China stum­bles try­ing to merge two-track econ­omy

The Pak Banker - - BUSINESS -

There is no bet­ter metaphor for the eco­nomic chal­lenge fac­ing China than the fu­tur­is­tic ar­chi­tec­tural mas­ter­piece de­signed to house the coun­try's state tele­vi­sion net­work, CCTV. A few months be­fore the land­mark build­ing was to be com­pleted in 2009, of­fi­cials at the net­work con­ducted an unau­tho­rised fire­works dis­play, spark­ing a fire that con­sumed a smaller build­ing in the com­plex, a wedge-shaped tower that Bei­jing's res­i­dents had nick­named the ' Ter­mite's Nest'.

The fire de­layed the com­ple­tion of the CCTV head­quar­ters un­til 2012. The Ter­mite's Nest re­mains un­fin­ished and un­oc­cu­pied; its struc­tural in­tegrity was de­stroyed in the fire, and it can­not be torn down for fear of un­der­min­ing its big­ger neigh­bour. The good part of the struc­ture can­not shake off the bur­den of the bad.

The two build­ings re­call China's in­creas­ingly two-tracked econ­omy: a new track based on ser­vices and con­sump­tion bur­dened by an old, slower track made up of in­dus­tries like steel and min­ing, which are in­ef­fi­cient and suf­fer from ex­cess ca­pac­ity. Strad­dling both tracks is the coun­try's real es­tate mar­ket, which is char­ac­terised by mas­sive over­ca­pac­ity in mid-size and smaller cities and ro­bust de­mand in large cities.

The prob­lem is com­pounded by the Chi­nese lead­er­ship's in­sis­tence on stick­ing with high growth tar­gets - 7 per cent at present - and the re­sult­ing re­liance on credit to pro­duce the req­ui­site out­put. Be­cause the credit sys­tem has been de­signed around im­plicit state guar­an­tees, much of the fi­nanc­ing is mis­al­lo­cated to the econ­omy's less ef­fi­cient, highly in­debted sec­tors.

As a re­sult, the foun­da­tions of China's growth mir­a­cle are steadily be­ing eroded by a debt over­hang that shows few signs of re­ced­ing. The gov­ern­ment's loss of con­trol over the econ­omy has be­come in­creas­ingly ev­i­dent. The me­te­oric rise and sub­se­quent crash in the coun­try's stock mar­ket has left in­vestors badly rat­tled. But the real wake-up call has been the be­lated ef­fort to sort out lo­cal gov­ern­ment bor­row­ing and mis­spending.

The Na­tional Au­dit Of­fice's first at­tempt to es­ti­mate the size of lo­cal gov­ern­ment debt un­cov­ered a stock worth 26 per cent of GDP at the end of 2010. A sec­ond ef­fort in mid-2013 re­vealed a fur­ther rise to 32 per cent of GDP. And the latest study by the Chi­nese Academy of So­cial Sciences shows that the debt jumped sharply, to 47.5 per cent of GDP, by the end of 2014.

In Novem­ber 2013, Pres­i­dent Xi Jin­ping laid out a re­form agenda that sought to in­crease the role of the mar­ket in China's econ­omy. This, it was hoped, would solve the cap­i­tal mis­al­lo­ca­tion prob­lem that seemed to be lead­ing to an un­sus­tain­able rise in debt. Lo­cal gov­ern- ment debt be­came a ma­jor test case. In early 2015, the cen­tral gov­ern­ment an­nounced plans to con­vert the lo­cal gov­ern­ments' short-term, high-in­ter­est bank loans into long-term bonds. By in­creas­ing the ma­tu­rity of the debt, the cen­tral gov­ern­ment hoped to al­le­vi­ate fi­nanc­ing con­straints on lo­cal gov­ern­ments and al­low them to pur­sue fi­nan­cial stim­u­lus.

When China's banks balked at ac­cept­ing the low yields of­fered on the new bonds, the goal of in­creas­ing the mar­ket's role in the econ­omy went out the win­dow. The gov­ern­ment forced banks to ex­e­cute the debt swap.

Un­sur­pris­ingly, banks sud­denly be­came risk-averse. Lo­cal gov­ern­ments dis­cov­ered that even with an im­proved liq­uid­ity po­si­tion, banks were re­luc­tant to ex­tend new loans. Mean­while a slump in the real es­tate mar­ket de­prived lo­cal gov­ern­ments of their main rev­enue source: land sales. Thus en­sued one of the more shock­ing de­vel­op­ments in mod­ern Chi­nese eco­nomic pol­i­cy­mak­ing: the gov­ern­ment's call for stim­u­lus was sim­ply ig­nored.

China ap­pears to be fall­ing into a trap that it as­sid­u­ously sought to avoid. The coun­try's debt prob­lem looks set to worsen as the gov­ern­ment ne­glects its re­forms in favour of short-term growth ob­jec­tives. The drag on the econ­omy will in­crease as re­sources con­tinue to be di­verted to­ward keep­ing in­ef­fi­cient firms alive. Banks will be­come ever more riska­verse as they seek to hide bad debts and avoid write-downs.

The gov­ern­ment has sought to in­crease liq­uid­ity by drop­ping con­trols on the move­ment of cap­i­tal. Do­ing so not only fur­ther un­der­mines its con­trol of the econ­omy; it also cre­ates the risk of a full­blown fi­nan­cial cri­sis that could en­gulf its neigh­bours and other emerg­ing mar­kets. For the mo­ment, with the ris­ing dol­lar adding to China's eco­nomic woes as its cur­rency ap­pre­ci­ates sharply against re­gional peers, the author­i­ties have fallen back on old in­stincts by de­valu­ing the cur­rency. That will not be enough. China's prop­erty mar­ket is de­flat­ing. Its eq­uity mar­kets have been dis­cred­ited. And its econ­omy seems in­creas­ingly slug­gish.

As a re­sult, the coun­try's vast pool of do­mes­tic sav­ings is in­creas­ingly look­ing to move abroad. Rel­a­tive to the size of China's for­eign debt and the sheer vol­ume of money that could go abroad, even its $3.7 tril­lion (Dh13.6 tril­lion) in for­eign re­serves starts to look puny. Like ter­mites, debt has a unique ca­pac­ity to make short work of an econ­omy's foun­da­tions. By the time the in­fes­ta­tion is recog­nised, it is of­ten too late. If China is to re­verse the dam­age, it will need to fo­cus on debt delever­ag­ing, re­pair its cap­i­tal al­lo­ca­tion mech­a­nism, and de­lay the abo­li­tion of cap­i­tal con­trols.

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