Having lived in China for almost seven years, I started blogging about China I believe about 4-5 years ago because what I was reading in the popular press was just not representative of what I was seeing on the ground. There were too many important details that were left out.
I actually believe today that the level of understanding on China among interested people, still has a ways to go, but is actually a lot higher than it is given credit for. I still see some people go on major outlets and talk about the Chinese economy with little more than an appreciation for General Tso’s chicken as qualifications, but I think the frequency of this type of “expertise” is falling relatively rapidly.
One of the primary dangers in trying to throw your arms around the Chinese economy is becoming too laser focused. The most obvious example is that most foreigners tend to live in Beijing, Shanghai, and Shenzhen and use that as their window on China. Those three municipalities have 47 million residents, which is a lot but when placed against the backdrop of a country of 1.3 billion that amounts to only 3.6% of China’s population. Just as everyone knows that New York City and San Francisco do not make the United States, it is important to understand the Chinese economy outside these cities. Whenever you see a graph showing housing prices in tier one cities like Beijing, Shanghai, and Shenzhen just remember how small a percentage of the country and even urban areas they really are.
As a professor and data junkie, I also think it is vitally important to add perspective by talking to as many people as possible about what is going on inside the Chinese economy. Both of these points were brought home to me yesterday by a conversation with a businessman friend of mine recently who regularly travels around China. Travelling even less than an hour outside major cities like Shenzhen, you feel like you can step back in time and China is still a developing economy.
He relayed a story to me about a small town he had recently been to with about 250,000 people that had a not insignificant “international” airport and was preparing for high speed rail station. However, his final destination was a town of about 75,000 a little further up the road which also had an “international” airport that was actually larger than actual town. He says if you look the town up on Google Maps, the runway is longer than the city itself.
He proceeded to relay the following story after questioning how on earth all this is being paid for or will pay for itself. One of the local bigwigs in the city of 75,000 in this poor part of China where subsistence farming was still common would drive around town in a new Bentley was also a major construction boss and linked to the government (I didn’t ask details). After securing money to install concrete lined rain ditches all over town, hence the new Bentley, during his last trip to this town my friend saw workmen jack hammering holes into the drainage ditches. Puzzled by this, he asked what the problem was with the ditch. Come to find out, there is no problem at all. However, by destroying what was just built is the surest way to get money to build it again. This nearly matches the old adage about increasing GDP simply by digging holes to refill them over and over again.
My friend, a smart guy who has held senior business positions at major firms, looks at me and says two things of note. First, imagine this problem multiplied by 1.3 billion. I forget which Chinese leader said it, but any small problem multiplied by 1.3 billion is a big problem. What is worse is that these are not small problems. Second, how does this not end in a fireball? This is someone that has worked in China for a number of years with years of senior business experience. As he pointed out, cities are building massive airports for a few flights a day with nearby cities getting airports and high speed rail stations everywhere. He took his family on vacation on a high speed rail to a popular destination for a price that would much too small to cover the costs. You can only continue to lend so much money out for unprofitable projects before you hit a limit.
Carmen Reinhart has a great piece on China’s Incompatible Goals about the impact of debt. Too many people have read her previous work has mechanistically predicting either crises or growth slowdowns. I think this is a serious misreading of what she and others have found about debt. I would recommend reading this piece about how economic slowdowns with calls for monetary stimulus frequently place central banks in positions to allow greater credit growth precisely at moments when bad loans are rising worsening the eventual outcome. China will find it difficult to run accommodative monetary policy and maintain a stable exchange rate. The reason this matters is simple: “banking sector problems have regularly set the stage for currency crashes.” Though I think a financial crisis in China is a low probability outcome, the scenario that scares me is a credit and currency crisis combining forces.
Eric Burroughs also has a good post on what we know about the bad debt in China making a point that many overlook: “what is private sector vs. public sector debt almost doesn’t matter. The state’s hand is everywhere.” Too many, primary foreigners and financial analysts, try to make fine distinctions about debt in China. To onshore investors, there is almost no distinction for most investments. Holding an SOE bond is considered by investors in China as almost equivalent to holding a Beijing bond. Think this is a small, irrelevant point? Junk local government debt is being priced in some cases better than sovereign and many SOE’s enjoy similar pricing as onshore investors believe these companies are equivalent to Beijing. Why does this matter? Beijing will have a hard time credibility wise distancing itself from these companies as they go bust. Before I get messages talking about increasing defaults, note that virtually every default has received some form of a quasi-state led bailout. As is my belief, Beijing will attempt to keep bailing out companies as long as possible because losing credibility is the bigger risk than financial losses.
Finally, the Financial Times has produced a great video on “The End of the Chinese Miracle”.
This is a great piece that combines on the ground reporting with solid academic references about the big pictures structural drivers at play here. In addition to the significant temporal headwinds like rising debt and NPL levels, there are major structural issues like an aging population and falling urban migration.
Probably what I find most amazing in many of the pieces I have cited is how much the discussion on China has shifted. Even among more bullish commentators, the talk is no longer about the poor Chinese economy but rather arguing that China will not face some type of financial crisis or hard landing. The human cost associated with a hard landing or financial crisis would be enormous, but it is clear even Beijing is increasingly worried about the economy and it is not getting resolved any time soon.