On the recommendation of a loyal reader, I just listened to Jing Ulrich talk about China’s economy over at China Money Podcast.  Ms. Ulrich heads up Global Markets at J.P. Morgan and I definitely put her on the very short list of those discussing China’s economy who actually know whereof they speak.

If you want an update on where China’s economy is today and where it is likely to be going in the future, I recommend you listen to this podcast.  If you want me to partially spoil it for you, read on.

In very brief summary, Ms. Ulrich noted the following:

  • China’s economy is rebounding, due at least in part to the government pumping large amounts of money into the system.
  • China real estate is in danger of overheating and so we should expect more government measures seeking to prevent this. Expect stricter enforcement of  existing laws and more cities rolling out a property tax.
  • Expect future infrastructure investment to focus on urban subways, light rail and the environment.

What do you think?

UPDATE:  While on the subject of China’s economy, just saw an excellent and informative interview of Michael Pettis by Tom Orlik (two people I put on the same “very short list” mentioned above — see my later post, entitled, Who To Read On China’s Economy?) over at China Real Time Report, entitled, “Eight Questions: Michael Pettis, ‘The Great Rebalancing.’”  Definitely well worth a read as well.

One of the things I love to ask people wherever I go (and yes, cabdrivers especially) is how’s business? How’s the economy.  I am constantly asking my clients that as well and most of them (no matter what the country, about which I am asking) are saying “it’s okay.”  Not great, but not all that bad either.  That includes China.

One thing that makes these conversations about China more relevant is that China’s economic statistics tend not to be particularly reliable. Some blame Beijing for this.  Others blame the local governments, whose salaries/bonuses/outlays are oftentimes based on how they are doing for their local economies.

So shadow figures are often used to track China’s economy, with one of the favorites being electricity consumption.  The thinking is that if China is doing well, electricity consumption will be increasing.  I am less of a fan of this measure than many for the following reasons:

  1. It may be a decent measure of manufacturing growth/output, but it is not as good at measuring the service sector.
  2. Who says the electricity numbers are entirely accurate?
  3. They fail to account for changing weather conditions.

Thought of all this just now after receiving an email from a Shanghai friend that said the following:

Exactly what I’ve been saying….
The coldest winter in decades accounts for the uptick in electricity and that’s why BJ is surrounded by smog from their coal fired power plants. Economy here is weak.  Glad somebody gets it.
The email had a link to a blog post, entitled, “Chinese Electricity Conclusions Reexamined,” [link no longer exists] the thrust of which is that China’s electricity consumption is way up not because the economy is recovering, but because China is suffering from record cold weather.
Makes sense to me.  So I have to ask, how’s business in China for you?  How’s the economy doing?  Please be as specific as possible.

I know I have been writing too much lately regarding China’s economy and I know that much of what I have written has been negative. But I have to tell you that I am starting to see all sorts of fissures breaking out in China’s economy and they are scaring the hell out of me. I am not writing to jump on any bandwagon (as one e-mailer accused me) but because I am really worried.

I am worried not just from what I am seeing, but because the real economists out there (not the people who claim to be economists just because they live in China) are also saying some pretty scary things. One of those real economists, Michael Pettis, just came out with what I see as a brilliant piece on how China has overinvested in capital and how its capital investments have been misallocated. It is entitled, “How do we know that China is overinvesting” [link no longer exists] and I strongly urge you to read the whole thing.

I love Pettis’s piece for three reasons. One, I have never bought into the idea that a bunch of geniuses sitting in Beijing are betting at allocating funds than the invisible hand. And I certainly have never bought into the idea that the local governments spending funds are either.  Two, I have been seeing with my own eyes what I thought to be misallocations, but at least half the time when I raise them to people, I get a response like, “well surely the people in Beijing are better equipped to know whether 3 million vacant condos, bridges to nowhere, and train stations in nowhere make economic sense than you are.” I have never thought that is the right question and I have always felt that many of those who refuse to admit China can do no wrong economically are so tied to the system as to have lost any real perspective. Three, the analysis is absolutely first rate and it has been a long long time since i have seen an analysis of Chinese economy of which I could say that.

The article focuses on China’s investment in electric car technology as an example of misallocated capital and it does a great job of explaining why even an investment so initially appealling as that can be a big mistake.

Pettis explains why he sees China having missollacted its capital:

Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect.  I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years.  The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis.  No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.

The fact that China is so poor is often proposed as an argument as to why this cannot also be the case for China, but of course this is a nonsensical argument.  Poorer countries with lower levels of worker productivity are less able, not more able, to absorb very high levels of investment.  This may seem counterintuitive at first, but only if you believe that there is a single optimal level of investment for every country regardless of its specific conditions.  If the purpose of investment is to save labor and labor cost, then it should be clear that the lower the level of worker productivity and the cheaper and more abundant the amount of labor, the less investment in capital stock is justified.

This is why when so many analysts compare the per capita capital stock of China with that of the US or Japan, and then announce that this proves China has a long ways to go before it runs out of investment opportunities, I am always surprised, and even a little skeptical about their economic backgrounds.  This comparison simply does not make sense.

If it did, overinvestment crises would be largely limited to rich countries, not poor countries – something that is certainly not confirmed by history.  Anyway I find bizarre the idea that the best comparison for China, one of the poorest countries in the world even if you accept the validity of GDP numbers and ignore the very low GDP share of household income, is the US or Japan, two of the richest and most technologically advanced countries in the world.

But I think there are more formal reasons to believe that China is misallocating capital.  Common sense suggests that when there is massive investment with

  • very little accountability,
  • severely distorted prices,
  • an incentive structure that concentrates the benefits of investment in specific jurisdictions and over a short time period while spreading the costs throughout the national banking system and over the debt repayment period (which can be decades),
  • no or very limited budget constraints,
  • factional and regional conflicts, and
  • shifts in responsibility as the instigators of the investment are promoted (often because of the positive impact of their own investment initiatives),

it would be a rare system in history that did not tend towards substantial capital misallocation.

Certainly the evidence on SOE investment suggests that this is indeed what happened.  A number of studies have suggested that if over the past decade you add up direct subsidies, the impact of monopoly pricing (which is of course simply a tax on households) and the interest rate subsidy, they total anywhere from six to ten times the aggregate profitability of the SOE sector.  This means that unless the externalities associated with the SOEs are also at least six to ten times their aggregate profitability, they are actually value destroyers.

If you have any interest at all in China’s economy, you really should read the whole article. I buy it. Do you?

Just saw this quote on China’s economy and liked it so much, I’m going with it:

“The reasonable bulls and bears among us agree on most of the facts,” Northwestern’s Shih said. “But at the end of the day, we disagree on the Chinese government’s ability to make tough changes.”

It’s from an LA Times article, entitled, “Predictions of an economic collapse in China are in vogue,” which says that the pendulum has swung so far regarding China’s economy, that the gloom and doomers may actually have gone too far.

I do find that most people agree on the shortcomings inherent in China’s economy and the dispute centers on whether the Chinese government can fix it enough for it to muddle through or will it fall off into a full-fledged tanking. What do you think?  I think that if the worldwide economy picks up and if China does not move too far away from being the place for cheap goods, it will make it. Otherwise, I too have my doubts. Et tu?

I know nobody wants to hear this and I know this is going to cause me to get hate mail from those whose livelihoods are tied in to China’s continuing to boom, but I am seeing all sorts of bad news on the horizon with respect to China’s economy.

A client meeting yesterday was the last straw. The client I met with is very sophisticated, very large, and, most importantly, very experienced. The client is a very large commodity seller who sells massive amounts to China. This company typically sells its product to Chinese private companies that use letters of credit. Prior to 2008, this client’s Chinese customers pretty much always paid. Then in 2008, they started contesting the letters of credit and seeking lower prices than that to which they had agreed. Soon after that, they started rejecting the shipments entirely. My client told me that in the last 3-4 weeks, nearly all of his non SOE (State Owned Entity) Chinese clients have contested the letters of credit and have sought lower prices of around twenty percent. They are confessing to my client that they cannot get loans and without loans they cannot pay so much.

If it were just that, I might chalk it up to problems in one industry, but it is not just that. Chinese companies that are going out of business or believe they are going out of business have an annoying tendency to ship bad or fake or no product at all. In 2008, pretty much every week we were getting calls from companies saying that the product they had ordered just was not coming. We handled one case where a company had bought about a million dollars of fish and received containers of cheap bricks surrounded by fish. That fake shipment was the dying gasp of a company that ceased to exist. We have started to get those same sort of calls in large numbers again.

We are also seeing it on the flip side of Chinese companies buying product from our U.S. clients or even trying to buy U.S. companies outright. The numbers are small to begin with, but it just seems like we are seeing an increase in Chinese companies that paid a deposit simply walking away from their deals.

What are you seeing out there? Is it really this bad, cause it sure feels like it?

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.

Co-blogger Steve Dickinson yesterday spoke at the Chengdu AmCham on China’s 12th Five Year Plan and he will be speaking on that again on April 14 at the Swedish Chamber in Beijing. Though Steve has already written a few posts on here regarding the plan, this one is an important update because it discusses how the plan has evolved such that it now differs markedly from even its most recent drafts.

As I have mentioned previously, China tends to very much follow its five year plans and so they can make an excellent blueprint for businesses located in or doing business with China.

This post will be in two parts, with Part II to come out tomorrow. Today’s post focuses on the guidance given for the Plan. Tomorrow’s post will focus on the plan as actually adopted. 

By:  Steve Dickinson

Guidance for China’s Twelfth Five Year Plan was adopted by the CPC [Communist Party of China] last October in two critical documents:

The Opinion of the CPC Central Committee on Establishing the 12th Five Year Plan (中共中央关于制定国民经济和社会发展第十二个五年规划的建议) (the Opinion) adopted on October 18, 2010

Explanation of the Opinion (央关于制定国民经济和社会发展第十二个五年规划的建议的说明) authored by Wen Jiabao and presented to the CPC Central Committee on October 15, 2010.

This preliminary review is based on those documents and on government and research institutes that have been published in China in response to those documents.

I. China’s Ten Major Challenges

The goal of the Chinese regulators is for China to become a moderately prosperous country by the year 2020. The current five year period will be critical in meeting that goal. China has recently reached a level where its per capita GDP equals $US4,000. The goal is to achieve a $US10,000 per capita GDP by the year 2020. This is a critical transition. It is generally believed to be relatively easy for a country to achieve the $4,000 number. It is common, however, for countries to stall out in GDP growth and never achieve the $10,000 goal.

The goal of the 12th Five Year plan is to prevent China’s growth from stalling. In the Opinion, the CPC identifies 10 factors that threaten the continued development of the Chinese economy

  1. Resource constraints: energy and raw materials.
  2. Mismatch in investment and imbalance in consumption.
  3. Income disparity.
  4. Weakness in capacity for domestic innovation.
  5. Production structure is not rational: too much heavy industry, not enough service.
  6. Agriculture foundation is thin and weak.
  7. Urban/rural development is not coordinated.
  8. Employment system is imbalanced.
  9. Social contradictions are progressively more apparent.
  10. Obstacles to scientific development continue to exist and are difficult to remove.

II. The Theoretical Solution

Before discussing the concrete outline of the plan, the party sets out the theoretical approach that will serve as the guide:

A. The Main Theme: Scientific Development

1. “During the period of the 12th Five Year Plan, economic development remains the key to resolution of all problems.” (Wen Jiabao, quoting from the Opinion)

2. Development must be “scientific”:Practical (unconstrained by ideology),  human centered, and sustainable.

B. The Main Line:  “China must rapidly engage in a complete transformation of its form of economic development.”

It cannot be stressed sufficiently how radical is the proposed remedy. The idea is not to refine the current system, but to completely transform the current system in only five years. This is a bold goal.

The focus of transformation is as follows:

1. From export led consumption to domestic led consumption.

2. From excessive reliance on exports to balance between export, import and domestic consumption.

3. From reliance on foreign technology to reliance on domestic innovation.

4. From reliance on “old” energy, and materials and industries to creation of a low-carbon /new-materials based economy.

III. Ten Point Outline of the 12th Five Year Plan

A. To address the ten challenges, and in accordance with the theoretical approach, the CPC proposes that the 12th Five Year Plan focus on ten major areas, as follows:

1. Expand domestic consumption while maintaining stable economic development.

a. Unleash domestic consumption. This will be done through the measures at item seven below.

b. Coordinate consumption, investment and export to create a balanced economy.

2. Modernize agriculture to create the new socialist rural village. .

a. Modernize agriculture through mechanization and measures that allow larger farms.

b. Invest in agriculture infrastructure, especially in waterworks.

c. Create non-agricultural rural employment.

d. Improve legal and financial development mechanisms.

e. Improve agricultural service business in areas such as wholesaling, warehousing, processing, transportation and marketing.

3. Develop a modern, balanced industrial and trade structure.

a. Develop service trade. Services currently contribute to less than 40% of GDP. The goal is to         raise this number to 70% or higher.

b. Develop modern energy and integrated logistics.

c. Develop marine resources.

4. Advance the integration between regions and encourage stable urbanization.

a. Combat regional disparities.

b. Eliminate the urban/rural distinction. Cities at the second tier and lower must accept rural migrants. The goal is to provide for industrial/service employment for agricultural laborers in areas close to their current residence. This will be done to avoid a mass migration of rural residents into the cities. 

5. Promote energy saving and environmental protection.

Currently, for every 1% increase in GDP, China’s energy use increases by 1% or more. If this rate of use were to continue, China would need to increase its energy consumption by 2.5 times to achieve its 2020 economic goal. To put this into perspective, this would mean increasing the current consumption of coal from the current 3.6 billion tons per year to an astronomical 7.9 billion tons a year. No one in China thinks this can be done. One major way to reduce the amount of energy required for the Chinese economy is to implement energy saving practices throughout the economy. A second way to reduce is to shift from hydrocarbon based energy to alternative energy sources. The new plan advocates an all out program in this area.

6. Create an innovation driven society by encouraging education and training of the workforce.

The plan seeks to shift China from its role as the factory of the world to a new role as a technological innovator for the world. There are two components to this approach:

a. China will seed to become a domestic innovator in all areas of current modern technology, with an emphasis on practical industrial applications.

b. Where China is not capable of domestic innovation, China will continue to import technology from advanced economies. However, China will seek to actively domesticate that technology through a program of “assimilate and re-invent.” The recent program for production in engines for high speed rail is offered as an example of the “assimilate and re-invent” approach.

7. Establish a comprehensive public social welfare system.

In order to meet the goal of unleashing domestic consumption, China has to move to a policy that puts more disposable income in the hands of its citizens. The plan proposed the following approach:

a. Labor and employment.  

China must provide jobs for a growing workforce. There are two key areas:

1. It is estimated that over the next ten years, 200 million persons will be shifted from agricultural labor to urban industrial/service labor. Jobs for these persons consistent with their training must be provided.

2. Currently, China’s colleges produce far more graduates than its economy can absorb. Entry level jobs for college and technical school graduates must be provided. Education must also be adjusted to accord with the realities of the job market.

            b. Wages

Chinese wage are abnormally low. Most planners are pushing for tripling of the average wage for factory workers during this 5 year plan.

            c. Provide comprehensive government benefit programs, especially retirement pensions.

            d. Provide government funded medical services with comprehensive basic coverage by the end of             2011.

            e. Maintain active population control.

It is interesting to note that two major issues are not effectively considered in the plan: the first is the cost of housing and the second is the cost of high school and college education. Though there has been some discussion of constructing low income housing, the measures proposed will do little or nothing to address the problem of affordable housing in China’s major cities.

8. Encourage cultural production in order to increase China’s “soft power”.

China will seek to make its case for the world to avoid misunderstanding of China’s goals and role within the world economy.

9. Increase the pace of reform of the economy.

            a. Financial market reform, especially the RMB.

            b. Energy price reform and price reform of other economic inputs (raw materials).

10. Continue with liberalization and “opening-up” to the outside, but on a new track.

            a. Shift from export only to a balance between export and import.

            b. Shift from inbound investment only to a balance between inbound and outbound investment.               China will continue with its “going out” policy.

            c. Actively participate in international economic governance.

I tend to put very little stock in economist’s predictions and I tend to put even less stock in economist’s predictions on China (and even less still on non-economists prognosticating on China’s economy as though their doing business there all of a sudden makes them an economist). Though I find the predictions to be of only very limited value, I do often find the assumptions on which the predictions are based to be intriguing and sometimes even worthwhile.

That is how I feel about a recently released Morgan Stanley report, summarized in this Beyond Brics post, entitled, “China ‘Megatrends’: How to Get Exposure to China’s Growth.” The post is ostensibly about the stocks in which you should be investing to take advantage of China’s growth, but it also delves in to what Morgan Stanley has to say about the China trends that will be shaping China’s economic future:

The trends set to reshape China over the next decade are demographics, urbanisation, infrastructure, social security network, education, and consumer financing. But this is not new. There are, for example, plenty of companies clamouring to tap China’s growing consumer market, but that doesn’t make them likely to succeed.

i agree there is nothing new here, but that is because these trends are so apparent and, to a very large extent, so uncontroversial.  

But the part of the Morgan Stanley report I found most intriguing was its almost over the top predictions on what will happen by way of wages, consumption and foreign investment in China over the next ten years:

Morgan Stanley’s optimism about the mega-trends is based on the assumption that three factors will change the economy over the next decade: that real wages will quadruple, consumption in total numbers will triple, and foreign investment will double.

The funniest thing is that I think Morgan Stanley might end up being right.  

What do you think? 

iLook China has a post up comparing China’s economic future with India’s. The post focuses on the recent Economist cover story positing that India’s economy will soon out-pace China’s. I never read that article because I find articles like that somewhat silly. Economists have trouble predicting two years out, much less ten or twenty. The problem with predictions is that they have to be based mostly on the past and though the past is one of the best predictors of the future, it is still not all that accurate.

So I thought the iLook post, “Comparing India and China’s Economic Engines,” would provide me a with a super-quick summary of the Economist cover story comparing India with China, but it did not. Instead, it puts forth an utterly absurd and panda-istic argument for why China’s economy will continue surpassing India’s into the distant future. iLook’s argument is essentially that China is working on becoming a republic and India’s existing democracy is not all that it is cracked up to be. In other words, iLook takes what he sees as China’s aspirations and assumes (without a shred of factual support or even argument) that China will very shortly fully achieve those aspirations. As for India, he takes India’s government as it is (and exaggerates its problems a bit for good measure) and assumes (again without a shred of factual support or even argument) that India will never progress even one iota.

Not fair, iLook. Not fair at all.

What do you think?

I am always getting asked deep questions regarding China’s economy and I almost always demur because I am not an economist.

But is China experiencing a bubble, people always want to know? Based on my experience of having been intimately involved (from the legal side) with two bubbles (the dot.com and the real estate bubble), my feeling is yes. I get that feeling because whenever anyone mentions there might be a real estate bubble in China, non-economists get angry and insist things are different this time or that You Ain’t Seen Nothing Yet?

This all feels a lot like irrational exuberance to me, but what do I know? Read or listen to those who really know economics, I tell people.

But where are those people?

There really are incredibly few real economists/finance people with China expertise writing/speaking in English to a general audience. Michael Pettis is one of them.  He is someone who clearly does know whereof he speaks. Do I agree with him? That’s irrelevant. What matters is that he applies legitimate economic/financial tools to analyzing China and for that alone, you should be reading his blog, China Financial Markets.

I mention all of this today because Pettis just came out with a great post analyzing how China can and likely will go about re-balancing its economy to increase consumer spending. Pettis sets out the following four options and analyzes each of them politically, economically, and, most interestingly, as to who will be the winners and the losers:

  1. Raising the value of the Renminbi
  2. Raising interest rates
  3. Raising wages
  4. Transferring state assets

This is an important and very thoughtful post and I highly recommend it [link no longer exists].