China: 'Airpocalypse' Now

Authored by Richard Iley of BNP Paribas,

  • China’s growth model, which has delivered an economic miracle over the last 30 years, is increasingly close to exhaustion. Diminishing returns are increasingly evident.
  • A bloated investment share, fed by financial repression and the systematic mispricing of capital, is producing growing resource misallocation and soaring credit dependency.
  • China’s lopsided investment-led growth is also feeding voracious growth in energy demand, particularly coal, which is generating increasingly deleterious environmental consequences.
  • Radical reform of the financial system that has spawned China’s alarming rise in credit and energy dependency over the last decade is the only solution.

China at the point of 'model exhaustion'

China’s economic model, which has delivered a genuine economic miracle over the last 30 years by lifting more people out of poverty than ever before in human history, is increasingly tapped out. While the authorities have been talking about rebalancing the economy since at least 2006, China’s macroeconomic imbalances have become progressively more extreme. The economy now has an investment share of ~48% of GDP, which no other economy has been able to reach, let alone sustain. Unsurprisingly diminishing returns are increasingly apparent.

Gauging the efficiency of investment is difficult, but one approach is to look at so-called incremental capital output ratios (ICORs). Calculated as the investment share divided by GDP growth, China’s ICOR, at over 5x, has been flashing amber for some time, implying that any further increase in the investment share will have next to no impact on GDP growth. Consistent with its ICOR rising to dangerous levels, China’s credit elasticity has soared to levels seen in the US immediately prior to the global financial crisis (see China: Would you credit it?). Consistent with ‘model exhaustion’, credit growth at a c.25% annualised pace over the last six months appears to be producing only a relatively lacklustre recovery by historical standards.

Environmental cost of China's model is high

The corollary of China’s unsustainably rapid investment growth and climbing credit dependency is unsustainably rapid growth in energy consumption and pollution. The media has focused on the suffocating levels of air pollution being experienced by Beijing, where levels of micro-particle pollution have reached over 880 on a scale that supposedly goes up to 500. While Beijing suffers from a number of idiosyncratic problems (sand storms, a ‘bowl’ location), official statistics only peg Beijing as the third-most polluted city in China after Lanzhou and Urumqi.

China’s CO2 emissions have soared since 2002 and at 8.9 billion of tons of oil equivalent in 2011, have surged past those of the US and EU. China’s share of global CO2 emissions (34 billion tons of oil equivalent in 2011) has jumped from 14% in 2002 to over 26%. As is frequently the case with China, its scale is what is makes it so different. The compound growth of its CO2 emissions has slowed to a still frighteningly fast 40% in the five years to 2011 (below India’s 47%). And its economy’s increasing size (it should reach USD 9trn this year) means that it has accounted for a stunning 73% of the increase in global CO2 emissions in the last five years.

China’s pollution problems reflect the fact that the investment-intensive nature of its GDP growth in the last five years has ensured that the energy intensity of per-unit GDP, previously falling, has started to flatten out. China’s strong GDP growth since the global financial crisis has, therefore, produced an huge surge in absolute energy consumption. China’s primary energy consumption has leapt from 1.1 billion tons of oil equivalent a decade ago to over 2.6 billion tons in 2011, much larger than both the US (2.26 billion tons) and the EU (1.69 billion tons).

Increased energy needs largely met with coal

Greatly exacerbating the problem is that China’s sharply rising energy demands continue to be met primarily by coal. While China’s coal dependency was showing signs of falling in the 1990s and the early part of the last decade, the rise in the investment share during the Wen era has seen China’s coal dependency pick back up, with the increase coal consumption accounting for two-thirds of the economy’s increased energy needs in the five years to 2011, for example.

Similarly, China’s coal consumption per unit of GDP has flattened out, breaking the downtrend in place between 1980 and 2002. The net result is that China’s coal consumption has reached extraordinary levels. From 2007 to 2011, it grew 40% to be worth almost 50% of global coal consumption, accounting for a staggering 89% of the increase in global coal consumption over the period. China was still a net exporter of coal as recently as 2008, but 2012 saw it run a coal trade deficit of USD 27.7bn (Chart 4).


And the torrid pace of increased coal consumption shows little sign of abating. Despite 2012’s sluggish 7.8% GDP growth, coal imports rose by more than 105 million tons. Regionally, Indonesia and Australia have been the key beneficiaries, with their coal exports over the last five years rising by around USD 25bn and USD 40bn, respectively.

Explosive investment math ominous

The unsustainable trajectory of China’s development arc has been long understood; that’s why Chinese policymakers have been talking about rebalancing China’s economy since at least 2006. Less well understood is that the imbalances have been getting worse and quite how toxic (literally) Premier Wen’s legacy is likely to prove (see China: ‘Helicopter Wen’ flies off).

We have previously highlighted how if China’s credit growth continues on its current trajectory, China’s total credit market relative to GDP will be on a par with the US’s immediately prior to the global financial crisis. Largely uneconomic investments in sectors already suffering overcapacity, such as real estate and steel, continue to accelerate, fuelling exponential growth in energy consumption and producing increasingly unbearable levels of pollution.

With GDP set to exceed USD 9trn this year, China’s investment share of close to 50% means that without radical reform of its economic model and financial system that pulls back the investment share, the economy will make new investments (ie, the gross flow into the capital stock) of almost USD 20trn in the next four years. While a substantial part of these investments will inevitably be wasteful and, so, depreciate quickly, such a mind-bogglingly large investment flow will inevitably see China’s energy consumption and pollution levels continue to soar.

Policies that address the symptoms, such as energy-reduction targets via curbs on driving and restrictions on factory activity near major cities, are likely to be of limited success unless the root cause of the problem – mispriced capital and the moral hazard created by the belief that the state backstops the entire financial system, whatever its size – is tackled. Despite the long-term gulf between reform rhetoric and concrete action, ‘hype’ at least continues to spring eternal.


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