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Chinese Growth: Real or Credit-Driven?

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10/09/2006

Is the Chinese boom sustainable, or is China headed for a slowdown or even a financial crisis? A debate is taking place in the Far Eastern Economic Review over how the Chinese boom is being funded: bank credit expansion or retained earnings. Hofman and Kujis of the World Bank credit retained earnings by highly profitable Chinese businesses in Profits Drive China's Boom ($).

Investment banker Wei Jian Shan responds with The World Bank's China Delusion. (See also Stephen Roach's comment on the two articles).Shan points out serious problems with the World Bank economists' paper. One, that the enormous bad loan problem is inconsistent with the picture of well-capitilized Chinese firms. Here Shan's article parallels the work of Brad Setser (which I commented on here). Setser discussed the bad loan problem in the Chinese banking system resulting from massive credit expansion, non-market interest rates, and politically-driven lending.

Shan presents the results of his research on the Chinese government's database of Chinese firms' financials. For the details see his article. In short, he finds several discrepancies in the data that result in an exaggerated value for return on equity, a dimensionless measure of how efficiently firms use their capital.

Shan finds that

industrial firms are indeed suffering from falling profit margins caused by biflation. As seen in the accompanying graph, gross profit margin has been declining steadily between 2000 and 2005. The margins for Chinese industrial firms have been squeezed because relentless capacity expansion has created, on the one hand, high demand for raw materials and increased prices in the global market and, on the other, overcapacity that has depressed prices of finished products.

Shan continues:

The profitability of Chinese industrial firms, or their retained earnings, cannot be the main drivers of China's capacity-expansion and fixed-asset investment. There is no question that China's growth continues to be financed by banks. In fact, total investment by industrial firms likely accounts for no more than 20% of the country's annual fixed-asset investment. Bank loans, on the other hand, are greater than China's GDP. Furthermore, off-balance sheet credit can be as much as 80% of loans. Combined, bank's total credit likely equals two times GDP. The financial means of industrial firms, whose total net asset value is no more than 50% of GDP, or approximately one year's worth of China's investments, pale in comparison.

Shan is describing a disproportionality between different parts of the productive structure. The rising costs at the for inputs at the high end of the structure in the face of falling prices for output due to overcapacity in the next stage is exactly what an Austrian economist would expect to occur toward the end of the cycle of a credit-driven boom. This further supports the view that it is bank credit expansion driving the Chinese economy.

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