Guest Post: This Is The China You Don't Want To Invest In
Submitted by Zarathustra of Also Sprach Analyst,
One used to describe how the Chinese economy is like (exactly who started saying that is no longer clear): a bicycle.
Anyone with the experience of riding a bicycle knows that you can’t ride it too slowly, or else you fall over. There was a common belief that China has to grow at least at 8% annual rate (now the number seems to have come down to 7.5%), or there will not be enough jobs being created so that there will be social unrest, that kind of thing.
We are not sure if we have ever had much faith in such theory. To our mind, the society has something seriously wrong if it requires 8% or more economic growth in order to keep it stable. And if this is true for China, the Chinese society is very wrong indeed (or perhaps the Chinese society has been seriously wrong with or without this implicit 8% requirement).
Now, the Chinese government is now worried about growth (we won’t speculate if the government is panicking or not). First, Premier Wen said growth has become a priority. Now, Premier Wen said it is important to “ensure reasonable growth of investment”. Remember that last month, as we noted obvious changes in languages regarding future economic policy, we pointed out that the Chinese government could have very well given up on rebalancing the economy from investment driven to consumption driven in hope to reflate the economy. So with Premier Wen making such comment, perhaps it is now official that the Chinese government has already given up.
If China wants to maintain high growth to eternity, it is possible theoretically even though it is not very realistic, because it requires the government to do things that have been done before, and have been widely regarded as wrong.
Because the government controls the issuance of the currency, there should theoretically be no budgetary constraint. So the government can spend and invest very heavily into eternity either directly or via state-owned enterprises even though there is nothing that China really needs but have not already had. In other words, investment will be done regardless of the expected return. To fund that, the government (including state-owned companies for the purpose of argument) borrow either from state-owned banks (while force banks to lend) or from the bond market (for the purpose of the current discussion, let us just say that both ways of financing are more or less the same). Money supply has to grow at some crazy numbers, and M2 will probably double every 2 or 3 years, and Chinese Yuan will depreciate substantially (there is a running joke among China sceptics that Bernanke is only an amateur when it comes to money printing. After all, Chinese invented paper, printing, and paper money). But because this implies ever more over-capacity in the economy, inflation could be surprisingly low. At the end, GDP will grow by 8% in Chinese Yuan term, and nothing disastrous would seem to have happened to majority of Chinese people (or maybe not).
If China can indeed create as much output as the government wish (at least in local currency terms), does it mean that China is fine? Does it make the case for investing in China stronger?
FT Alphaville points us to this piece of research from Colonial First State, which is, quite frankly, rubbish. It does not seem to worth the time to refute every false claim that research has written about, simply because there are too many, so we would just pick on one thing.
In here, the author of that research seems to think that high investment with low return or even negative return is fine, partly because:
By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards.
|China is not Europe, surely…|
The first bit about “improves allocation of capital” is something totally absurd (when was the last time you hear anyone said that “the state allocates capital better than the market?”), while the second point about raising living standards is actually correct in some way. To clarify, the process of having government directing money into fixed-asset investments, possibly through state-owned enterprises and/or local governments, no matter how useless they are (i.e. how low returns are), means that those money being spent are included in the GDP calculation. In an economy, expenditure of one sector is the income for another sector, so by channelling money into railroads constructions, for example, the government is raising the income level of construction workers who would otherwise be unemployed, commodities producers who would otherwise have massive unsold inventory, and probably restaurant owners that serve those construction workers, etc. In that sense, it improves people’s lives for that given period.
On the other hand, investing a huge amount of money into something with very low return is destroying wealth. Let us say that a state-owned real estate developer invested a huge amount of money into a large-scale residential development. Despite being sold out, most of these flats were not occupied nor let out. These assets are generating no return, thus they are next to worthless. The real estate developer was lucky to have sold them all, but those buyers would have bought something with huge amount of money which turned out to be worthless. This is by no means the only scenario. The real estate developer in question could very well be unable to sell, and being drowned in debt. To speak more formally, if a country is directing resources into investing something that cannot generate return in excess of the cost of funding, the country as a whole will be destroying economic value even though the country is generating GDP.
Because of overcapacity, the private corporate sector will probably not invest and have very low level of profit (if not close to zero as a whole), leaving the state-owned sector and local governments the only agents that will borrow and invest. The process of directing state-owned corporate sector to borrow and invest will generate output or GDP, but they will create even more capacity, leading to ever diminishing return. At the end, corporate profit (state-owned and private sectors combined) will fall to zero, if not negative.
If the author of the research is trying to make the point that China can still grow regardless of diminishing return on capital, what the point exactly is he trying to make for investors in, for example, Chinese equities? If the above scenario that corporate profit will fall to zero is true, why should any one care if GDP growth can hit 8%? In fact, he seems to acknowledge the fact that Chinese equities have been doing extremely badly compared to the peers. So why should we care?
To be clear, we are sceptical about whether China can really hit 7-8% growth in the longer run, and we are more comfortable with a long-term growth of 3% per annum. But even if we are wrong in being too bearish on China’s future GDP growth, and that China successfully reflate its economy to 7-8% growth, we are genuinely not impressed if that is going to mean even lower return on investment and even lower corporate profit. That means we have come to an uncomfortable conclusion that China is just not the place we would like to be in, regardless of GDP growth.