A Great Leap Forward? Making sense of China’s cooling credit boom
On Monday 27th July 2015, the Shanghai stock market dived 8.5% despite the Chinese government’s attempt at intervention. Commodity prices also continued to fall in fear that the Chinese economy, which has fueled global demand for raw materials in recent years, was slowing down faster than expected. On Friday 31st July 2015, Beijing was awarded the Winter Olympics in 2022, making it the first city to host the summer and winter versions of the games. This despite a round of protests by human rights associations against the recent Government detentions of human rights lawyers on the Mainland.
Thankfully, it was against this background of contemporary events that I finished reading “A Great Leap Forward?”, a collection of essays from top China-watchers brought together by John Maudlin and Worth Ray which offers a useful insight into what is going on in China at the moment.
Essentially, the essayists divide into two opposing camps: (1) The Pessimists - who think that China is about to follow in Japan’s foot-steps and go bust, after years of unprecedented and unsustainable debt fueled growth; and (2) The Optimists - who suggest that instead, China will slow to a healthier, lower and more sustainable growth rate of around 4%, but in so doing achieve a successful re-balancing of its growth model, away from one driven primarily by credit-dependent infrastructure and property investment, to a consumer demand driven model focused on services and technological innovation.
The Pessimists
Those in the “hard” landing camp, focus on the performance of the Chinese economy since 2008. When the Global Financial Crisis tipped the rest of the world into recession, the Chinese government stepped in to stop this from happening in the Middle Kingdom, forcing state-controlled banks to lend and local governments and state-backed companies to borrow for the purpose of financing a multitude of domestic infrastructure and construction developments. This, in turn, fueled a property bubble but kept GDP growth at the Government’s target 8% level.
Because of the Chinese Government’s success in this respect, certain commentators began to question the Washington Consensus, which had it that capitalism and democracy was the only way for countries to make the step from developing to developed. Instead, such commentators started to vaunt the China-model of state capitalism, where the volatility and greater prospects of social unrest in a capitalist economy were ameliorated by the greater role played by the state in controlling the manner in which the capitalist economy develops.
According the pessimistic essayists, these commentators are, however, about to be proved wrong in no uncertain terms. The cost of China avoiding a slow-down since 2008, has been enormous. This credit-driven growth model has seen China’s banking assets grow by US$17 trillion since 2008, while nominal GDP has grown by US$4 trillion. In this short period of time, China has added the equivalent of 20% of global GDP to its banking assets (or the equivalent of the entirety of the assets in the US banking system); a phenomenal amount by any standards.
If this growth model were to continue to deliver the new target GDP rate of 7%, it would require 4 yuan of new credit to create every 1 yuan in GDP. This would see outstanding debt continuing to expand at nearly twice the rate of GDP, so that the debt to GDP ratio would double again by 2022. There is no way this can continue.
The alternative of managing the amount of debt downwards, however, is impossible. The fragility of the system at the moment means that any attempt by the Government to slow GDP growth by managing credit down, will trigger a collapse – witness the 8.5% drop on the Shanghai stock market as an example. Instead, therefore, the likelihood is that the Government will continue to deliver its target growth rates because not to do so will be political suicide. Hence, credit fueled infrastructure projects will continue (delivering the Winter Olympics has assisted in this respect), and the tough steps the Government should instead be taking will be kicked down the road to a time when it’s too late. At that time, bust will follow boom as inevitably as night follows day.
That then is the pessimistic view, the greatest proponent of which you will find in the essay and interview with Raoul Paul.
The Optimistic viewpoint
On the optimists side we find David Goldman, who argues that social conditions in Chinese society are the same seem in Europe in 1815, when that continent embarked on a mass flourishing and an epoch of economic expansion driven by the technological entrepreneurialism of the industrial revolution. Whilst the industrial revolution was driven by scientific advances, however, these advances were achieved by ordinary members of society seeking to break the mould in the industries in which they worked. Men like Arkwright, an ordinary wig-maker who invented the water-powered spinning frame.
Inventors such as Arkwright were representative of a culture that protected and inspired individuality, imagination, understanding and self-expression; a culture which drove one nation’s (Great Britain’s) indigenous innovation. The same building blocks for this culture are, in Goldman’s view, evident in Chinese modern-day society now.
Essentially, China is still emerging from an era in which conformity was imposed top down by the Cultural Revolution, to an era where entrepreneurialism is not just permitted but positively encouraged. This emergence is characterized by the unleashing of a drive for innovation, embodied by entrepreneurs like Ali-baba’s Jack Ma, Tencent’s Ma Huateng and Huawei’s Ren Zhengfei, each of whose companies are shaking the foundations of the world. Further, as a late-adopter, China is able to jump straight to the front of the queue of the wireless revolution, rather than waiting until its fibre optic technology (defended by vested interest) is rendered completely obsolete. Witness the fact that the Middle Kingdom has the largest number of internet users in the world at 640 million, with penetration being still only 46%, below the US’s 83%. Further, by 2020 all Chinese cities will have free Wifi. Witness also how technology companies are disrupting other traditional service sectors, like Ali-baba which has married up its distribution network with financial services, offering savings accounts at rates that outdo banks.
This explosion of innovation coupled with the entrepreneurial potential of China’s population, will not only enable Xi Jinping to rebalance the economy away from credit fueled infrastructure investment in favour of high value services and consumption driven growth, but it will also allow China to leapfrog its more developed peers in the greatest economic transformation in modern history.
Food for thought all round, then!
Who, then, is right?
Seeing what is happening in China’s stock markets at the moment, it seems that the pessimistic view is rightly gaining the upper hand. That said, with China’s backing of the Asian Infrastructure Investment Bank and its Silk Road initiative, the China government is trying to fuel export demand for Chinese construction companies to keep growth ticking over just enough, so as to give time to the technology revolution which will eventually create the consumer demand led growth model, to gather pace. The same role will be played by the Winter Olympics project, no doubt.
What is abundantly clear from these essays, however, is that the China government has an incredibly difficult path to steer. There is certainly fragility in the system and limits to what a Government can do. Were I betting man, therefore, I’d back the pessimists (which include fund managers that explain how they are shorting the China market at the moment). One can only hope, however, that these pessimists are wrong and that China does successfully navigate the tricky path to a slower, but healthier growth model. Otherwise, the negative consequences for the world economy would be enormous.
Though heavy on economic jargon and analysis in some places, this book is a must read for anyone interested in China; which given her impact on the world, should be everybody!
Thankfully, it was against this background of contemporary events that I finished reading “A Great Leap Forward?”, a collection of essays from top China-watchers brought together by John Maudlin and Worth Ray which offers a useful insight into what is going on in China at the moment.
Essentially, the essayists divide into two opposing camps: (1) The Pessimists - who think that China is about to follow in Japan’s foot-steps and go bust, after years of unprecedented and unsustainable debt fueled growth; and (2) The Optimists - who suggest that instead, China will slow to a healthier, lower and more sustainable growth rate of around 4%, but in so doing achieve a successful re-balancing of its growth model, away from one driven primarily by credit-dependent infrastructure and property investment, to a consumer demand driven model focused on services and technological innovation.
The Pessimists
Those in the “hard” landing camp, focus on the performance of the Chinese economy since 2008. When the Global Financial Crisis tipped the rest of the world into recession, the Chinese government stepped in to stop this from happening in the Middle Kingdom, forcing state-controlled banks to lend and local governments and state-backed companies to borrow for the purpose of financing a multitude of domestic infrastructure and construction developments. This, in turn, fueled a property bubble but kept GDP growth at the Government’s target 8% level.
Because of the Chinese Government’s success in this respect, certain commentators began to question the Washington Consensus, which had it that capitalism and democracy was the only way for countries to make the step from developing to developed. Instead, such commentators started to vaunt the China-model of state capitalism, where the volatility and greater prospects of social unrest in a capitalist economy were ameliorated by the greater role played by the state in controlling the manner in which the capitalist economy develops.
According the pessimistic essayists, these commentators are, however, about to be proved wrong in no uncertain terms. The cost of China avoiding a slow-down since 2008, has been enormous. This credit-driven growth model has seen China’s banking assets grow by US$17 trillion since 2008, while nominal GDP has grown by US$4 trillion. In this short period of time, China has added the equivalent of 20% of global GDP to its banking assets (or the equivalent of the entirety of the assets in the US banking system); a phenomenal amount by any standards.
If this growth model were to continue to deliver the new target GDP rate of 7%, it would require 4 yuan of new credit to create every 1 yuan in GDP. This would see outstanding debt continuing to expand at nearly twice the rate of GDP, so that the debt to GDP ratio would double again by 2022. There is no way this can continue.
The alternative of managing the amount of debt downwards, however, is impossible. The fragility of the system at the moment means that any attempt by the Government to slow GDP growth by managing credit down, will trigger a collapse – witness the 8.5% drop on the Shanghai stock market as an example. Instead, therefore, the likelihood is that the Government will continue to deliver its target growth rates because not to do so will be political suicide. Hence, credit fueled infrastructure projects will continue (delivering the Winter Olympics has assisted in this respect), and the tough steps the Government should instead be taking will be kicked down the road to a time when it’s too late. At that time, bust will follow boom as inevitably as night follows day.
That then is the pessimistic view, the greatest proponent of which you will find in the essay and interview with Raoul Paul.
The Optimistic viewpoint
On the optimists side we find David Goldman, who argues that social conditions in Chinese society are the same seem in Europe in 1815, when that continent embarked on a mass flourishing and an epoch of economic expansion driven by the technological entrepreneurialism of the industrial revolution. Whilst the industrial revolution was driven by scientific advances, however, these advances were achieved by ordinary members of society seeking to break the mould in the industries in which they worked. Men like Arkwright, an ordinary wig-maker who invented the water-powered spinning frame.
Inventors such as Arkwright were representative of a culture that protected and inspired individuality, imagination, understanding and self-expression; a culture which drove one nation’s (Great Britain’s) indigenous innovation. The same building blocks for this culture are, in Goldman’s view, evident in Chinese modern-day society now.
Essentially, China is still emerging from an era in which conformity was imposed top down by the Cultural Revolution, to an era where entrepreneurialism is not just permitted but positively encouraged. This emergence is characterized by the unleashing of a drive for innovation, embodied by entrepreneurs like Ali-baba’s Jack Ma, Tencent’s Ma Huateng and Huawei’s Ren Zhengfei, each of whose companies are shaking the foundations of the world. Further, as a late-adopter, China is able to jump straight to the front of the queue of the wireless revolution, rather than waiting until its fibre optic technology (defended by vested interest) is rendered completely obsolete. Witness the fact that the Middle Kingdom has the largest number of internet users in the world at 640 million, with penetration being still only 46%, below the US’s 83%. Further, by 2020 all Chinese cities will have free Wifi. Witness also how technology companies are disrupting other traditional service sectors, like Ali-baba which has married up its distribution network with financial services, offering savings accounts at rates that outdo banks.
This explosion of innovation coupled with the entrepreneurial potential of China’s population, will not only enable Xi Jinping to rebalance the economy away from credit fueled infrastructure investment in favour of high value services and consumption driven growth, but it will also allow China to leapfrog its more developed peers in the greatest economic transformation in modern history.
Food for thought all round, then!
Who, then, is right?
Seeing what is happening in China’s stock markets at the moment, it seems that the pessimistic view is rightly gaining the upper hand. That said, with China’s backing of the Asian Infrastructure Investment Bank and its Silk Road initiative, the China government is trying to fuel export demand for Chinese construction companies to keep growth ticking over just enough, so as to give time to the technology revolution which will eventually create the consumer demand led growth model, to gather pace. The same role will be played by the Winter Olympics project, no doubt.
What is abundantly clear from these essays, however, is that the China government has an incredibly difficult path to steer. There is certainly fragility in the system and limits to what a Government can do. Were I betting man, therefore, I’d back the pessimists (which include fund managers that explain how they are shorting the China market at the moment). One can only hope, however, that these pessimists are wrong and that China does successfully navigate the tricky path to a slower, but healthier growth model. Otherwise, the negative consequences for the world economy would be enormous.
Though heavy on economic jargon and analysis in some places, this book is a must read for anyone interested in China; which given her impact on the world, should be everybody!
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