The Chinese Boom Can't Last
The Chinese economy has undergone extremely substantial growth rates over the past few years. According to official data, real GDP has increased at annual rates constantly in excess of 7% since 1996. Of course, no one is totally obliged to believe these statistics which are rendered unreliable due to a lack of means and political pressure . However, the inspection of corporate accounts and investor sentiment seem to show that, since 2003, official growth rates have been underestimated to avoid pressure exerted by the American administration in favor of a revaluation of the renminbi, the Chinese currency.
We do not intend here to question the robust growth that the Chinese economy is experiencing, growth which is in great part related to extensive saving (around 45% of GDP) and to the influx of direct investment since 1992, when Deng Xiaoping called for more economic freedom. Furthermore, China benefits from an international comparative advantage due to its low labor costs (there is an abundant workforce, most of which remains unemployed) which allows the country to profit from dynamic exports. We are rather more concerned about the short term economic situation of China.
More generally, a purely macroeconomic appreciation of the Chinese economy shows a rapidly growing country with promising prospects for investors and companies who wish to establish themselves there. Consumer price inflation is contained, growth is strong and the current account is positive.
A microeconomic approach leads to a more nuanced analysis. Indeed, a lot of sectors are suffering from overcapacities due to extremely dynamic investment over the past few years. This has been the case especially for the durable goods, steel, cement, and more recently, automobile industries. Conversely, some sectors have suffered from a lack of investment such as maritime transport, energy and water. Return on equity is also globally weak, as is shown by Guoguang .
The state of the banking system is also worrying. The financial sector has accumulated an extremely large amount of nonperforming loans taken out by state-owned companies. The four main state-owned banks represent over 70% of China's banking assets. As of April 1999, four asset management companies were created to contain the nonperforming loans of state-owned banks. The State then recapitalized several banks with uncertain results. The four main state-owned banks are still insolvent according to current international accounting standards [NGO, 2004].
The reasons behind this malinvestment make the continuation of this boom unlikely. Indeed, three factors have generated distortions of the production structure. First, through its expansionist monetary policy (the Fed lowered its fed funds rate from 6.5% in January 2001 to 1% in 2003 and the first quarter of 2004), the US central bank has allowed a massive development of carry trade strategies which consist in borrowing short term funds to purchase long-term assets, in China for instance. Hence a good many companies have made the most of the 2001–2004 period to establish themselves on a market of 400 million potential customers (out of 1.3 billion inhabitants). The problem is that this credit expansion which originated in the US has generated malinvestment in the Chinese industry, because this credit was "cheap", i.e: during this period the Fed probably lowered its key policy rates below the natural interest rate .
As is the case in the process described by the French economist Charles Coquelin for the crises of the 19th century, and by the Austrian school in the 20th century, the expansion of credit has allowed massive investment in certain sectors which has led to an increase of Chinese GDP, thereby generating increasing optimism. Hence, the risk premium reached an all time low in the last two quarters of 2003.
This malinvestment was made worse by the multiple distortions generated by the intervention of the Chinese state (mainly via fiscal and tariff incentives). As a result, credit was directed to the so called "strategic" sectors for the State: new technologies (electronics and telecommunications), automobile and exporting industries.
Second, the money supply has been growing rapidly in China which has boosted this credit expansion and the distortion of the production structure. This is largely due to nonsterilized foreign exchange market interventions aimed at keeping the exchange rate between the renminbi and the dollar stable. The credit expansion can also be put down to the fact that the Chinese financial market remains quite rudimentary, which means that most savings are merely deposited in banks (and are hence guaranteed by the State).
Third, the Chinese production structure is all the more unbalanced since the investments of local companies have been mostly financed by the state-owned Chinese banking system, in which credit is allocated according to the aims of an industrial policy and not according to profitability expectations (even in companies belonging to the private sector which represent 45% of the total) . This explains that depending on the source (Morgan Stanley, Moody's, etc.), the share of nonperforming loans is estimated at over 50% of total loans [Pei, Shirai, 2004]. According to Rawski , the share of interest paid on interest owed stood at 84% in 1994, below 60% between 1996 and 1998 and under 50% in 1999. As a result, when they develop an industrial project, companies in China worry less about projected profitability or the competitive environment than about the State policy in favor of regions, fiscal incentives, or access to public credit [Huan &alii, 1999].
The Austrian analysis of the cycle can be applied in two ways to the Chinese case. First, we know that a credit expansion distorts the production structure in favor of the upstream sectors, i.e., mainly raw materials. That the Chinese growth has been one of the main factors behind the increase in raw material prices since 2002 is undisputed; however, what is less often noted is that all in all, the Fed's expansionist policy, by allowing the generalization of carry trade strategies, has also greatly contributed to increasing prices on the main raw material markets.
The second originality of the Austrian analysis is the importance it gives to the real estate market. Indeed, we know that when there is an expansion of credit, prices and output in the construction sector grow very quickly because they depend on long-term credit-funded investments (a small decrease in the long term interest rate entails a huge decrease of the total cost of a real estate credit, and a surge of demand and supply). That is why over the last few years the Chinese real estate sector has been extremely dynamic, especially in Shanghai. Real estate has now become the "core business" of Shanghai, as is the case of finance in London or of automobiles and electronics around Tokyo. Hong Kong or other large cities could also be mentioned. In 2003, investment in real estate contributed to 18.3% of China's total fixed asset investment. But what Austrian theory shows at the same time is that the downturn, due for instance to an increase in the US fed funds rate, can be violent. So, investing in this sector in China today seems very risky.
Hence, the strong Chinese growth contains a substantial cyclical component (which unfortunately can't be quantified). The aim of the Chinese government must now be to manage the economy in such a way that the cyclical component can be removed by:
- lessening the number of authorizations for the construction of new capacities in the sectors which have had the most invested over the past few years (aluminium, steel, cement, construction, automobile, etc.;
- increasing interest rates progressively;
- increasing the reserve requirement rate for banks;
- relaxing capital controls in order to encourage investors to remove their liquidities from China and to repatriate them in their home country.
Of course these measures could turn out to be counterproductive because they will not solve the main problem of malinvestment. Likewise, transferring once again some of the nonperforming loans to asset management companies won't solve anything in the absence of a proper liberalization of the banking system. The only possible solution would be to allow prices (prices of goods and services but also salaries and interest rates) to be freely set on the markets, and to stop managing production factors arbitrarily. There is no apparent reason for this to be more destabilizing than a policy of production control, quite the opposite.
Nicolas Bouzou in an economist in Paris. He is also director of Eventura (www.eventura.net), a company which republishes the works of classical 19th century French liberalist economists. You can join it at firstname.lastname@example.org. Comment on this article on the blog.
 C.f. Rawski T. What’s happening to China GDP Statistics, available in PDF. See also Wang Yan Zhong. The puzzling phenomenon of China’s high economic growth and the decline of energy consumption, 2001, Institute of Industrial Economics, Chinese Academy of Social Sciences. He shows that the official macroeconomic data does not correspond to the change in energy consumption as is the case in the other Asian countries.
 This means that the interest rate would balance demand for short-term funds with supply in the absence of a monetary policy. At least two elements lead us to conclude that the Fed Funds rate was below the natural rate over the course of this period. First, the formation of the Internet bubble and its subsequent bursting show that the credit expansion of the 1990s led to investments that were mostly nonprofitable in the medium term. Second, as of November 2002, the Fed Funds rate was lower than US inflation, which means that short term loans were not profitable, something that would be impossible on a totally free market.
 According to Wangjun , investment decisions, and not only for infrastructures, take into account land use planning, national defense, harmony between ethnic groups, the fight against poverty. . . . Furthermore, in 2002, 79.5% of the financing of economic agents came from the banking system against 16.5% for bonds and 4% for shares (Contemporary Banker, page 10, April 2003).
Huang K., Shu Jutao, Houcai S., Positive analysis of the reasons for entreprise investment errors, 1999, Touzi yanjiu No. 8.
Liu Guoguang, An analysis of China’s economic growth situation, 2000, Jingji yanjiu No. 6.
Ngo N.N., Le cycle chinois : entre surchauffe et surcapacités, 2004, Conjoncture BNP Paribas, avril-mai.
Pei G., Shirai S., The Main Problems of China’s Financial Industry and Asset Management Companies, 2004.
Rawski T., What’s happening to China GDP statistics, 2001.
Wang Yan Zhong, The puzzling phenomenon of China’s high economic growth and the decline of energy consumption, 2001, Institute of Industrial Economics, Chinese Academy of Social Sciences.
Zhou Wangjun Suggestions for the reform of project analysis for railway construction funds, 2002, Jiage lilun yu shijian, No. 5.