revenue (direct taxes such as VAT, business tax, and tariffs account for 63% of tax revenue), cutting tax does not stimulate the economy effectively. ‘Borrow and spend’ could be effective, however.

Increasing infrastructure spending is the policy suggestion that I have heard most. However, it won’t be easy technically. The transportation sector accounts for 40% of infrastructure investment and is already experiencing overcapacity. The container ports, for example, are headed for overcapacity on existing projects, despite rapid trade growth. China already adds more highways every two years than Japan has in total. The utilization rate of highways is low in most provinces. Even the railroads are not as underinvested as many believe. The coal-shipping bottleneck has eased and is likely to be solved for good once the three dedicated rail lines under construction are completed.

The electricity sector has accounted for 90% of investment growth in the utilities sector. According to the National Statistics Bureau, installed capacity reached 500 GW by end 2005, with 300 GW under construction. The amount of capacity under construction is similar to the total capacity in the UK, France, and Germany combined. This sector is headed for a prolonged period of overcapacity, in my view.

Gas and water distribution seem to deserve more investment. These sectors accounted for 1% of total fixed investment in 2005. 3G could increase telecom investment. This sector is less than 2% of total fixed investment. Similarly, rail, at about 1% of total fixed investment, may deserve more investment. These three sectors totalled 4% of total fixed investment. A push there could ease the decelerating trend, but would hardly reverse it.

Second Wind for Property?

Stimulating property is the hottest macro idea in the market at present. The cement and steel industries have massive overcapacity. Property construction needs both. Wouldn’t it be smart to stimulate property again?

Property has become a vast industry that involves all local governments, tens of thousands of property developers, thousands of construction companies, banks, and tens of thousands of materials suppliers. The government reported 18.6% growth in property under construction in November 2005. If that growth rate continued into December, total property under construction would be 1,666 million sq m.

At Rmb 2,759/sq m (the official average selling price in November 2005), the total market value of property under construction would thus be Rmb 4.6 trillion – or 25% of revised-up 2005 GDP.

The property data are not reliable. Local governments have incentives to skew the data in their favor in relation to the central government and potential buyers. The overwhelming incentive is to underreport volume under construction to boost price expectations. It is obvious that property is not selling well in some key cities. But, local officials still report brisk sales. Hence, volume under construction is probably considerably understated.

Understating average selling prices has also become widespread, as the central government has shown displeasure at skyrocketing prices that upset people. However, to entice potential buyers, local governments and property developers must project a picture of skyrocketing prices. This is why the media under the control of local governments or property developers report sensational stories about price rises while the government statistics show low and stable average selling prices.

I would not be surprised if the properties under construction were worth 35% of GDP if all the data were properly adjusted. Even levels of around 25% are associated with economies that subsequently experienced big problems (e.g. Thailand in 1997).

The average selling price of an 80 sq m flat is 8 times average urban household income, on my estimates. In some hot cities, the ratio is as high as 12 times. While such high prices are not unheard of (about 8 times in Hong Kong), the combination of such high prices and high volumes has never happened before. If we take the official data, China was building 1,290 mn sq m of residential properties or about 16 million flats at the end of 2005. That is about 10% of urban households.

The government data still show strong sales of properties. Because this is such a fragmented industry, it is impossible to verify the data. However, it is easy to see the empty buildings in so many cities. In the western cities, the situation is even worse than in the coastal region, I believe.

If China wants to give property a second wind, it could cut mortgage interest rates. China’s mortgages are all floating rate. The interest rate of 5.5% is 3.25% higher than the one-year deposit rate. This sort of spread for mortgage products is unheard of elsewhere. It would seem reasonable to cut mortgage interest rates by one percentage point.

Such a policy decision would certainly lift the property industry, mainly through reviving speculation rather than genuine final demand, I believe. For final demand, the disconnect between price levels and income is the main issue.

Further, it would lead to another wave of borrowing for land speculation. Land purchases have exceeded land under development massively in the last few years. I estimate that purchased land not developed could total 725 mn sq m, 3.6 times the land that went into development in 2005. Anecdotal evidence suggests that land flipping is widespread. Cutting mortgage rates could lead to another wave of bad debts, in my view.

If 725 mn sq m land does go into development, and 80% of it is for residential property, this could result in 25 million more flats. Together with the 16 million already under construction, 41 million flats would be equal to 25% of urban households. We do not know how many sold flats are empty, but a figure of 5 million wouldn’t surprise me.

In my view, giving property a second wind is just an excuse to turn bank loans into revenues for local governments and profits for speculators and leave a wave of bad debts behind for the Chinese population. I am not ruling it out, though. Vested interests may be powerful enough to bring about such a policy shift.

Lifting Consumption

Shifting to a consumption-led growth model has been China’s dream for ten years. The reality, I believe, is that consumption declined to around 50% of GDP in 2005 from 65% in 1995, after taking into account the GDP revisions. There are many technical reasons why China’s consumption is relatively weak. The main political factor is that the Chinese government is too powerful in the economy and too interested in mobilizing resources to invest to show progress.

The household savings rate is about 30%, on my estimates. This is high by international standards, but cannot explain China’s low consumption level. The low share of household income in GDP (56%) could be a more important factor. To boost consumption, then, the government needs to increase household income.

I think the most effective way is to securitize government-owned assets and distribute them among the population. Currently, monetizing natural resources such as coal, oil and land creates income that goes immediately into investment through government-controlled channels. Were these assets owned by the broader population, they could decide how much to consume and how much to save. Such a policy could lead to multi-year consumption boom, in my view.

However, in the past few years, powerful vested interests have emerged to take advantage of government-controlled assets, making pro-consumption reforms difficult. This is why I am not optimistic that China can shift to consumption-led growth.

Declining cyclical savings could naturally lead to a higher share of consumption in GDP. During an economic boom, the prices of natural resources (e.g., coal, oil, and land) surge, which is a tax on household income and shifts money to businesses and government, which are more interested in investment. When the cycle cools and the prices of natural resources decline, the process reverses and household income’s share in GDP rises. Consumption’s share in GDP also rises naturally. However, this sort of cyclical fluctuation does not signal any change in China’s development model.


Post a Comment

<< Home