Global Economic

Policy Institute

The Chinese Economy

Macroeconomic Risks 11th October 2005 – ICEA

Prof. Paul E M Reynolds

Tel + 44 20 8741 1166

Mob + 44 7974 188087

paulreynolds@email.com

paulemreynolds@gmail.com

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Aim of presentation:assess Chinese economic risks

• Chinese economic performance – the landscape

• ‘Landings’- None- Soft- Hard- ‘Free fall’

• An assessment of risk

Exploration of these arguments

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The schools of ‘Chinese landings’

No landing Economy did not overheat 2003/4

Admin control is ‘PR’ & not needed

Soft landing Growth will slow to 8% or 7% 2005/2006

Lending growth slowed 20% 2003 to 14% by late 2004

Hard landing Loan/investment growth still excessive

Interest rate ‘brakes’ needed, (measures failed)

Free fall NPLs still rising, returns low

Lending/invest. is out of control

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Some features of the Chinese economic

landscape

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The well-known Chinese economic

growth story• GDP doubled in 9 years to 2004, (oil consumption up 90% to 6.3m

b/d)• GDP growth 9.5% 2003-4. Target 8% 2005 (PM Wen Jiabao, March

05)• Export-led growth. (Exports 35% GDP in 2004 – 40% 2005 ?)• Government revenue up as % GDP - growth sectors more easily

taxable (1994 govt revenue 11% of GDP – 2004 21% GDP) Budget deficit 2004 1.5%GDP

• Growth mainly from private & coop sectors, BUT 100m workers remain in SOEs; some profitable but most not and saddled with huge debts

• PRC government has a ‘problem by-pass’ strategy – to see growth sectors engulf the problem SOEs, gradually deal with SOE-related debt*

• PRC balancing act is to maintain interest rate currency & price stability (spend to keep currency stability post-revaluation, encourage up to 300m workers to ‘go East’), and avoid a major employment fall out, while tackling structural problems

• Qs 1-3 2005 - Tax revenues up 20% , exports up 31%, imports up 16%

* Asset Management Cos (AMCs) set up in 1999 to sell SOE non-performing loans (NPLs)

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Growth of non-state sector

1980 – 2001 (40% of industrial

employment) State sector Non-state sector % of gross

industrial output

% of fixed capital investment

% of industrial employment

% of lossmaking enterprises

% of gross industrial output

% of fixed capital investment

% of total industrial employment

1980 76 82 - - 0.5 13 - 1985 65 66 - 9.6 3 21 - 1990 55 66 - 27.6 10 22 - 1995 34 54 67 33.8 29 29 11 1996 36 53 66 33.6 32 32 12 1997 32 52 65 38.2 36 32 14 1998 28 54 57 - 40 31 26 1999 28 53 54 36 44 32 30 2000 25 50 51 - - 35 35 2001 24 47 47 - - 39 40 Lin & Zhu 2000 + China Statistical Yearbook, From A Tylecote & Jing Cai Asia Business & Management 2004/3, Palgrave Macmillan

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One valuable import arising from the

‘opening up’ policy – international economic

analysis• An assumption – the PRC government at

senior level is aware & seeking short and long term solutions to identified problems

• Central Bank Governor Dai Xianglong said he is ‘fully aware’ of the debt & NPL problems (Sept 04)

• International participants MUST assess risk, including low probability catastrophic risks

• Will the ‘problem by-pass’ strategy work ?• Will vulnerability to speculative attack

translate to a burst bubble ?

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FEATURES OF THE BALANCING ACT: KEY ECONOMIC

VULNERABILITIES (RECOGNISED BY THE CHINESE GOVERNMENT)

* Excess liquidity + possible speculative attack (FX/property)

* Low average quality of investment* Overinvestment/underemployment, simultaneously* Poor provincial/local fiscal discipline* Overdependence on exports (35% of GDP

2004)/low domestic consumption* Messy & distortive ownership & governance reform* Large non-performing loans in 4 state banks

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‘NO LANDING’

(A strong belief in the system)

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The ‘no landing’ view

• Short term inflation blip due to investment time-lags – inflation has already fallen back

• Administrative measures already applied, were needed for international confidence not for technical reasons

• Hence small interest rate rise (benchmark lending rate up in Oct 04 from 5.31% to 5.58%) & modest change in bank reserve requirements

• Banking portfolio problems declining – the ‘problem by-pass’ strategy is working

• More social programs & lower agric taxes in 2004, but paid for by profits from oil & steel + better tax collection (2004 revenues up by 21.4% but expend only up by 15.1% )

• 2005 budget deficit projected at 1.4% (1.5% 2004)• Huge pool of cheap labour remains – 150m

underemployed (IMF) – may be decades before labour shortages appear

• Per capita income still less than $1000 - wages at the coastal export factories have barely changed in the past decade (Morgan Stanley 03.05)

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Inflation rose due to investment time lags,

but is falling back

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May be decades before labour shortages appear * 1.3bn population – 9m new urban jobs 2004* Estimated surplus labour 150m (IMF 2005)

Source: Andy Xie, Morgan Stanley, March 2005

Chinese employment (2005)

Not in labour force

Urban pre-2004

Non-agric rural

Farming

New urban jobs 2004

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SOEs reforms claimed to be in full swing (From

crienglish.com)

• ‘China has closed 3,377 state enterprises, retiring bad debts of $27 billion & offsetting $16.2 billion of deficits’ Li Yizhong, Secretary of the Committee of the Communist Party of China for the State-owned Assets Supervision and Administration Commission (SASAC) Jan 2005

• ‘China has more than 1,000 state companies listed overseas, accounting for 17 percent of the country's total state enterprises and contributing 46 percent of the total profits’ Xinhua Jan 05

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Soft landing

(The conservatives’ choice)

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The soft landing argument assumes economic fundamentals

are OK and have responded to necessary short-term adjustments

• Fixed asset investment growth 2003/4 25.8% (Target 16% 2005 – Wen Jiabao PM March 05)

• 1.5% of the 2003/4 growth comes from agric (agric. taxes reduced in 2004). Non-agric growth 8%

• AMCs have high recovery rates; eg 22% from a $25bn portfolio in 1st ½ of 2002

• Banks may now increase spreads – restrictions lifted

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Policy of interest rate, price & exchange rate

stability, but use of administrative controls• ‘I don't see the necessity to raise interest rates again’

(Guo Shuqing, Director, China's State Administration of Foreign Exchange - Bloomberg

March 05) (Dr Guo also ruled out a large-scale appreciation in the renminbi)

• Inflation will ease to 4 percent or less in 2005 – [from a seven-year high of 5.3 percent in July and August 2004] (Premier Wen Jiabao March 05)

• Credit curbs that were imposed last year on overheated industries like steel, cement and property, ‘cannot be loosened’. Land use will be more strictly regulated to stop illegal construction (Premier Wen Jiabao March 05)

• ‘Changes to bank reserve requirement have had successful short term effects’ Central Bank Governor Dai Xianglong May 2005

• ‘The apparent effects [cooling investment] have been achieved.’ Ma Kai, Minister at the State Development and Planning Commission (March 05)

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Hard landing

(Home of the sceptic)

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The 1995-2005 period: end of a macroeconomic era ?

• Interest rate changes Oct 04, first time since July 1995,

• PBC sterilisation of money supply*, reserve ratio hikes, and temporary ‘commands’ to banks & SOEs - not working

• ‘It is more difficult in 2005/6 to achieve a soft landing as the investment excess is much greater than 2002/3’ (Morgan Stanley 03.05)

• WTO membership opens up banking sector in 2007 – reform timetable is tight (foreign banks will take deposits and ‘good loans’)

• 1 yr deposit rate only 2.25% AND Grey market loans 8%-20% = unsustainable monetary expansion & inflation

• End of the low inflation era ?

* Government securities increasingly difficult to sell given limited returns

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The hot money problem

• 2004 FX spending $193bn to maintain peg• Hot money was flowing into China – based on assumed

exchange rate and property price changes (net foreign debt inflows up 360% 2003-2004 – Lardy May 2005)

• Excess liquidity remains despite slowing measures. Taking into account the increase in the deposit reserve ratio, the surplus liquidity in the system could still exceed one trillion yuan.

• The source of liquidity is capital inflow for currency and property speculation. Another hike in the deposit reserve requirement is therefore unlikely to solve the problem.

• The current account surplus rose from $46 billion in 2003 to $70 billion in 2004 – $68.3bn first three quarters 2005, (projected 2005 - $90bn)

• 1995-2005 exchange rate peg was 8.28/$ - 2.1% revaluation July 21st 2005 to $8.11 and switch to currency basket

• ‘The Renminbi is still undervalued by 20% to 25%’ (N Lardy, July 2005)

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The advent of ‘free financing’ in China

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Runaway investment ?Investment as a % of GDP

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Large investment share of GDP:

is it normal ?• Taiwan: 8% av. Investment growth over 50 years

but NEVER at 30%+ for more than 3 yrs• S Korea: NEVER reached 40% BUT in Taiwan and

S Korea, banking system problems not so great, most investment private, quality of investment MUCH greater

• Sustainable rate of investment as % of GDP must be significantly lower in mainland PRC than S Korea & Taiwan (ie current rate is unsustainable)

• China is 4% of world GDP but 50% of world cement consumption, 28% steel and 15% water in 2005

• Jan 05 – Communications Ministry announces 85,000 Km highway roadbuilding programme (‘infrastructure building 45% of GDP’ - CEIBS Shanghai)

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The perspective of aggregate lending raises further concerns

From ‘Fixing China’s Banks, Not Russia’s’ by Michael S. Bernstam and Alvin Rabushka

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Historic NPL rates (last investment boom) suggest unsustainability of lending

(tr RMB, bankloans outstanding)

0

1

2

3

1998 1999 2000 2001 2002 2003

Chinese bank sector lending 1998-2003

Non-performing

Performing loans

Accumulated NPLs as % of GDP

NPLs

Conclusion: NPLs 1998-2003 alone may represent 20%20% of GDP

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Free fall

(Analysis paralysis among the pessimists ?)

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Risk of ‘free fall’

• Economic bottlenecks + cheap money = inflation• Huge cost of restructuring NE rustbelt – by-pass

strategy ineffective• Underemployment will tie the hands of policymakers• Investment is not rate-of-return or interest rate

sensitive• NPLs are not declining (SOE debt clearance – AMCs –

are refuelling SOE borrowing)• Bank lending is still political• SOE governance practice defies centrally-directed

reforms• Ownership reforms are messy and distortive• Ownership/control fog causes misuse of assets• Local/provincial + SOE non-market investment

decisions underlie macroeconomic dilemmas

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Economic bottlenecks

• Energy shortages persist – coal imports up nearly 50% Sept 05, but coal prices fall 5% due to power bottlenecks

• Skills shortages in the coastal region• Policy on the release & use of land restrictive• Regulatory barriers used to protect private-but-

quasi-state investment• Many sectors still ringfenced from ‘foreign’*

investment

* In practice – ringfenced from returning resources from Hong Kong. Taiwan, & Macao with FIE status

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Huge cost of restructuring NE ‘rustbelt’ - by-pass strategy

more difficult• 3 Northern Provinces; Heilongjiang, Jilin,

Liaoning - SOE employment is 73% of all formal employment

• Some cities – eg Fuxin, Beipiao - unemployment by Western measures is 50% (Economist Jan 04)

• Document No 11 - $7.3bn infrastructure investment 2004-2007 in 3 provinces. Can sectors respond ?

• Is limited FDI enough (BMW, VW, LG) ?• SOE reform measures remain weak – 9m layoffs

in 8 yrs (approx. 16% of SOE employees)

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Underemployment will tie the hands of

policymakers

• 10-11m + under-employment in SOEs (IMF Oct 04)

• Rate of retrenchment in SOEs has been slow

• The Chinese Government expressed ‘concern about the impact that a large change in the renminbi might have on employment’. (Report from IMF’s during 2004 Article IV consultations)

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Most investment is not rate-of-return or

interest rate sensitive• The People’s Bank of China (2004) criticized

‘the blind expansion of seriously low quality, duplicate projects’ in steel, aluminium, and cement

• Investment by local/provincial government – 18%+ spend growth 2004

• Party connections still play a major role

• Danger: government may be forced to raise interest rates but not adjust the exchange rate – effects will be limited (& will suck in ‘hot money’, making monetary tightening more difficult)

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Lending is still political, and distorted by

ownership structures• Banking lacks market discipline or effective regulation.

2/3 of SOCB loans still to prop up state-owned enterprises. ‘The best way to get capital in China is to be too big to fail’. Economist Oct04

• Local governments all have ‘blueprints’ & borrow asap for new projects, & for JVs & FIEs

• New ‘quasi-banks’ (Q-Bs) are defying administrative belt-tightening in SOCBs

• SOE/local government borrowing unaffected by higher interest rates at Q-Bs (10%-20%) - secured on undervalued assets ?

• Negative real interest rates = private capital flight to new Q-Bs - a run on banks is simmering ($25-$30bn fled to QBs in 2004 – John Dessauer, Investor’s World, Jan 05)

• WTO - 2007 banking sector open to competition – deposits and ‘good loans’ will go to new banks

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SOE governance practice defies

centrally-directed reforms• Misuse of assets is widespread

• Party appointees still control decision-making – especially investment

• Evidence shows price manipulation by parent Co management prior to IPOs, leading to asset tunnelling*

• ‘Managers of SOEs are exploiting inadequate laws and regulations to divert government assets and give themselves lucrative shareholdings’ (Prof. Lang Xianping, Chinese University of Hong Kong 2004)

• Provincial/local governments protect state firms and collude in spending hikes (expend growth up 11.8% 2003, up 18.1% in 2004) Business Week March 05

* ‘Related Party Transactions as a direct means for EarningsManagement and Tunneling during the IPO process in China’ Joseph Aharony and Hongqi Yuan 2004

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Messy ownership reformsPrivatisation is a concept hard to

apply• What is the Chinese ‘non-state’ industrial

sector ? [Data hard to find & verify]• Most JVs and FIEs are ‘quasi-state’, or are

most SOEs quasi-private ?• Related Party Transactions (RPTs) & insider

control lead to ex-pat/re-pat of rents as ‘Foreign Invested Enterprise’ investments & JVs

• Use of state assets for private means, accelerating: 11.6% of assets lost (1994 NABSOP), or 50bn RMB average annual unaccounted for funds1982-1996 (1997 WB)

• Informal allocation of shares is common among party officials

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PRIVATIZATION: Returning ‘foreign’ capital is being replaced by direct management ownership

•Guo, Kai & Yao, Yang Causes of privatization in China .The Economics of Transition Feb 05 

Table 1. Trends and composition of private shares (%)

Year Trends Composition of private shares

Private shares in all firms Private shares in privatizing firms Management Employees Outsiders

1996  4.1 61.6  0.5 24.2 75.3

1997  5.3 57.2 13.3 26.2 60.6

1998  7.1 61.1 13.2 30.5 56.3

1999 12.1 65.2 14.5 27.9 57.6

2000 20.9 76.4 21.4 32.5 46.1

2001 26.1 80.4 25.7 34.1 40.2

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Long history of SOE governance reforms – dancing around

ideological taboos ?• 1979-1991 Autonomy reforms (SOE Contract Responsibility System post 1987, &

SOE law 1988) + separation of various property & managerial rights, recognition of ‘management techniques’, role clarity

• CRS ‘failed’ (WB survey). Need to replace oscillating control vs. autonomy, local/national etc

• Continuing inefficiency + problem of information asymmetry + competing control claims = need for formal system for state bodies to share ownership & control…

• 1992/3 Use of company law, SOE corporatisation, & standardised corporate governance rules. Many state SMEs became ‘private’ (20% of other SOEs could be ‘private’, but this was loosely defined). Ownership/control confusion persists at some levels.

• Further waves of measures to address SOE debts – AMCs initiative emerged.• 1999 4th. mtg/15th National Congress – ‘Modern Enterprise system’ recognises

corporate governance as core further reform needed• Shanghai Stock Exchange: March 2000 – new CG rules for listed firms• Codes and Standards of Corporate Governance of Chinese Listed Companies

2001 + independent directors system, for insider problem• At 1st mtg of the 10th National People’s Congress of PRC, the State-owned

Assets Supervision and Administration Commission of the State Council (SASAC) is set up – supervises large SOEs & mediates between state institutions - multi-layered (& cumbersome ?) monitoring, strengthening senior SOE managers

• June 2003 1/3 independent directors a requirement

NB. Rise of Authorized Investment Institutes (ie Holding company, National Assets Management Co, Group Co.)

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Messy ownership reforms

SOEs consume vast resources, but cloudy ownership/control

hides misuse1999/2000 G.O.V. Employment SOEs 28 55 Collective 35 15 Indiv. 18 Private & F.I. 26

30

• LISTED SOEs: 1400 listed SOEs, still 50% state ownership, in aggregate

• 2/3 assets, ½ urban workers, ¾ investment & credit

• Insiders: most directors are executive + 2-role state reps, party appointees

• 60% of shares non-traded, complex holding structures reduce transparency

SOE inefficiency persists – employment, technology, 1/3 make losses (ADB 2001), subsidy, debt accumulation, ‘asset mining’, RPTs

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NPLs are not declining

• 4 largest SOCBs are unclosable = most of the country's 1 trillion in household savings

• 23% of portfolios officially (25% of GDP 2004) + $170bn in 4 AMCs trans in 1999 = 50% of 4SOCB portfolios (plus unfunded pensions $?)

• NPLs - $500bn (E&Y) to $600bn (Dragon Ventures) – at 50/60%, threaten household wealth (OA Oct 04)

• Average AMC recovery rate declined from 20%+ to 5% in 2004. By 2005 only 3.5% of total NPLs recovered (target 15%)

• 80 NPLs converted to equity 2002, but remedy has faded (control unchanged, valuation arguments, sectors barred from foreign ownership, 20% tax on NPL transfers, confused governance & role of party, unreliable accounts)

• NPLs still rising > Evidence that SOEs borrowed to pay down debt + that NPLs bounced back in excess of 3.5% recovered

• NB. Bank of China's NPLs were found to be 2.6 times as high using international criteria as they were using the traditional Chinese definitions (Lardy 2001).

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Misuse of funds appears

widespread – problems for PRC

leadership• China Eagle scandal $752m (losses + ‘misuse’) 2004• Loan fraud case in Nanhai, Guangdong province ($893m Industrial and

Commercial Bank of China + $380m from 7 other instits. including Nanhai City) 2003/4

• China Securities $687m embezzlement, $722m losses revealed 2003• ‘The head of a BOC branch bank in Harbin disappeared with RMB billions

worth of bank funds.’ China Construction Bank reported the disappearance of US$18.1 million on July 28 2004 – scandal revealed that all loan decisions were made by the Party

• China 's state-owned asset administrator and the Ministry of Finance (MOF) issued new rules on MBOs of State enterprises to stop manipulation of State assets transfers to company insiders – acknowledged problems of low valuations

• ‘In the banking sector, most cases involve collusion between banking insiders and outside players. Often local government officials are involved as well. Regulatory agency bosses insist on closed investigations, in order to ‘stabilize the securities market and protect the reputation of the industry’ and advocate lenient penalties ‘for the sake of industry morale’. Caijing Magazine

• $249m ‘China SOE’ scandal 2005: The former president of Xinjiang Delong, whose stock market crash in April led to a series of defaults by more than 20 financial institutions it controlled, fled China in June to an unknown foreign country. He returned to Beijing on July 18, where the director of the central bank's Financial Stabilization Bureau met him at the airport.

• Scandals involving popular listed companies such as Yi’an Keji, Yinguangxia, Lantian Gufen and MaiKeTe being discovered to have falsified in their financial accounts Naomi Li, Asia Programme, RIIA

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Non-market ‘local’ investment decisions underlie

macroeconomic dilemmasCRUX OF FREE-FALL SCHOOL• Pre-IPO manipulation is common – misuse of funds is

widespread• Informal allocation of non-tradable equity creates SOE

policy pressures, and fuels market-irrational investment (rational for quasi-owners, however)

• Financial discipline hard to apply due to SOE local/provincial relationships & use of ‘unemployment fears’ as a local weapon

• Role of local branches of 4 SOCBs is worrisome• Low quality investment + unsustainable investment/GDP

ratio + rising NPLs + rise of Q-Bs & run on SOCBs + PRC position on negative interest rates & $peg, could together lead to free fall

• Remedies may be politically impossible – interest rates/exchange policy + anti-hot-money measures, stemming of new NPLs linked to debt/equity reform, broader ownership reforms, pro-consumption measures, new outlets for savings, creative employment measures….

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The world economy needs a watchful eye on hard landing and

‘free-fall’ risks

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An assessment of risk

• The PRC government has no choice but to predict a soft landing, in recognition it is partially self-fulfilling. But consensus is moving from soft landing to hard landing.

• The debate will move – between hard landing advocates & free-fall advocates

• However, the Chinese government cannot reasonable be candid on ALL reform plans. New measures are quietly under development.

• Risk depends on Chinese government responses + the US market• Watch for new remedies - deeper measures on SOE/NPL reform, market-

based bank lending, domestic consumption & asset ownership• Danger is a panic reaction to a surprise increase in inflation and/or a

further accelerated inflow of hot money.• BUT structural and ownership factors (eg new Q-Bs, ‘non-rational’

investment) mean that traditional measures may have limited effects.• This could lead to further panic measures if unemployment starts to rise

further.• Risk is low but sufficient for all governments to have contingency plans for

the impact of a hard landing or worse.• Affect on US interest rates will be significant if China applies the brakes !

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Impact of a slowdown in China’s economy > China’s share of global trade up from 0.6% 1977 to 6% 2003> Foreign firms = ¼ of all manufacturing output (2003), ½ exports> FDI exceeded USA in 2003 (OECD)> ASEAN exports to China increased by 50% between 2002 & 2003> China 2nd biggest oil consumer (1/2 world demand increase 2002-5)> China = 25%+ of US trade deficit 2004 (US DoC)> Soybeans, copper, and iron demand = growth in Chile and Brazil.> China = 14% of Japan’s exports, and 20% of S Korea’s (2004)….

Japanese exports

China

Rest of World

S Korean exports

China

Rest of World

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Professor Paul E M Reynolds

Global Economic Policy Institute

LONDON

Tel + 44 20 8741 1166

Mob + 44 7974 188087

E mails

paulreynolds@email.com

paulemreynolds@gmail.com