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China’s Economy. How Much Do We Really Know?

By Dan Harris on Posted in China Business

Had lunch yesterday with Benjamin Shobert. Benjamin is very intellectual and very knowledgeable about China. At some point during our lunch, he talked of recently having attended a China cleantech conference at which the participants talked of how China is THE place for developing cleantech because, among other reasons, it is so heavily supported by the government.

Benjamin told me he then asked about the risk to cleantech investments were China to pull its massive government subsidies and a private equity person responded by saying that he cannot even consider that risk in his investments. Benjamin and I then talked of how that probably makes sense, and not only because this person is investing other people’s money, but because their is no good way to quantify it and his job is to try to make money now while the making is good. 

Benjamin then said that a lawyer at the conference mentioned that there is always the risk of some crisis arising that forces the Chinese government to divert its cleantech funds for something else. Benjamin and I then talked of what such a crisis might look like and we thought it might involve the government needing to pay off on bad bank loans or having to prime another pump or two.

Benjamin then posed the following three part question:  How we will know when China has reached the point where its bad debt load has gotten too high? Will investors in things like cleantech know in sufficient time to get out? How do we know it has not already started?

I answered as follows:

  • I don’t know.  
  • Almost certainly not.
  • We don’t know.

How do you answer?

UPDATE: Countless readers (by emai and by comments) have pointed out that Michael Pettis just recently wrote a post entitled, “Looking for debt” in which he does a seriously (he’s a real economist) analyzes information in an effort to determine China’s debt load. Whether you agree with Pettis or not (and I tend to), he is one of the very few real economists who closely studies China and for that alone, his blog is always worth a read. 

  • HI

    “How we will know when China has reached the point where its bad debt load has gotten too high?”
    That’s actually a very good and difficult question. Michael Pettis addressed precisely this question recently. The short answer seems to be that we don’t (and can’t?) know until a downward spiral starts, and then it’s too late.
    Below are some excerpts from Michael Pettis.
    “First of all, to ask the most basic question, how much debt is too much debt?　 The simple answer is that there is too much debt whenever the market believes that there is too much debt. This may sound like either an absurd statement or a truism, but it is neither.　 I mean this quite technically.
    [...]
    As perceptions of default probabilities rise (rising credit spreads), local businessmen are more likely to disinvest, lenders are more likely to restructure their loans in ways that increase risk for the borrower (shortening maturities, for example), politicians become more concerned about political instability and so shorten their own time horizons, and so on.
    [...]
    Once we know how much debt is too much debt, in other words, it is usually too late to do anything about it.　 But how does the market determine that it believes there is too much debt. By looking at debt levels, of course, but more importantly by estimating the probability of a mismatch between revenues debt servicing costs.

  • Tony

    Just to be fair, those are problems everywhere….Spain cut subsides for solar a year or two ago, with the predictable impact. US solar subsidies can change quickly, too, depending on Congress.
    As far as debt problems go, I’d worry more about European countries first (PIIGS) and then the US, if the US doesn’t get its act together soon, before worrying about China (and I’m a bit of a China skeptic). Maybe that’s because we know more about potential problems in the US and Europe, but often times, knowing about problems doesn’t help solving it — many governments won’t change until they have to.

  • Bill Rich

    In a mostly government directed economy, the government is making the call on what is hot, not the market. The government is controlled by a small number of people, much smaller than in a truly free market economy. And this small number of people have a different view of the market than most people operating within the market. In a market, individuals do have biases. But when you accumulate all the biases from the large number of people, they tend to cancel out each other, and becomes quite neutral. This is not the case with a government directed economy. Especially in an authoritarian dictatorship whose sole interest is in the hold on power. Most economic and market decisions are non-economic but political. So the support of green energy in China is subjected to mostly political considerations, not economics.
    What if Xi have another pet project, though, for political reasons, he had to appear to agree with the current leaders ? When will we know he changed his mind ? How do we know that one of his main supporters have some axees to grind ? Which industry are his kids working in ?

  • Twofish

    Dan: How we will know when China has reached the point where its bad debt load has gotten too high?
    There are some aggregate measures that you can use, but a lot of it involves this thing called “gut feeling.”
    Dan: Will investors in things like cleantech know in sufficient time to get out?
    No, but thats the nature of PE. You invest in ten things, and get soaked in nine of them. The one remaining is the home run that covers the losses of the other nine. Yes, you might get soaked if you have a wind farm in China, so try to invest also in soybeans in Brazil.
    Dan: How do we know it has not already started?
    We don’t. On the other hand, we also don’t know that China is at the start of a sustained boom in greentech.
    Again, a lot of it boils down to individual gut feeling.

  • Anon

    Interesting parallel in high speed rail. Pat Chovanec just wrote a really good article:
    “Critics, however, worry that the new rail system may go bankrupt before it has the chance to realize its potential. The portion of China’s railway investment funded by debt has increased from 50% in 2005 to 70%, and now accounts for 10% of all outstanding debt in China. Analysts estimate that MOR will rack up over $600 billion in borrowing by 2020. China’s high-speed rail lines will have to perform very well financially— sooner, not just later—to support this debt burden. A default, even if averted through a government bailout, could seriously impact China’s financial system.”
    http://chovanec.wordpress.com/2011/05/25/chinas-been-working-on-the-railroad/
    @Twofish
    “On the other hand, we also don’t know that China is at the start of a sustained boom in greentech.”
    That’s true, but the skeptic in me believes that the world market is probably decades away from providing a self-sustaining source of revenue that is large enough to support the scale of China’s green tech industry, as it has grown through heavy government support. Every time I hear analysis of the potential for a global energy market based on green tech, I hear that we are a long way from the “breakthrough” that will make alternative energy price competitive with fossil fuels, even at rising prices. And the Chinese government has been investing with the aim of supplying the world, not just the domestic market. If that global market doesn’t materialize soon enough, the whole thing could come crumbling down.
    Given financial burdens in other sectors, there’s a good chance that funding will become scarce before the market has really developed. If that happens, I think it’s only realistic to assume that a huge chunk of China’s green tech industry will go bust. Seems like it’s always a gut feeling until after the fact, when the euphoria is gone, and people ask themselves how they let their gut feelings ignore all the warning signs…

  • LH

    hmm. I think I’m with TwoFish on this one. Make this substitution as a mental exercise: U.S. for China; electronics and computer industry for modern energy technologies; late 1980s for now. The U.S. overinvested in some regards, and it resulted in at least one bubble (dotcom). But overall, and deeply, the investment was in something that represented the future and was necessarily deeply profitable for a long time. You either believe that about new energy technologies or you don’t, but as I sit here choking on the air in Beijing I find it impossible not to believe it.
    In other words, this is very unlikely to look like a foolish investment in hindsight.

  • SMG

    Great questions. At first they spooked me, but then I started thinking that they could just as easily apply to the U.S. or any other country as well. Sure, the statistics in the U.S. are more reliable than in China, but things can turn on a dime and do there too.

  • dan berg

    Everyone, including the Chinese govt, has been talking about the need to re-balance for years. PBofC website indicates that first qtr. 2011 investment as a % of gdp INCREASED; consumption as a share of gdp DECREASED; so an even greater imbalance. My guess is that, IF after the next generation take over they decide to acually rebalance, then things will begin to unravel.

  • Twofish

    One problem with both Pettis and Chovanec is that they just quote big numbers without giving any context.
    For example: The portion of China’s railway investment funded by debt has increased from 50%
    in 2005 to 70%, and now accounts for 10% of all outstanding debt in China. Analysts estimate that
    MOR will rack up over $600 billion in borrowing by 2020. China’s high-speed rail lines will have to
    perform very well financially— sooner, not just later—to support this debt burden
    Well then how well is well? What’s the break even number and does this look reasonable?
    Well, the wikipedia article says…..
    http://en.wikipedia.org/wiki/Beijing%E2%80%93Tianjin_Intercity_Railway
    Breakeven is 40 million/rides year. Last year it was 22.3 million and the year before 18.7 million. It doesn’t look that unreasonable that over the next decade you’ll hit 40 million.
    Same problem with Pettis article. He quotes lots of big numbers, but there is no real analysis about how bad the situation has to be before you have serious problems.
    Anon: Every time I hear analysis of the potential for a global energy market based on green tech, I hear that we are a long way from the “breakthrough” that will make alternative energy price competitive with fossil fuels, even at rising prices. And the Chinese government has been investing with the aim of supplying the world, not just the domestic market. If that global market doesn’t materialize soon enough, the whole thing could come crumbling down.
    You have 1.3 billion Chinese people that want to live like Americans, and behind them are 1.2 billion Indians and about 2-3 billion Africans. If it turns out that we can have all of these people live like Americans and not radically change the way that the we do things, then that’s fine by me, but given how polluted Beijing is *NOW* I just don’t see how this is possible.
    Now if it turns out that you *can’t* have 1.3 billion Chinese people live like Americans, then I’d hate to be the person that tells those 1.3. billion Chinese that.
    Anon: Given financial burdens in other sectors, there’s a good chance that funding will become scarce before the market has really developed. If that happens, I think it’s only realistic to assume that a huge chunk of China’s green tech industry will go bust.
    Sure but sometimes a technology bust is not a bad thing. We had a ton of dot-com companies to bust but the world is better off for the few that survived. Something is likely to happen for green tech.

  • John

    Just a quick point on high-speed railway and greentech.
    First, it seems a lot of western economists treat high-speed railway as a project that is supposed to be profitable. The truth is it was never intended to be a cash cow, but more of a strategic public service. Instead of focusing so heavily on the financial statements, people should pay more attention to the IMPLICIT benefits, such as greater social mobilities, more efficient logistics and more rapid development in second and third tier cities. I have yet to read an article that gives an in-depth analysis on these factors. From a geopolitical standpoint, high-speed railway is the modern version of silk road. There has been news about China discussing building high-speed railways into neighboring countries. Do you have any idea how significant this is? This means Beijing will be able to project its influence over other countries more quickly and efficiently, and paved way for an Asian version of “European Union” with China leading the way.
    Solar has become much more affordable in recent years and it has reached grid parity in some states in USA. The overcapacity will drive down the price, weed out the weak, and stimulate great demand. It is free-market at work.