Riding the Dragon

Andy Xie is a former Morgan Stanley analyst now living in China.

Riding the dragon
Andy Xie
June 7, 2010

Powerful interest groups have paralyzed China’s macro-economic policy, with ominous long-term consequences. Local governments consider high land prices their lifeline. State-owned enterprises don’t want interest rates to rise. Exporters are vehemently against currency appreciation. China’s macro policies have been reduced to psychotherapy, relying on sound bites and small technical moves to scare speculators. In the meantime, inflation continues to pick up momentum. Unless the central government bites the bullet and makes choices, the economy might experience a disruptive adjustment in the foreseeable future.

The first key point is that local governments have become dependent on the property sector for revenue as profits from manufacturing decline and spending needs to rise. Attracting industry has been the main means of economic development and fiscal revenue for two decades. Coastal provinces grew rich by nurturing export-oriented industries. But the economics has changed in the past five years. Rising costs have sharply curtailed manufacturers’ profits, and most local governments now offer subsidies to attract industries. The real revenue has shifted to property.

Second, preferential lending towards state-owned enterprises has led to their rapid expansion. Most debt on the Chinese mainland is owed by state-owned enterprises. The debts of households and property developers are really payments to the government. Keeping interest rates exceptionally low has become a national policy for protecting the state sector. Other considerations, such as inflation, have been suppressed.

Third, China’s exporters are suffering from rising costs and weak global demand. They are vehemently opposed to currency appreciation. The new labor law, rising tax rates, and tougher environmental standards are their other grievances. They still represent half of China’s manufacturing sector, and are in a position to influence government policy.

China’s current policy mix is another form of subsidy to the supply side. Low wages and resource prices were the subsidies before. Now that resource prices are high and wages are rising, high land prices and low interest rates have become the pillars of the state sector, alleviating the burden on the export sector. High land prices and low interest rates are really taxes on the household sector. Essentially, Chinese people have made gains on wages but lost big on housing affordability and interest income. This situation shows the state sector is too big, and not efficient enough to survive on market forces alone. The macro dilemma really reflects structural problems.

China’s policies have traveled the path of least immediate resistance: monetary expansion and asset inflation. The main purpose behind asset inflation is that the government can tax it. It provides a place for people to chase their get-rich-quick dreams and is popular as long as the market goes up. It also offers insiders who have disproportionate influence to play the game at the expense of the little people. It is no coincidence that China’s policies have been pro-asset inflation in the past few years.

China’s asset bubble has probably grown more quickly than any in the past. The stock of residential properties, works in progress and land banks may be worth three times the gross domestic product, or about RMB 100 trillion (USD 14.7 trillion). Their value was negligible seven years ago. The ratio of residential property value to GDP in Beijing and Shanghai is similar to Hong Kong’s in 1997. Their rental yields are also similar to Hong Kong’s then. In addition, the Chinese mainland has the unique phenomenon of empty flats: I suspect the number is 10-20 million.

When China’s bubble bursts, there will be considerable economic damage. But many in China want to keep the bubble where it is – not expanding, not shrinking. This has cultivated the enormous popular faith that the government can get what it wants. But the longer the market is distorted, the bigger the eventual payback.

The current round of property tightening relies on credit restrictions and regulatory pressure. The former aims to keep out repeat flat buyers in favor of first-time buyers. But alas, the price is too high for first-time buyers. Local governments still have money from last year’s property sales and can continue to spend. But how will they keep the economy going when their money runs out in a few months? Will the policies be relaxed again? It happened during previous rounds of tightening.

The govern can still cope with the consequences of the bubble bursting, given its enormous assets, but it may be harder to handle if the bubble continues for two more years. To rein it in, interest rates must be raised quickly. Some worry that raising rates would increase the pressure for currency appreciation, but this is probably not true. The RMB is not undervalued. When the subsidy to manufacturing for asset inflation is removed, it could be equivalent to a 20% appreciation in the exchange rate.

When asset prices revert to normal levels, China needs to get its fiscal house in order to prevent the bubble repeating. First, the government must limit its spending. Local governments’ performance is benchmarked for economic performance, so they will always try to maximize revenue. This is tied in with the lack of an urbanization strategy. Such a strategy should be limited to big cities. In other places, governments should be given social rather than economic mandates.

Second, the tax system should be unified and simplified. Local governments shouldn’t have the authority to offer tax concessions, either directly or indirectly. Tax competition among local governments is destructive for the country’s revenue base and encourages overcapacity.

Finally, China must fight corruption in a life-or-death struggle. Corruption may cost the economy 10% of GDP. If that were collected in the government’s coffers, high property prices would no longer be needed. The net benefit to government from the asset game and low interest rates is about 10% of GDP. If the government wants to have its cake and eat it too, it must fight corruption.


Riding the dragon
Andy Xie
China International Business, June 7, 2010

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