[Debate] (Fwd) China's 'End Game' (Dee Woo)

Patrick Bond pbond at mail.ngo.za
Mon Jul 16 11:45:01 BST 2012 

(Don't know Dee Woo or his tradition, which is associated with Forbes... 
but his charts are chilling.)


  *China's End Game, the dark side of a great deleveraging *

Economics <http://www.marketoracle.co.uk/Topic6.html> / China Economy 
<http://www.marketoracle.co.uk/Category86-All.html> Jul 15, 2012 - 10:20 AM

By: Dee_Woo <http://www.marketoracle.co.uk/UserInfo-Dee_Woo.html>

Economics <http://www.marketoracle.co.uk/Topic6.html>

*1. The **frustrated and aggressive**central bank***

If one wants to know how bad the health of China's economy has gone, 
look no further than PBOC's composure, which seems rather frustrated and 
aggressive as of late. On 5th July, the central bank cut benchmark 
interest rates for the 2nd time in less than a month. This happened 
right after the fact that in December 2011, PBOC cut the reserve 
requirement ratio(RRR) by a 50 bp to 21%, it followed up with another 50 
bp in February and another 50 bp in May to 20% currently.

On top of all the rate cuts, PBOC also made its biggest injection of 
funds into the money market in nearly six months. PBOC injected a net 
225 billion yuan ($34.5 billion) through the reverse-repurchase 
operations(repo) on last Tuesday and Friday, following a combined 
injection of 291 billion yuan in the previous four weeks.

2. The systematic short-circuit of debt financing's in order

So why PBOC is in such an urge to open the floodgate of liquidity?This 
economist will spare you the boredom of looking at the diagrams of 
China's economic misery: HSBC PMI, etc, since you were bombardedwiththis 
type ofeye candies everywhere else on the web. Let me cut to the chase: 
However high it aims, PBOC's action in practice merely work as the 
monetary band aid forthe bleeding economy. But it won't fix it. The 
central bank's aggressive pro-liquidity maneuvers at best serve to 
sustain the over-leveraged economy and avoid the systematic 
short-circuit of debt financing. Nowallow me to divulge:

The main drivers of China's debt financing,China's state-owned banks, 
are starving for cash. According to Citigroup 
<http://imcmsimages.mediacorp.sg/CMSFileserver/documents/006/PDF/20120425/2504HNP008.pdf><http://imcmsimages.mediacorp.sg/CMSFileserver/documents/006/PDF/20120425/2504HNP008.pdf>estimates 
<http://imcmsimages.mediacorp.sg/CMSFileserver/documents/006/PDF/20120425/2504HNP008.pdf>, 
in 2011 seven of the biggest Chinese banks raised 323.8 billion renminbi 
($51.4 billion) of new funds. Several financial firms are expected to 
raise another $17.7 billion in the next few months, with China's 
fifth-biggest lender, the Bank of Communications, accounting for $9 
billion. The unprecedented lending binge encouraged by the central 
government,increasingly rigorous requirement of regulatory capital and 
excruciating continuanceof excessive dividend payouts haverendered the 
most-profitable banks in the world--Chinese banks--in a rather 
precarious position.GaveKal <http://gavekal.com/c/>' 
<http://gavekal.com/c/>s 
<http://gavekal.com/c/><http://gavekal.com/c/>data 
<http://gavekal.com/c/>will illustrate this is no exaggeration: In 2010, 
China's five biggest banks --- the Big Four plus the Bank of 
Communications --- paid more than 144 billion yuan in dividends while 
raising more than 199 billion yuan on the capital markets. The 
ballooning balance sheet drivenby the loan frenzy and strict capital 
requirement make China's banks' cash-craving burning at both ends:this 
march, China's big four--- Industrial and Commercial Bank of China, the 
Bank of China, China Construction Bank and Agricultural Bank of China 
--- have a combined 14 percent increase in total assets, to 51.3 
trillion yuan, which is roughly the size of the German, French and 
British economies combined. Meanwhile, under a new set of rules, the 
country's biggest banks will need to increase their capital levels to 
11.5 percent of assets by the end of 2013.Their core Tier 1 capital 
ratio will need to be at least 9.5 percent. These requirements are more 
stringent than the rules appliedto American and European banks. Hereby, 
we shouldn't be surprised why the world's most profitable banks are in 
the dire need of cash. It has to be PBOC who comes to the rescue.

But we can't expect the alchemy of central banking to conjure miracles 
other than administrating monetary band aids when the economy is broken.

3. The over-leveraged economyand unsustainable bubbles

According to the great Ray Dalio's principles 
<http://www.bwater.com/Uploads/FileManager/Principles/Bridgewater-Associates-Ray-Dalio-Principles.pdf>, 
the credit-fueled China's economy is so over-leveraged that a great 
de-leveraging is going to be the only way out. The pyramid of 
debt/credit is cracking and will collapse since the conditions of 
underlying economic agents are deteriorating.There's no mount of 
monetary band aids that can alter that destiny.

According to Fitch 
<http://www.fitchratings.com.cn/en/news_detail.php?id=1504>' 
<http://www.fitchratings.com.cn/en/news_detail.php?id=1504>s 
<http://www.fitchratings.com.cn/en/news_detail.php?id=1504><http://www.fitchratings.com.cn/en/news_detail.php?id=1504>data 
<http://www.fitchratings.com.cn/en/news_detail.php?id=1504>, the ratio 
of total financing/GDP in China rose from 124% at end-2007 to 174% at 
end-2010, and rose by another 5pp to 179% in 2011.In 
<http://www.businessforum-china.com/news_details/items/fitch-china-credit-slowdown-accelerating-but-still-outpacing-gdp.html>2012 
<http://www.businessforum-china.com/news_details/items/fitch-china-credit-slowdown-accelerating-but-still-outpacing-gdp.html>the 
growth of broad credit will slightly decelerate but still outpace GDP. 
Clearly China is not suffering a liquidity crisis but the diminishing 
economic return on credit. According to Fitch 
<http://www.businessforum-china.com/news_details/items/fitch-china-credit-slowdown-accelerating-but-still-outpacing-gdp.html>, 
in 2012, each CNY1 in new financing will yield ?0.39 yuan in new GDP 
versus ?0.73 yuan pre-crisis.Returns would have to rise above ?0.5 yuan 
for domestic credit/GDP to stabilize at 2011's 179%.The dilemma is that 
business entities will need more and more credit to achieve the same 
economic result, therefore will be more and more leveraged, less and 
less able to service the debt, more and more prone to insolvency and 
bankruptcy. It will reach a turning point when the increasing number of 
insolvencies and bankruptcies initiate an accelerating downward spiral 
for underling asset prices and drive up the non-performing loan ratio 
for the banks. And then the over-stretched banking system will implode. 
A full blown economic crisis will come in full force. The chain of 
reaction is clearly set in the motionnow. The question is when we will 
reach that turning point. What PBOC has done is only adding fuel to the 
fire because it is unable to tackle the root causes of China's economic 
ills.

The root causes are unsustainable economic bubbles and collapsing demand.

Firstly, I will analysis China's construction industry to illustrate the 
severeness of China's economic bubbles.

According to Société Générale 
<http://www.scribd.com/doc/58599536/SocGenChinaConstruction>,in 2010, 
China spent more than $1,000bn on construction (including 
residential/non residential real estate and infrastructure), 
representing around 20% of its nominal GDP,or almost twice the world 
average. In 2010 Chinese construction market surpassed that of the US 
and became the largest construction market worldwide with around 15% 
share. That year China's construction binge push its investment/GDP 
ratio to 48.5%, a record unprecedented in the recent history of China or 
any other major economy. It's sufficient to say China is a 
construction-led economy.

In 2010, China's cement consumption surpassed 1,800mt, which is around 
55% of global consumption and about 25 times more than US consumption. 
With average consumption of 1,400kg per capita, China stands well above 
the world average ex-China of 300kg. History shows that such high 
consumption is hard to sustain for a number of years and ultimately 
leads to a construction crisis sooner or later.

In 2010, China has built around 1.8bn square meters of new residential 
floor space, which is the equivalent of Spain's housing floor space 
stock. This construction has already provided accommodation for 60 
million people while the urban population has merely increased by c. 20 
million. If China were to keep its current construction pace over the 
next five years, the 9bn sqm new housing area built would provide 
accommodation for 300 million more people by 2015. Therefore the 
available floor space stock in China will then be able to accommodate an 
urbanization rate of 65-70%.But according to IMF's forecast, it won't 
beuntil 2030 for China's urbanization to reach that level. How can the 
central government punish those farmers migrating ever so slowly to the 
cities? Obviously, China will have more and more cities like Ordos, a 
modern Chinese Ghost Town photogenically praised by the 
<http://www.time.com/time/photogallery/0,29307,1975397,00.html><http://www.time.com/time/photogallery/0,29307,1975397,00.html>Time 
<http://www.time.com/time/photogallery/0,29307,1975397,00.html><http://www.time.com/time/photogallery/0,29307,1975397,00.html>magazine 
<http://www.time.com/time/photogallery/0,29307,1975397,00.html>.

Still not convinced? China can look to pre-crisis Spain for signs of 
construction bubbles. Spain had a very high consumption per capita for 
years before it crashed with the financial crisis. Spanish annual cement 
consumption topped off at nearly 1,300kg per capita in 2007, ahead of 
the financial crisis. 4 years later, Spanish consumption stands barely 
at around 500kg per capita, down 60% from its peak. If China's cement 
consumption per capita keeps its current momentum, sooner or later 
China's construction bubble will reach its end game.

Economic bubbles are unsustainable. It works like a Ponzi scheme. When 
it first starts, the excess liquidity unleashed by the central banks 
will drive the asset prices higher and higher. There will be more and 
more people and money buying into the game assuming the price will keep 
going up. Back then the leverage is not a problem. But when the great 
de-leveraging is beckoned, there will be a stampede towards the exit. 
That's when any Ponzi scheme collapses. Let's make no bones about the 
fact that China's investment-fueled growth including the construction 
binge is just such a Ponzi scheme.

4. Bust the myth of China's transition towards a consumption-led economy

To this stage, China can't reply on the excessive investment to propel 
its growth much longer. So what about seeking the growth more and more 
from the demand side of the economy: the foreign and domestic demand? 
Well, that path looks rather bumpy as well.

As to the foreign demand, China's export growth clearly is decelerating 
recently as the major customers--EU and the US--are both fighting on the 
edge of double-dip. It is immoral to accelerate the export growth while 
trade partners are drowning in their debt crisis. It is also rather 
dangerous while those trade partners are fighting for their survival and 
won't hesitate to start a trade war to defend their lifelines. China can 
sincerely hope that EU and the US soon bounce back from the economic 
abyss to become their best customers again but that won't happen for a 
long time. I agree with Ray Dalio that this economic crisis is a great 
deleveraging, which will take more than a decade to unwind. According to 
UBS Wealth Management Research 
<http://www.bloomberg.com/article/2012-01-12/aaCIt7cRS8kE.html>'s 
report, the great deleveraging will likely play out through 2020. The 
ratios of debt-to-incomes must go down in EU and the US. Sorry, China, 
no more easy fuel for your export growth.

Now that's too bad. The Ponzi scheme of investment growth and the export 
growth are both collapsing. What's left for China to seek the growth 
then? Domestic demand aka private consumption? It's much promised but 
not very convincing.

Let's examine the structural reasons that China's domestic demand will 
have its work cut out to refill the tank space of the economic growth 
left out by collapsing investment and export:

1st, Contrary to what many choose to believe, China's trade surplus is 
not caused by Chinese consumers' high saving rate, but has much to do 
with their deteriorating disposable incomes which far lag behind GDP 
growth and inflation. According to the All China Federation of Trade 
Unions (ACFTU), workers' wages/GDP ratio have gone down for 22 
consecutive years since 1983. It goes without saying that the 
consumption/GDP ratio is shrinking all the while.Meanwhile, Aggregate 
Savings Rate has increased by 51% from 36% in 1996 to 51% in 2007. Don't 
jump to your conclusion yet that Chinese consumers has been 
over-tightening their purse strings. The truth is far away from 
conventional perceptions: according to Development Research Center of 
the State Council's report, that increase is mainly driven by the 
government and corporations and not by the household. For the past 11 
years, Household Saving Rate has only increased from 19% to 22%. Even 
India's Household Saving Rate of 24% is higher than China's right now. 
All the while, government and corporations' saving rate has increased 
from 17% to 22%, which accounts for nearly 80% of the increase on 
Aggregate Savings Rate. For the past decade, Government's fiscal income 
is growing faster than GDP or Household Income. In 2009, the fiscal 
income was 687.71 billion yuan, and achieved an annual growth of 11.7% 
while GDP growth was 8.7%, Urban household disposable income growth was 
8.8% and agriculture household disposable income growth was 8.2%. It is 
obvious that the state and corporations has taken too much out of 
national income and hence they continue to weaken the consumers rather 
than empower them.

2nd, The state enterprises and crony capitalists heavily dominate the 
income distribution. The deteriorating income inequity makes it harder 
for GDP growth to trickle down to the overall consumption. In 
<http://business.sohu.com/20100830/n274563685.shtml>2010 
<http://business.sohu.com/20100830/n274563685.shtml>, the net profits 
from two central enterprises(China Mobile and Petrol China) outstrip the 
net profits from the top 500 private enterprise combined. Meanwhile 
<http://baike.baidu.com/view/481701.htm>, Central enterprises only 
contribute 30% of GDP, and provide 20% of national employment while the 
private enterprises contribute 70% of the GDP and provide 80% of the 
national employment. Adding fuel to the fire, monopoly enterprises also 
account for 55%of national wage and salary. The widening income gap will 
skew more and more national income towards corruption, rent seeking, 
capital flight, asset investment and speculation. Thus the 
consumption-side of economy will be continually weakened.

The biggest problem for China is the state, central enterprises and 
crony capitalists wield too much power over national economy, have too 
much monopoly power over wealth creation and income distribution, and 
much of the GDP growth and vested interest groups' economic progress are 
made atthe expanse of average consumers stuck in deteriorating relative 
poverty. If these problems aren't solved, the faster the Chinese GDP 
growth, the less Chinese consumers will be able to support the 
over-capacity expansion, the more export momentum China will need to 
sustain its growth. This is a vicious circle of global imbalance. Even 
the revaluation of RMB can't break it.

5. The end game is coming

There you have it: the unsustainable economic bubbles and collapsing 
demand are the root causes plaguing China's economy. PBOC's current 
maneuverers won't fix any of it. As I said previously,those alchemy 
recipes of central banking at best can serve to sustain the 
over-leveraged economy and avoid the systematic short-circuit of debt 
financingfor now. Other than that, there won't be much liquidity 
invested in capacity and job intensive projects since there's no much 
demand to go around and the economic return on credit will deteriorate. 
If these structural deficiencies aren't properly addressed by the 
central government, things will get worse, more frivolous rate cuts and 
RRR cuts and other central banking's gimmicks are sure to come but to no 
avail, the chain reaction will be accelerated, and China will face its 
end game: the dark side of a great deleveraging.

Dee Woo
-- 
Citizen Economist and Citizen Diplomacy Activist

http://www.businessinsider.com/author/dee-woo
http://www.forbeschina.com/column/wudi
http://twitter.com/dee8woo
http://cn.linkedin.com/in/dee8woo
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