China Financial Markets: Building Debt

Discussing the Flyvbjerg paper in the light of China’s massive infrastructure spending, Michael Pettis wrote:

It is not a very happy paper in general, but I am pretty sure that many people who read it probably had a thought similar to mine: if infrastructure spending can be so seriously mismanaged in relatively transparent systems with greater political accountability, what might happen in a country with a huge infrastructure boom stretching over decades, much less transparency, and very little political accountability? Isn’t the potential for waste vast?

Michael Pettis at China Financial Markets has been looking into China’s capital misallocations for some time. Here he quotes from a recent Caijing article:

(…) rail lines were built where few people live on the outskirts of the Hunan Province city of Changsha, said Wang Chengli, an urban transit professor at the city’s Central South University. Today, exit gates for some of the city’s finished subway stations lead to farm fields.

Wang said Changsha authorities installed far fewer kilometers of track in the city’s center than in its suburbs. Each project was approved by the central government, he added.

Zhang says China learned important lessons from the fast-track subway program. For example, he now thinks subways should never have been built in “many cities.”

Doesn’t this mean defaults? Not in China, because the central government will backstop the defaults. But the debt service can only be managed by means of more financial repression. In that light how can China grow the consumer side of the economy?

The fact so few of the companies have accumulated that much debt suggests a bigger problem, says Fraser Howie, the Singapore-based managing director of CLSA Asia-Pacific Markets who has written two books on China’s financial system. “You should be more worried than you think,” he said of Bloomberg’s findings. “Certainly more worried than the banks will tell you.

(…) The problem, then, is not that there will be defaults. The problem is that the only alternative to default is to service the debt, and this is what will cause the real damage to the economy. If the economic benefits generated by the investment are less than the correctly-valued debt-servicing costs, as they almost certainly are, the difference has to be made up in the form of a transfer of resources from some sector of the economy.

As we saw in the last debt crisis, a decade ago, debt-servicing costs are only manageable in China thanks to financial repression – i.e. extremely low lending rates funded by even lower deposit rates — which implies a huge transfer, equal to several percentage points of GDP annually, from household savers to corporate and government borrowers. Households, in other words, typically clean up banking messes.

Only consume!

The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.

Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010.

(…) It isn’t about household savings

The only way to boost household consumption is either to redistribute income from the low-consuming rich to the high consuming poor, or, better yet, to redistribute wealth from the state to households. Both of these have serious political implications that have to be resolved and are unlikely even to be addressed with consumption subsidies. After five years of this argument, during which time consumption has plummeted relative to total savings, you would think they would start to abandon the idea that all we need to do to get consumption to surge is to reduce household savings a little.

FYI, Fraser Howie is coauthor with Carl Walter of “Red Capitalism”. I’m currently reading their book. I recommend you do not read this before sleeping.