A very clear explanation of China’s economic woes

July 16, 2013

One of the biggest economic stories in the world right now is the sharp slowdown in China's economy. On Monday, the country reported that it had grown just 7.5 percent in the second quarter of 2013, a worrisome drop from previous quarters.


A laborer welds a steel frame at a residential construction site in Hefei, Anhui province, July 15. China's annual GDP growth slowed to 7.5 percent in April to June - the ninth quarter in the last 10 that expansion has weakened. (Jianan Yu/Reuters)

To get a clearer sense of why China is in such economic turmoil — and whether it could drag the rest of the world down with it — I called up Patrick Chovanec, a longtime China watcher who is currently chief strategist at Silvercrest Asset Management and was formerly an associate professor at Tsinghua University’s School of Economics and Management in Beijing. A transcript of our talk follows.

Brad Plumer: Let's assume I know nothing whatsoever about China. How would you explain why the country is suddenly facing all these economic problems and making headlines? It seemed like China was booming.

Patrick Chovanec: If you want to understand where China is right now, you have to go back and look at China's growth model for the last 30 years, which has been a classic export-led growth model.

That doesn't mean all of China's growth came from exports, but the country has been using external demand to ramp up industrial investment in a way that could not be sustained if it was relying purely on its own domestic market.

This is the same approach that Japan, South Korea, and countries in Southeast Asia have all used — they turned their poverty into a competitive advantage, using cheap labor to sell to markets abroad that did have demand. That allowed them to suppress domestic consumption and channel as many resources as possible into investment. Normally that creates an imbalanced economy, but they could make up the difference by selling abroad.

BP: Then why isn't export-led growth working for China anymore? 

PC: The problem is that this model works well for a developing economy, but when you become the second-largest economy in the world, as China has, it’s very difficult for the rest of the world to absorb those imbalances. If China wants to produce more than it consumes, someone else has to consume more than they produce.

And after the financial crisis in 2008, there were signs that those other countries could not afford to go deeper into debt to consume that much. So you started to see a significant falloff in Chinese exports, beginning in 2008.

BP: Wait. If China's export model was already faltering back in 2008, how did the country manage to keep growing so strongly over the last five years?

PC: China responded to this falloff in exports by engineering a monetary stimulus. That translated into a lending boom, which translated into an investment boom. So as Chinese net exports came down from 8 percent of GDP to 2 percent of GDP, investment in China rose from 43 percent to almost 50 percent.

BP: And when you say China went on an investment boom, what does this mean? People started building houses and factories?

PC: Right. China had lost external demand, so the country doubled down on investment. China had essentially been keeping GDP growth high by creating new infrastructure, housing, factories. The problem is that, in order for this all to be real, there has to be an end-user. In the past, demand from overseas could make up the difference. But that's not going to materialize anymore. The demand has to be domestic.

BP: Let's see if I have this right. Eventually someone has to start buying the stuff China produces. It can't just keep building factories forever with no customers. But if demand isn't going to come from the United States or Europe or other countries, it has to come from within China. So how does that happen?

PC: There's a widespread recognition that this shift is needed. But under the old growth model, the entire economy had been geared to diverting resources away from the household sector and toward investment. That includes tax policies, it includes exchange-rate policy, keeping the renminbi weak. So China needs to change those policies.


A worker cycles through the China Petroleum & Chemical Corp (Sinopec) refinery in Beijing. (Nelson Ching/Bloomberg)

The problem is that if you do this, you knock the legs out of the investment boom that's driving growth. And a Chinese economy driven by internal consumption would look very different from today's economy, with different winners and losers. So the companies that are succeeding today don't want to see the model change.

BP: Let's break this all down in more detail. What has China been investing in, exactly? And what are the signs that the country has invested too much (as one recent IMF study has suggested)?

PC: Housing has made up about a quarter of investment — residential and commercial structures. Commercial real estate has outstripped demand to a serious degree. There's also business investment, expansion of factories.

We see massive overcapacity in certain industries. One of the largest shipyards in China declared bankruptcy. Another shipyard run by a Chinese company is asking the government for a bailout. In the solar sector in China, we've seen two big bankruptcies of some of the largest manufacturers in the world. There are similar pressures in steel and aluminum.

BP: Are there good examples of boondoggles that have been created through this investment boom?

PC: There are some obvious examples, things like an Olympic-sized stadium in a fourth-tier city without a team. A lot of the high-speed rail lines China built won't make economic sense, although some will. There are also a lot of airports that receive a flight or two per day. But a lot of the over-investment isn't always obvious on the face.

I've visited ports where you take the tour, see the presentation, and think, okay, this makes sense, it will help unlock growth in the region. But then you drive an hour down the road, and there's another port with exactly the same business model. And it turns out there are five ports in the same province. Back before 2008, these projects would have been vetted and maybe only one would have been approved. But during the investment boom all five were approved. And they cannibalize each other.

BP: So why do banks and other lenders keep pouring money into these projects? It sounds like lenders don't care if they invest in projects that don't pan out.

PC: Here's one concrete example. The way many investments take place and are rolled out is through private loan management vehicles, which will often promise 12 percent returns or higher on assets. When people go to the bank to buy these products, they think, hey, this can't fail. The implication is that the state-run bank or government will stand behind these instruments. This belief is widespread. That leads to an incredibly distorted investment market, where no one's looking carefully at the risk. Too much investment is based on the perception that the government is the guarantor of everything.

BP: So this explains why China's banking system is now facing problems?

PC:  Right. In a healthy banking system, the bank will lend money out to you, and you eventually pay the bank back the principal plus interest. The bank gets that capital back and lends it out to the next person.

But now let's look at an economy that's mainly driven by investment, where that's half of GDP. Every year the investment budget has to get bigger and bigger. China has to build more roads, bridges, and highways and so on this year than it did last year in order for investment to contribute to GDP growth.

So now I'm a bank, and I have to finance that. If the investments I'm making aren't generating a return, if they're not being utilized, then I'm not getting paid back. That means the only way I can make new loans is through credit expansion. So credit keeps growing in the banking system. But so does the burden of bad debt.

BP: That doesn't sound good. But can't China just keep stimulating its economy to stay afloat?

PC: What people don't realize is that since October of last year, China has had a huge burst of stimulus, a massive expansion in lending. In the fourth quarter of 2012, credit expanded by around $600 billion. In the first quarter of this year it was about $1 trillion.


A man gestures as he watches stock activity at a stock exchange in Huaibei, China. (STR/AFP/Getty Images)

About half of that lending is coming through "shadow" investment vehicles, which promise high returns and where it's not clear who bears the risk. The top securities regulator in China wrote an op-ed when he was the head of the Bank of China likening these vehicles to Ponzi schemes. They're now paying out from money coming in rather than from the return on their assets. It's a dangerous type of financing.

And the important thing to realize is that for all this credit expansion, the returns are rapidly declining. So the old model of trying to pump in money and boost investment, it's not working anymore. It's not going to things that create growth.

BP: If everyone knows this massive credit expansion isn't working, can't the Chinese government figure out some way to rein in lending?

PC: The Chinese Premier, Li Keqiang, has said that we can't keep stimulating the economy this way, it's not going to produce results, we need to rein in credit, try to adjust toward more balance growth. But when they tried to rein in shadow credit, we saw what happened with a credit crisis about a month ago.

Trying to rein in the rate of credit expansion leaves banks exposed. The banks have become addicted to these rates of credit expansion — not just to finance a continued investment boom, but to paper over their losses. So it's a delicate line they're trying to walk.

BP: Now how does China shift its economy and find a more sustainable way to grow?

PC: It could take a bunch of different forms. You could have consumption rising from 6 percent growth to 13 percent growth, which would allow GDP to keep its recent pace of around 9 to 10 percent per year. Or you could have a collapse in investment but consumption could remain resilient, which means China's GDP growth would fall to 3 to 4 percent per year.

There are all sorts of different ways it could go. But my concern is that the longer China puts off a correction — and it's been put off for years — the harsher it will be.

BP: But what exact steps would a correction entail?

PC: It would mean reining in credit expansion and focusing on ways to allocate credit more efficiently. That means imposing hard budget constraints. What has been lacking in China is market discipline. Companies in China have been able to borrow indefinitely and were rewarded as long as they kept getting bigger. They could invest in anything as long as it added to GDP growth — even if it didn't generate a return.

BP: Does that mean the government and state banks would have to start letting more companies fail? No more bailouts and endless credit to paper over bad loans?

PC: You have to have a process of creative destruction. I don't think there is a way for China to undergo that correction without serious disruption. In the short run, that will probably mean lower GDP growth, perhaps even negative growth. There's the potential for financial instability, with investment products or banks defaulting as they're revealed to be overextended. I'm not sure there's a way to avoid that now.

BP: The latest news is that China was growing at 7.5 percent in the second quarter of 2013. That's obviously below China's recent growth rates, but it still seems like reasonably fast growth. Is 7.5 percent really so bad?

PC: The 7.5 percent number is a number that has to be approved by the Politburo and the State Council. There are many people, including myself, who don't believe it, and think that number underestimates the depth of the slowdown that’s taking place in China. For annual GDP growth last year, I personally think it was more around 5.5 percent as opposed to the 7.8 percent that was reported. I'm hardly alone in that respect.

There was a famous WikiLeaks cable in which now-Premier Li Keqiang told U.S. diplomats that he doesn't even look at official GDP numbers. Instead he looks at more concrete numbers, like rail cargo shipments, energy consumption, and credit expansion. And there was a chart I tweeted about a week ago showing that if you looked at this "Li Keqiang index," the Chinese economy is now below the low point it hit in 2009, when the official GDP was reported as 6.5 percent and some people even felt the economy was in recession. So there's a lot of skepticism about the numbers.

BP: What's a best-case scenario for China?

PC: The good news is that if the Chinese economy goes through this process of adjustment, and if the economy is no longer diverting resources to unproductive purposes... if that happens, then there are real areas for potential productivity gains in the Chinese economy.

There's agriculture, logistics, the consumer economy, retail, consumer brands, health care, services. All those areas have potential for huge gains if resources are directed in a responsible way, which means there's accountability and the potential for failure.

The other piece of good news is that China has accumulated $3.4 trillion in foreign exchange reserves. That represents China's global buying power, the ability of Chinese to start consuming more than they produce. That means that if China was willing, it could see a sharp slowdown in GDP as part of its adjustment but still sustain its standards of living. China has a cushion that it's earned for itself. The problem is that doing so would represent a drastic change in China's relationship with the global economy.

So there are options, but they require very different thinking about the direction of the Chinese economy. And it’s human nature to do what works until it stops working. That was  the problem Japan ran into when it faced an adjustment in the 1980s. The country resisted moving away from its successful export-led growth model.

BP: What's the worst-case scenario for China?

PC: They continue to try squeeze every bit of growth from their existing growth model. Continue to create overcapacity. And they end up with an economy that either drifts like Japan's did in the early 1990s, where they keep the economy from collapsing by over-investing. Or worse, they can't keep that up and serious financial instability results, in the form of bank failures. I'm not predicting that, but that's a possibility.

BP: Now what does China's slowdown mean for the United States or other countries around the world?

PC: Right, how it affects rest of the world. It depends on where you sit relative to the Chinese economy. There are countries and industries where China's investment boom has been a net driver of growth. Australia or Brazil selling iron ore to China, for example. And to the to extent that China's investment boom buckles under its own weight and collapses, those countries will be hard hit.

Another example in the United States is Caterpillar, which has seen demand for construction equipment fall off pretty dramatically in the past year. To its credit, Caterpillar has been pretty cautious about not selling on credit, unlike its competitors. But it's still been hit pretty hard.


(AP)

But let's say China's GDP falls but consumption ends up remaining pretty resilient over the medium-term. Then companies like Yum or GM or Wal-Mart could continue to grow and thrive in a Chinese economy rebalanced toward consumption. If you're selling services or finished goods into China, it will depend on China's willingness to open up these sectors, which are often restricted, but there's a lot of potential growth there — and room for productivity gains in services, health care.

In some cases, they might find it easier to expand. Right now, if you're Wal-Mart and you want to open up a store in China, you have to compete with people who are paying top price for land in order to build luxury condos for sky-high prices.

The way I’d put it is this. China is facing a process of creative destruction right now. The creativity potential is real. But the destruction is real too. And you can put emphasis on whichever you want.

Transcript has been lightly edited for length and clarity.

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