W(h)ither China? "The End Of Extrapolation"

On November 5, just as the 18th Chinese Congress was about to elect a leadership that would merely perpetuate the status quo, in "The Chinese Credit Bubble - Full Frontal" we presented a little known fact: namely that while China's sovereign debt is whatever the country wishes it to be (which due to the SOE basis of its banks is really a hybrid of sovereign and financial debt), one bubble that the country can not hide is that of its corporate debt level, which has hit the highest relative to GDP level in the enitre world.

Ten days later Businessweek followed up with "Corporate China's Black Hole of Debt", which contained the following replica chart:

And so the cat of China's real debt bubble is out of the bag and out for general consumption. Yet as promptly as it appeared, it was forgotten, as a desperate for any favorable economic news punditry has ignored the fact that economic data coming out of China is merely for propaganda purposes and consumption by the gullible (not our words, they belong to China's current Vice Premier and the man who will soon take the post of Premier, Li Keqiang, who 5 years ago said that "China's GDP figures are "man-made" and therefore unreliable...[most] figures, especially GDP statistics, are 'for reference only,' he said smiling."), and has latched on to the prior month of modestly more favorable, "rebounding" economic statistics.

As UBS George Magnus says, "Many people think the downswing has now ended, pointing to slightly feistier data in September and October for industrial production, fixed asset investment, retail sales, and exports, continued high levels of total social financing, and a renewed rise in corporate leverage." The trivial rebound will soon end but a far bigger problem will then reemerge: "the short-term outlook for growth pales into significance against the view that China will continue to grow at 7-8.5% for the foreseeable future."

And herein lies the rub: because while China is currently experiencing a brief dead cat bounce, a far greater question remains open: can China reverse its declining GDP growth rate and continue growing at what most realists now perceive as an unsustainable pace. Says Magnus in attempting to provide an answer: "This [...] rests on three critical but questionable propositions: political will and capacity, the insensitivity of consumption to the investment outlook, and the nature of rebalancing, itself."

Magnus then proceeds to share his vision of whether China can "rise above" the reality of an economy forced to transition from investment driven to one of consumption: a vision which is the topic of his latest paper titled "China: the end of extrapolation."

In short, his answer (which at 11 single-spaced pages is hardly short) is that the party in China has ended. Of course, he is far more diplomatic:

After a decade or more of turbo-charged growth, the economic model that drove it has led to deep imbalances, especially as regards the investment and consumption shares of GDP, significant increases in both the investment- and credit-intensity of GDP growth, and the distribution of income between profits and wages. A host of institutional, monetary, financial, tax and other fiscal arrangements has been developed to support this economic model. As we will explain below, changing this model has become of paramount importance if China is to avoid a disruptive bust in investment in the next 1-2 years, and lapse into a middle income trap in the medium-term. A change is all the more important as China’s competitive advantages in the global economy are slowly being chipped away by rising wage and labour cost pressures at home, and the development of cheap energy and new lower-cost, advanced manufacturing technologies in the US, South Korea and other OECD countries.

The biggest issue for a largely welfare safety-net free China has been balancing economic growth with broad prosperity. Focusing just on one, can and will promptly lead to social instability and "rising pressure":

Social pressures have continued to build with respect to income inequality, corruption, living and working conditions of migrant workers, miscarriages of justice and ‘land grabs’ by local government officials, and air and water quality and environmental degradation. According to one Chinese sociologist, the number of incidents of unrest may have been of the order of 180,000 in 2010.

So China has to keep growing at the required pace of 7%+ to keep the population mostly satisfied. But how, now that as noted above, the "turbo-charged" growth period is over. And how when the new Chinese Politburo leaders are even more conservative than the old ones, and even less willing to force the much required transition from an investment-driven to a consumption-led model.

The first proposition, following on from the political economy issues discussed above, is that the government has the political will and capacity to introduce reforms that lead to both a sharp fall in the investment share of GDP, and a roughly equivalent rise in the consumption share by strengthening or introducing important adjustment mechanisms discussed earlier. But we don’t know yet how strong the climate for reform in China is, even though there is a popular feeling that things can’t carry on as before. Some initiatives of political reform, aimed at restoring trust in the Party by curbing corruption and ‘purifying’ the Party so as to prevent the abuse of power for personal gain, certainly seem likely. More radical political reform, though, doesn’t look likely.




This raises questions about the wider significance of rebalancing, which means reforms that would abandon the key drivers of the ‘old model’, including wage rises significantly below productivity growth, repressed interest rates, a managed exchange rate, and other subdued factor prices, that is, of land, water, energy, and importantly, of capital. There is little question that, over a decade and more, a correction of repressed factor prices, money and capital especially, would help to generate the resource shift needed to drive a more household- and private enterprise-oriented economy, and strengthen resource allocation, efficiency, innovation and total factor productivity. We can be hopeful that China’s new leaders will reform gradually in this direction. But intent will count for little in the face of inertia or a concerted push-back or resistance from others in the Party and the state apparatus, and it may be prudent to remain cautious. Remember that fundamental economic reforms are all about politics that are highly controversial and could, in some respects perhaps, prove to be of existential significance to the Party.

So while politics is certainly the primary consideration for what is still largely a centrally-planned economy, an even bigger concern may be simple math.

The maths are problematic. If investment is 50% of GDP and the growth rate falls from 15% to say, 5% per annum, consumption growth has to accelerate from about 8% to an unprecedented 12% per annum or so if the underlying GDP growth rate is to stay at 7.5%. You can do the maths of alternative scenarios at leisure, but the bottom line is that rebalancing requires investment to grow more slowly than GDP, and consumption significantly faster over an extended period of time. Otherwise the model isn’t changing.


The more structural reason is that the mechanisms that would allow consumer spending to strengthen further don’t yet exist, and would, in any event, compromise the legacy sources of economic growth that have generated structural imbalances in the first place. For example, higher wages dent corporate profits and investment; higher interest rates and a stronger exchange rate help consumers, but to the disadvantage of companies, whose debt-servicing capacity would be compromised; pro-household tax, income and social security reforms have to be financed, one way or another, by companies, or the government.


The issue, specifically in China, is more about the speed of capital accumulation, and misallocation of capital, given that, uniquely, the investment share of GDP has been in a range of 40-50% for about a decade now. Roughly two-thirds of the stock of capital has been built in the last decade, and half of infrastructure investment since 2000, for example, has been in transportation projects, many of which serve the same objectives, and must, for a while at least, be redundant or not viable commercially.15 And while total factor productivity growth, which is a  measure of the efficiency of capital and labour utilisation, did rise strongly during the 2000s to about 4% per annum as the pre-imbalances  apex boom gathered momentum, it has fallen back to around 2% per annum since.

But perhaps the biggest concern is the one that needs no introduction on this website, and is always summarized simply in what is the real four letter word: debt.

It is well known that China has experienced strong credit expansion. The growth in regular RMB loans by banks may have slowed down from about 35% in 2009, to a more modest 15% since the middle of 2011, but these loans capture only half of China’s credit creation. Total social financing includes also a number of informal financing arrangements, including commercial bills, trust and entrusted loans, other trust assets and corporate bonds not held by banks. The last item, in particular has been growing rapidly, reaching a record RMB 300bn in October 2012. The different definitions of credit creation are shown in the following chart, which comes from a research note by UBS China economist, Tao Wang.


The chart differentiates between regular bank loans, the total of bank credit and off-balance sheet credit, and total credit in the economy. As  hown, the broadest credit share of GDP has grown from about 150% in 2007 to around 200% in the last 5 years, quite unprecedented for a country of China’s size.


The rising credit intensity in the economy is also evident in the changes in the relationship between total social financing and GDP. Between 2002 when the former data start and 2007, credit outstanding grew by RMB17 trillion, compared with a rise in GDP of RMB14.5 trillion, a ratio of 1.2, but since then, credit has soared by nearly RMB61 trillion, compared to a rise in GDP of RMB25.5 trillion, or a ratio of 2..


The biggest expansion in debt financing has occurred in the corporate sector. Chinese companies’ debt ratios have risen to join some of the most indebted corporate sectors in major countries, according to Li Yang, vice-president of the Chinese Academy of Social Sciences.19 At 107%, the ratio is right up there with those of the US, Canada, France and the Eurozone, though the standardised OECD ratios may not accord to Li Yang’s definition. But he noted the recent BIS warning that corporate debt levels over 90% of GDP make companies increasingly sensitive to changes in income and interest rates, financial fragility and default risk. These things are liable to weigh on SOEs and other companies, as GDP growth slows, profits and cash flows weaken and in the wake of expected financial liberalisation. And, inevitably, tougher times for  orrowers mean tougher times for banks. Most people doubt the officially estimated 0.97% is a realistic number, and higher loan losses are inevitable. China is better equipped financially than most to deal with banking sector loan loss or recapitalisation issues. The point, though, is that someone has to pay: the cost is almost bound to fall on the household sector, one way or another, and so where does that leave rebalancing?

Most ominously, however, is the realization that China too is now engaging in the developed world's favorite pastime, simply known as "kicking the can".

Unfortunately, it isn’t really possible for us, or more to the point, China’s government, to know precisely where the country stands in this  process, any more than people were able to gauge where the West was in 2006, for example. A Chinese Minsky Moment, to coin another phrase, may not be imminent. In a highly managed economy with dominant state industrial and banking sectors, the state can deploy policies, and sources of finance to minimise cyclical fluctuations (as now), helping to sustain the status quo and lowering perceptions of risk. But this is the equivalent of ‘kicking the can’ at the risk of a harsher and more disruptive adjustment later

Finally, Magnus on what happens if instead of the hoped for 8% trendline growth, China can at best muster half of the previous 10% growth rate:

The incremental changes in economic rebalancing, and gradual deceleration in investment spending, which are implicit in the extrapolations of 7-8% GDP growth, don’t stack up for this scribe. A more significant fall to 5% over the coming decade – to pick a number – need not be the cataclysm that springs to mind, unless you’re a dyed-in-the-wool industrial commodities and commodity currency bull.... A halving of China’s superlative growth rate would still see GDP double by 2027, and continue to converge on the US. And since we can imagine China’s citizens care more about living standards than GDP, a change in the economic model and in its incentive systems need not be threatening, if the process is managed well and in a timely fashion. But there’s an unfortunate truth about changing your development model, which is that when you get to the point of having to do so, sustainable and stable growth and prosperity are about politics, institutions and legitimacy. You have reached the end of extrapolation.

Much more in the full paper below, which is a perceptive analysis to be sure, but really one which puts into words what the simple chart at the very top of this article succinctly summarizes without a single word: that the age of credit-driven expansion is over, in the entire developed world, as well as in China, as China too succumbs to the tractor beam of peak consolidated (or is that fungible?) leverage. Because without the ability to create any more debt, and thus money, out of thin air without the threat of an ensuing debt delinquency, discharge and default avalanche, there is no more growth.

Full George Magnus paper on China: