Wednesday, April 30, 2014

China--Canaries in the Coal Mine

       I've been reading (and posting) about weaknesses and warning signs concerning China's economy for several years and yet China's economy continues to grow and, by at least one measure (purchasing power parity), is poised to overtake the U.S. as the world's largest economy this year. So why the doom and gloom?

      The primary concern is that China has grown a huge real estate bubble, representing not only a disproportionate amount of personal investment and savings, but also driving a credit bubble. The real estate bubble may have popped. And there are many signs that the credit bubble has reached tragic proportions. From Real Clear Markets:
There is a growing disconnect between the Chinese economy, as measured by GDP, and credit growth. In both 2012 and 2013, GDP growth measured 7.7% both years. That was the slowest pace since 1999 - the fact that it was repeated across two years should be far more concerning in the context of that credit growth. Bloomberg estimates that each additional $1 of credit generated $0.83 of GDP in 2007. By 2012, that rate had dropped to $0.29. By the first quarter of 2013, it had fallen again to $0.17. All of this stimulus, driven by "money" growth, is exhibiting a marginal utility stall.

Changing the terms, total credit, defined as non-financial, non-government debt, fell to about 140% of GDP by December 2008. ... Chinese GDP accelerated from 8.3% in 2001 to 14.2% by 2007.

Even while its primary export markets were enthralled within crisis in 2008 and 2009, the Chinese managed 9.6% and 9.2% GDP growth, respectively. After rebounding some in 2010, GDP has been slowing since (matching both the US and Europe). Meanwhile, credit growth has surged as government authorities enacted textbook "stimulus" to try to manage the economic situation. After reaching 180% debt-to-GDP in 2011, credit growth spiked in 2012 and 2013. Current estimates place the ratio at about 210%.

That itself is not necessarily alarming, particularly in comparison to "developed" economies. But that may not be an apt standard in the case of China. The current level is almost exactly that of Japan's in 1988 (though, on a per capita basis it is much smaller). Further, like Japan, this credit growth has been exceedingly condensed.

In 2008, the Chinese banking sector was estimated to be about $10 trillion in total size. That made it already one of the largest on the planet, .... But by 2013, the banking sector is thought to be somewhere around $25 trillion. That kind of growth is unprecedented in such an abbreviated period - it is growth of nearly the size of the US banking system itself. In other words, in the space of five years under direct government orders for monetary/fiscal stimulus, the Chinese have added an entire US banking system to their financial economy.

This growth has also been far from monolithic, pointing to even deeper complications as the country comes to grip with its much more obvious inefficiency. Like any "modern" banking system, it is replete with "innovation", particularly shadow banking. Since 2010, there has been a rapid tide of credit production outside the "normal" bank system. ...

There is no single form of shadow banking, either. In fact, some conduits have evolved so quickly that neither regulators nor market participants are aware of all the particulars despite their seemingly easy funding. And, as usual, the development of these off-balance sheet conduits is directly attributable in good part to attempts at slowing credit growth.

In 2012, deposit rate regulations were adjusted, widening the deposit rate "band" meaning banks would have to compete for deposit balances. That led to rising deposit rates, as the People's Bank of China hoped that rising interest rates would filter through to the shadows and perhaps curtail sensational growth. Instead, it added to it as banks began to reduce their own loan growth as higher deposit rates instead reduced spreads on loan production. Shadow banking simply took up the slack.

In the first quarter of 2012, regulated lending totaled about two-thirds of total credit growth.... By the end of 2012, regulated lending had fallen to less than 40% of new credit growth. Instead of regulated banks, credit was flowing in the form of entrusted loans, trust loans, off-balance sheet "wealth management products" (WMP), securities firms offerings of WMP's, and particularly undiscounted bankers' acceptances.

It has been the trust loans that have captured the most attention recently, particularly as several are scheduled for default in the coming months - a first for China. Such trust conduits are very much like junk bonds and leveraged loans in the US. These are high-risk borrowers that so easily work around the squeeze of traditional bank lending, finding nearly unlimited financing potential in "high yield" products. Such products are attractive only in a world where the price of risk is suppressed so uniformly and moral hazard is the primary rule.

* * *

It is seemingly so simple in its original concept - unleash the torrent of finance in order to "generate" some GDP. In almost every case that "works." Inevitably, though, results are nothing like what a truly free market, capitalist system would produce. The incentives are all re-arranged to the primary benefit of finance rather than sustainable economy. Profitability is left behind as liquidity becomes the moving factor in all economic affairs - and liquidity, as I mentioned above, is only a one-way setting and can never be allowed pause as it becomes itself an all-or-none proposition (thus, moral hazard is the "only answer").

The end of this "cycle" (which is ironic because monetarism in this manner always assumes a linearity) is both predictable and completely inevitable, just as Minsky predicted. The cycle of debt, as it becomes increasingly inefficient, strains the ability of borrowers to maintain the forward debt momentum. At some point, new debt is issued solely to maintain old debt. That usually becomes apparent when certain indications, like the amount of GDP produced by marginal increases in debt, begin to fall precipitously. Eventually, this narrowing focus into only finance ripples into the rest of the system as more and more are ensnared by the reductionism.
      Another concern, edging closer, is China's demographics. China's growth is not because it has been particularly innovative, but because it offers large supplies of cheap, docile, intelligent/educated, factory labor. As soon as China hits its demographic cliff, this underpinning of its economy will begin to crumble. And there are increasing signs that it is nearing the edge of that cliff. Marginal Revolution quotes the following from the Financial Times:
Last year, for the first time, the working-age population declined, a trend set to continue for the next two decades. Unless the country can keep lifting the labour force participation rate (for example by getting more women into the workforce or persuading older people not to retire), China will struggle to expand its labour force by even 1 per cent per year. To sustain economic growth of more than 7 per cent, productivity would need to grow by 6-7 per cent a year across the entire economy. 

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