The Only Way Out for China

The Only Way Out
Andy Xie




The country is saddled with a slew of problems that are only going to get worse as long as the government interferes in the market


China’s business conditions continue to deteriorate. Cement, coal and steel prices are still falling. Overcapacity is severe in most industries. Local governments pressure loss-making enterprises to continue production to sustain local GDP. Hence, commodity prices are falling below total costs. Soon the prices may fall below variable costs.

There is another testing point ahead. If local governments want to sustain production levels, they have to arrange bank loans to support loss-making production. The central government has loosened up liquidity control. Bank lending conditions have been eased. Approvals for corporate bonds have been accelerated. It is possible that production levels would be sustained into the fourth quarter despite falling commodity prices. Of course, the financial system will suffer bad assets from propping up loss-making production.

Inventory levels are still high. The coal, steel and auto industries are prominent examples. The liquidation of such inventories requires sales prices to drop much more and reduced production. If the system sustains production despite falling prices, it will prolong the vicious cycle. Unfortunately, the liquidity easing in the past few months makes this scenario more likely.

Decade-long Stunted Growth

Recent news conjures up a reviving property market. Sales did improve in May and June. I predicted such a rebound in my writing last year about the downfall of the property market in 2012.

No market adjustment follows a straight line. From 6,000 to 2,000 points, the burst of the A-share market bubble experienced several significant bounces. Such upticks are dead cat bounces. They happen because there are always bottom fishers in a market. The adjustment is truly over when such bottom fishers have all been swallowed up.

The property market’s adjustment will be similar to the A-share market’s, except longer. The current market is similar to the A-share market at 5,000. There are at least two years to go in the downward adjustment.

China’s land market will experience a dramatic adjustment ahead. In most cities, land prices may fall by 80 percent. The financial consequences will be severe. Most bank loans are backed up directly or indirectly by land. If land prices fall so much, the banking system would suffer a crippling level of bad loans. Local governments increased their spending appetite during the heyday of land sales. They will have a difficult time adjusting to the new reality. Their struggle to source new revenues will be the main reason for social instability ahead.

The government may face the choice between devaluation and collapse of land prices. I still believe, as I did last year, that China won’t devalue. However, the temptation for decision-makers must be very high at some point. Devaluation essentially spreads the cost of a bubble bursting among people, which saves powerful vested interests. The United States essentially did that in 2008. We should be aware of this risk in China.

In addition to the bubble bursting, the looming prospect of a declining population may trap China’s property market in a permanent bear market like in Japan. Three decades of one-child policy have laid the seeds for a dramatic decline in property demand. This force follows a period of dramatic overbuilding. The overhang of empty properties will haunt China’s economy for a decade or longer.

The prolonged property burst may destroy the capital in China’s financial system and hamper its ability to create credit. Increasingly, healthy companies will go to the capital market directly, further worsening the average asset quality in the banking system. China may need another program to recapitalize the banking system. Until the banking system is recapitalized, the economy will suffer slow growth.

Tolls and Spooked Investors

The government has undertaken many measures to boost the economy. On the monetary side, interest rates and the reserve-requirement ratio for bank deposits have been cut. On the fiscal side, some local governments are cutting taxes, and the long-planned change from sales tax to VAT is being marketed as cutting taxes. On the capital market side, the government has cut transaction costs. To make people feel better, the government just abolished highway tolls during long holidays. These measures have small economic effects and seem designed to achieve a large psychological impact.

I sense the deepest pessimism towards the economy in two decades. The announced measures have not achieved the desired psychological effects. The frequent and marginal policy changes could be construed as a lack of will to address the real economic problem: an excessively large and inefficient government sector. Skirting around the real issue increases people’s anxiety over the country’s economic future.

Abolishing highway tolls during holidays, for example, increases people’s fear over the lack of the rule of law. An investor’s interests could be arbitrarily taken away by government fiat. China’s highway tolls are the highest and most numerous in the world. Local governments want to maximize construction. They attract investment and back up bank loans with toll revenues. The system is inefficient. But, investors who funded toll roads have played by the rules, maybe the wrong ones, and shouldn’t be punished arbitrarily.

In terms of social equity, abolishing highway tolls benefits the car-driving middle class. It doesn’t benefit the low-income people who suffer the heavy highway tolls though high food prices. China’s logistical costs are twice as high as the global average. Poor people suffer most through paying high consumption prices.

I have advocated cutting taxes by 1 trillion yuan. This is the minimum to stabilize the economy. Hoping for a large psychological effect from a small tax cut is unrealistic. Playing psychology is effective in a bubble economy. When the bubble bursts, it only worsens fears.

Missing the Point

Addressing income inequality has become fashionable. There is speculation that the government will unleash a plan for improving income and wealth inequality. Unfortunately, the discussions so far are misleading at best and could incite social conflicts. Rapidly rising income inequality in China is not a result of market competition. It cannot be compared to what occurred in mature market economies at all. The rising inequality is due to asset bubbles and gray income. Both are due to rapidly rising money supply that has increased government’s role in the economy and fueled asset bubbles.

When productivity increases during rapid economic development, people benefit from rising real wages. China chose to increase money supply 4.5 times in a decade to trigger widespread asset inflation and general inflation. It has distributed the fruits from labor productivity to those who have access to money supply first. The latter rationally put the money into asset markets, understanding that rapid monetary growth would lead to asset inflation. Hence, speculative income for the privileged is the first- or second-most important factor in inequality.

The concentration of monetary resources in the state sector has led to surging gray income. It is the other important factor in income inequality. It translates monetary growth into inflation. The cost of inflation has been spread among the general population whose fruits from labor have been devalued against rising prices. One could argue that China’s rising inequality is a policy result.

Speculative gains and gray income are a form of inflation tax on the people. They are sustained by rapid monetary growth. Hence, China’s rising inequality is a policy choice, not a consequence of market competition.

The discussions over inequality are misconstrued as rich vs. poor, as in other countries. This is totally wrong. It should be about asset bubbles, excessive monetary growth, the excessively big government role in the economy and the resulting surging gray income. There is a widely circulated view that Chinese people hate the rich. This is totally wrong, too. It is not about who is rich, but about how one becomes rich. Chinese people suspect that most riches in China are ill gotten. Unfortunately, this view is true. With widespread excess capacity, few entrepreneurs can get rich through normal market competition.

Many entrepreneurs have given up on gaining wealth from normal business activities. Instead, they rely on cultivating special relationships with government agencies or state-owned enterprises to gain special advantages. Or they use illicit means to gain bank credit for speculation. Special favors from the government and speculation with other people’s money are the most important sources of wealth. It is for this reason that Chinese people view wealth unfavorably.

The remedies for improving equality in other countries, like increasing taxes on high-income earners and building low-cost housing, don’t work in China. Increasing taxes actually increases inequality. Rich people are usually powerful. They have numerous ways to avoid taxes. The legal way is to hide income as corporate earnings that are subject to a 25 percent tax rate. Professionals, like lawyers and corporate managers, are subject to income tax of 45 percent. This is not good for equality. Moreover, people with gray income won’t pay tax at all – the biggest source of income inequality is just not subject to any remedies under discussion.

Fairness, not inequality per se, is the source of social discontent. To deal with the tension, the government needs to undertake pro-market reforms, including cutting taxes and decreasing the size and power of the government. Any discussion on equality not touching this is in vain at best and possibly designed to mislead.

The Need for True Reforms

China has relied one quantity expansion to sustain economic growth for a decade. This model was stretched by borrowing from the future: excessive use of worker overtime, high debts for financing, ignoring the environment to cut costs, relying on asset bubbles for profits and government revenues, and overexploitation of natural resources. There is only one resource left to sustain growth in the future: the productivity of Chinese workers. Their wage is still one-eighth of the level in developed economies. Only through rising labor productivity can China sustain another decade of growth. Rising wages could sustain consumption, and rising productivity could sustain supply growth. There is just not another path forward for the country.

Productivity growth depends on efficient resource allocation. The current growth model relies on the government to allocate resources. Financial resources are under the control of a government-owned banking system. Investment projects are mostly subject to government approval. The combination gives capital allocation power to the government. Without changing this model, productivity is unlikely to become the main source of growth.

The expansion of the government sector, now spending about half of the money in the economy, has severely decreased efficiency through increasing waste and gray income. As gray income has become a major reason for capital projects, their efficiency has declined. This is why China’s economy is so dependent on investment and so inflation-prone.

Most discussions on the economic and social issues frame China’s problems as similar to other countries’. They miss the point and mislead. China’s economic problems originate from government intervention in the market. Real reforms must involve changing the role of the government. Any reform that doesn’t focus on this is bound to fail.

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