China – could the great growth story all come crashing down?

As global investors seek diversification and relatively superior returns from emerging markets, they find China a particularly alluring proposition. Consider the headline GDP growth rates, new role as key player in the global financial and economic ecology, and perceived promise of a domestic market.

But risk specialists warn of structural developments that can stop the music. “There is an apocryphal story about a visiting world leader drawing back the curtain of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District.  ‘How long has this being going on?’ he asked. Today, the question might be: ‘How long can this go on?’” remarks Satyajit Das, author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.

His argument is that China’s economic model needs significant re-engineering to sustain growth over the longer term. Das refers to the China incremental capital output ratio (ICOR), which is the ratio of gross fixed capital formation to GDP, divided by real GDP growth. A lower ratio indicates greater efficiency of capital spending in generating growth.

“It has deteriorated sharply. In 2009 it was more than two times higher than in the 1980s and 1990s average. The falling returns reflect the maturation of the country’s development cycle as it enters the third successive decade of rapid growth but also the speculative and policy-directed nature of the capital investment. China’s political structure may also encourage poor investment choices. Central and local party officials may be incentivised to build excess capacity by seeking funding and maximizing short-term growth,” Das says.

Yet, China has continued along a trajectory of extraordinary government spending and loose monetary policies to resuscitate an economy bitten by the global financial crisis. The superfluous investment into infrastructure and production capacity, amid retarded global demand, may result in a supply glut and deflationary pressures, he reflects.

Indeed, in the first half of 2009, such investments accounted for over 80% of growth, approximately double the 43% average proportion over the last 10 years. “Experience suggests that such a level of investment will be difficult to maintain. The development of Asian economies in the 1980s and 1990s and the post-war reconstruction of Germany and Japan indicate that the marginal effect of such investment declines rapidly. This has the effect of lowering growth, which becomes increasingly linked to the level of return on investment. Decreasing efficiency can also lead to high levels of speculative investment,” Das says.

Growth that is built on credit is another apprehension, especially when China’s credit-fuelled expansion seems to be relatively inefficient. In the US, at the growth phase’s peak before the credit crisis, it took US$4 to $5 to create $1 of GDP advancement. “In China, there are indications that approximately $6 to $8 of credit is currently needed to generate $1 of growth. This is an increase from a ratio of around $1 to $2 of credit for every $1 of growth that prevailed in China until recently,” Das says.

The recent lending surge, which has worried China’s banking regulators and central bankers, may froth into a domestic banking crisis. If that occurs, it would be a case of déjà vu, Das says.

Indeed, credit expansion in the 1990s ended in high ratios of non-performing loans. The questionable credit was sold to “bad banks” such as Huarong Asset Management and China Cinda Asset Management. The sellers received government-guaranteed bonds in return.

Cinda and Huarong have found it difficult to meet the bond obligations that recently came due. Huarong had problems repaying the principal of a RMB313 billion bond that was due to Industrial and Commercial Bank of China late last year. Cinda had to extend by 10 years the maturity of a bond held by China Construction Bank.

Of particular concern is the eventual appreciation of the RMB, an event that could trigger something similar to Japan’s Lost Decade.

Das presents the parallels: Japan’s export-driven economy produced average growth of 10% in the 1960s, 5% in the 1970s and 4% in the 1980s. “This growth was driven by a number of factors, including an artificially low exchange rate. But in 1985, Japan, the US, UK, Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Mark by intervention in currency markets. The Accord had limited success in reducing the US trade deficit or helping the American economy out of recession, and the effects on the Japanese economy were disastrous.”

The stronger yen eventuated in a recession in Japan’s export-dominant economy, which led to expansionary monetary policies that produced the Japanese asset price bubble which burst in 1989 with the Nikkei at 39,000.

Moreover, “Japan’s problems must be viewed against the background of many significant advantages that may not be available to China,” says Das. “Japan is a relatively rich country and has the world’s largest savings pool. It has a number of advanced and world-class industries that enabled her to use exports to offset the lack of local demand. Japan’s problems occurred during a period of strong growth elsewhere in the global economy and no major dislocation in credit and financial markets. The country’s ethnic homogeneity, sense of community and nationalism allowed the country to survive the end of the ‘bubble’ economy.” 

He concludes: “China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.”