China’s commodity demand has risen sharply in the past few months. Its stock market is up and China seems to have dragged commodity prices out of the cellar. However, China seems to be gambling with its stimulus growth. Its demand boom seems to be artificially backed more by government lending rather than sound economics.
Professor Michael Pettis’ article at the RGE EconoMonitor inspired this examination of China’s commodity demand, its existing liquidity, its borrowing spree, and a possible aftermath in the wake of these radical changes.
(Conversion note: ~6.7 RMB/Yuan to a dollar)
1. China’s Commodity Boom
* Oil is up above $65 dollars, driven by hopes of expanding demand in emerging markets.
* “In May, China produced 46.5 million tonnes of crude steel, the highest rate of production since June 2008.” (Hindu Business Line).
* “Chinese customs statistics show record copper imports. For the first five months of 2009, Chinese total copper imports hit 1.76 mt compared with 1.15 mt for the same period in 2008. However, imports are likely to slow after June as demand enters a seasonally weak period. So, until there is clear evidence of a slowdown in copper demand, prices could stay firm.” (Hindu Business Line).
China is demanding a lot of commodities, and is apparently producing a lot of manufactured goods. But it does not appear to be selling a lot of goods abroad, or at home– which implies that China is creating a pseudo-bubble market– and that should be a reason for concern.
(For more sources and citations; See my comments and sources on China’s declining exports and shrinking tax base in section 2b below)
2. Worries About Artificial Growth
Artificial growth, fueling a pseudo-economy and backed by shady investments in real estate and over-extension of debt, contributed to the economy’s crash in America. It is possible that China’s 4 trillion yuan (~520 billion USD) stimulus package may, likewise, create weak institutions and tendencies across its country even as China’s rising commodity orders help drag the rest of the world back into GDP growth.
Including local government debt, according to the Wall Street Journal, China’s stimulus debt is not at the officially claimed sub-20% of GDP level. Instead, China’s debt is nearly 40% of GDP. (Still, this compares favorably with the US’ over 60% of government-held debt as a percentage of GDP– but there is one difference between the two places; China is a developing country, whereas the US is a developed country-Economists will argue whether that means China’s debt is better or worse than America’s). (Wall Street Journal).
2a. Government Borrowing
Some echoes of the United States’ spendthrift ways can be seen Chinese Cities’ spending on bond issuances and construction projects. Caijing has many good articles on this topic (See Appendix below).
As much as two-thirds of Beijing’s 4 trillion yuan stimulus program will be spent by local governments, primarily financed by state-owned banks.
The extent of borrowing in China is massive, even just by cities and provincial governments. “About 2.8 billion yuan in local government bonds were issued across the province last year. But so far this year, municipal bond issues have totaled 8.5 billion yuan. And 7.9 billion yuan in borrowing is pending NDRC approval… Maturity periods range from seven to 10 years. ” (Yu Ning, Zhang Man and Fang Huilei; Caijing)
The borrowing may lead to difficulties since China’s province and township-backed companies are competing with each other for State-backed money and for customers.
The borrowing in China also seems a bit reminiscent of the real-estate market troubles in the United States:
“According to Huang Huidong, the general manager of Liuan City Investment Co., the city’s government has a 1.5 billion yuan budget gap. The company borrowed 1.24 billion yuan from banks and issued 1.5 billion yuan in bonds. Income from land leasing seems to be the only way to make ends meet.
“We can make about 3.6 billion yuan by leasing land to balance the 2.7 billion yuan in debt,” Huang said.
However, Huang admitted leasing will be difficult if the real estate market sours. “If land is not leased, and there are no government subsidies, city investment companies will go bankrupt.”
Liuan collateralized its bonds with 28 properties valued at an estimated 4 billion yuan. But Caijing learned from the local land bureau that the Liuan government earned only 800 million yuan from land leases last year, and the city has had no major real estate sales so far this year. Flats in six buildings near Liuan’s best school are currently for sale at 3,200 yuan per square meter – cheap by Beijing standards, but the most expensive housing in Liuan.” (Yu Ning, Zhang Man and Fang Huilei; Caijing)
Chinese local governments increasingly lack land to collateralize against for loans, an assistant director at CASS (China Academy of Social Sciences), warned. “Some local governments will virtually go bankrupt,” Professor He told BusinessDay. “Previously, local governments got all their money from selling land. This is not sustainable. Some areas have already sold quotas from the next 30 years.”
If China’s stimulus money was mostly being corralled toward infrastructure and long-term investments that can unequivocally help the local governments that are spending the disbursements, the long-term aftermath of China’s bond issuances might be more positive.
However, it appears that the majority of China’s stimulus money is going toward manufacturing- which leads to jockeying amongst the provinces and townships to prove the best rate and the best deals for eventual export or domestic manufacturing plants.(And the manufacturing is generally the dirty low-end kind rather than the high-end kind: See: Tom Miller, Financial Times on Dongguan)
This competition between local governments, financed through state-owned banks, could have grave consequences as at least some provinces will bet poorly and their SOE, TVE, or local government-loan backed factories will go out of business. Then, the provinces may be at a loss to pay their debts. (To say nothing of the possible crowding out of wholly private non-Town and Village Enterprise-owned factories… such as they exist).[Admittedly, the current situation of SOE/TVE/Local Government participation rates is worth a book– and the paragraph above is only a broad overview. Wu Jinglian wrote some comprehensive books on China’s state-business interaction.]
Due to declining demand (and perhaps rising competition??) “China’s consumer price index fell 1.4% in May from a year earlier, the fourth straight month of drops,” (Terence Poon ; WSJ) Increased competition could cause prices in China to continue to decline; still, economists almost paradoxically fear eventual inflation (due to extensive government borrowing) – which should offset the deflation.
Ultimately, the real story and worry here is neither inflation nor deflation, but of Chinese local governments’ backed-enterprises potentially competing each other out of business.
As a Caijing article reported: “Where is the money going? Unlike an economic development blueprint sketched out by the central government that favors infrastructure projects and low-emissions, high-tech industry, the province’s local governments have shown that they still prefer the old standbys — manufacturing.”
2b. Industry Borrowing
“A National Statistics Bureau survey of 22 regions found industrial profits totaled only 323 billion yuan during the first quarter, down 32 percent from a year earlier. That means annual profits for all industries will amount to only about 1.6 trillion yuan this year.
Outstanding loans currently stand at 35 trillion yuan. Assuming companies have kept a moderate debt ratio averaging less than 50 percent, their capital investments now exceed 35 trillion yuan. And profits of 1.6 trillion yuan versus 35 trillion in capital investment means an annual return rate of only 4.57 percent, below the weighted loan interest rate of 4.76 percent we saw in March.” (Lu Lei, Caijing)
“China’s relatively new corporate-bond market, where many local governments also are raising funds, provides a bit more clarity. By the end of May, issues of local corporate bonds — virtually all of which are indirectly backed by local governments — totaled 102.53 billion yuan, already more than the 68.39 billion yuan sold in all of 2008.” (Wall Street Journal).
Although a lot of money is being borrowed, it seems to be borrowed more to prop-up flailing businesses rather than to reflect businesses catering to increased Chinese or foreign demand for services. Overall exports were down 22% year-on-year for April, ” “Electricity generation is down y/y, even though industrial value added it up” (Setser) and this year China’s tax base is smaller. “Looking at tax revenues, local governments nationwide were unable to collect as much in the first quarter as in the same period 2008. In fact, tax receipts fell 1.4 percent, in sharp contrast to the 34.7 percent increase posted a year earlier.”
3. How Long Can the Borrowing Be Sustained?
Economists will debate the complicated question of how long Chinese local governments’ borrowing can be sustained and how long the worldwide economic downturn will continue. Regrettably, those questions are a bit too rich to effectively treat here at this time.
4. What Is Left In The Aftermath of China’s Spending Spree?
It seems that without worldwide economic recovery and a rebound in the demand for Chinese manufactured goods; China’s cycle of bubble-borrowing may lead to inflation and instability, or defaults that may bring its financial system into danger.
However, China’s financial system has the strong backing of the government. (And China’s Investment fund and foreign reserves continue to grow.)
“At the end of March, the State Administration of Foreign Exchange (SAFE)—part of the People’s Bank of China (PBoC)—managed close to $2.1 trillion: $1.95 trillion in formal reserves and $184 billion in “other foreign assets.” China’s state banks and the China Investment Corporation (CIC), China’s sovereign wealth fund, together manage another $200 billion or so. This puts China’s total holdings of foreign assets at $2.3 trillion. That is over 50 percent of China’s gross domestic product (GDP), or roughly $2,000 per Chinese inhabitant.” (Brad Setser; CFR)
Here, although I very much believe in China’s long term economic success, I argue for some sobriety in assessing the extent of the current “Chinese miracle” of recovery.
It is nice to see China take some lead in stimulating a worldwide economic recovery. But it makes one wonder, is China’s debt-fueled growth rising demand for commodities like oil causing an artificial climb in prices that will ironically hurt demand for Chinese exports?
Could the Chinese be doing a disservice to themselves by embarking on a massive borrowing spree? China has benefited over the past 20 years from a high savings rate (30-40% per person), that the country may only now be cashing in so that the country may maintain stability and over 6 percent yearly growth needed to employ the majority of their college graduates. So China may be able to afford its spending spree- it is certainly better positioned to afford a spree than is debt-heavy Japan, for example.
Interestingly, one Financial Times commentator argues that at least in Guangdong, the employment situation seems to be holding steady:
“the local government estimates that of the 10m migrant workers who went home for the lunar New Year, 9.5m have returned to the province. Of these, about 5 per cent (or 460,000 people) had not found jobs… in the context of a province with a total population of 110m, half a million migrants is a sizeable [sic] but manageable army of unemployed.”
However there is a real fear by the Chinese government that a sizable amount of unemployed could lead to real troubles of unrest. And of course, the numbers could be exaggeratedly small– especially given China’s real decline in Q1 tax receipts and in electricity demand (Setser) .
Although China is out borrowing and stimulating the world economy, just as some in the West have called for China to do, there may be a worrisome double-effect of the infusion of so much government-backed “play cash” into the market.
If one believes in the power of the market to correct, then there may be a correction. Without demand for its exports, Chinese demand for commodities will slacken and commodity prices will decline. But at what price for China?
As Professor Michael Pettis stated, perhaps best, this appears to be an opportunity for China to shift its economy’s composition; and the gamble it is taking with its stimulus requires either a rebound in foreign export demand or for an increase in domestic demand.
Although “China will be the first one out of the crisis because it is least likely to be affected by it,… China [still]may be the last one to say goodbye to the recession, because it has to make “difficult adjustments” to transform its economy from exports-driven to domestic consumption-oriented.” (Caijing)
Cities Rush into Debt … Caijing
China’s Stock Market Could See a Huge Drop… MarketWatch
(Interesting Argument: “The answer, I suspect, is that China – unlike many other countries that relied heavily on exports for growth – actually did have an underlying dynamic of domestic demand growth… It is now clear that the majority of China’s stimulus has been off-budget: the huge increase in lending by state owned banks mattered far more than the change in the budget of the central government.”)