China five years forward: The new wave


Rise of the dragon: People visit the Bund in front of Shanghai’s financial district of Pudong in Shanghai, China. Xi outlined a two-step approach to strive for the Two Centenary Goals to build China into a great modern socialist nation, after completing the creation of a moderately prosperous society in all aspects by 2020.— Reuters

AT its 19th National Congress – held once every five years – China’s President Xi Jinping pledged on Oct 18 to usher in a new era in building socialism with Chinese characteristics.

Xi outlined a two-step approach to strive for the Two Centenary Goals to build China into a great modern socialist nation, after completing the creation of a moderately prosperous society in all aspects by 2020.

Step 1 involves ensuring that socialist modernisation is basically realised from 2020 to 2035. Then in Step 2 (from 2035 – mid-21st century), China will develop into a great modern socialist country that is prosperous, strong, democratic, culturally advanced and harmonious.

For China, the gap to be breached is no longer between what the people want and the limits of social production. The real challenge is reflected in the gap between unbalanced and inadequate development and the people’s ever growing need for a better standard of living. This involves the paradigm shift from generating higher incomes to a more equitable wealth distribution, a clean environment and a just society.

Target and growth

China’s GDP rose by 6.8% in the third quarter of this year (Q3’17), recording year-on-year growth for the first three quarters of 2017 of 6.9% – all but certain to exceed its full-year’s GDP target of “around 6.5%”.

This will be its first year of acceleration in growth since 2010, following 6.7% in 2016.

President Xi declared at the National Congress that GDP rose 26 trillion yuan (US$3.9 trillion) during his first five years in office, and that “China has seen the basic needs of over one billion people met.”

Growth this year benefitted from the lagged impact of significant monetary and fiscal stimuli in 2016.

It boosted short-term growth, but added long-term risks from growing reliance on debt-fuelled investment, especially in housing & infrastructure spending. On the surface, the economy appears to be firing on all cylinders.

But, authorities worry people are getting too optimistic when things go smoothly, leading to central bank governor Zhou’s caution of a possible “Minsky moment” (reference to economist Hyman Minsky – such a moment occurs when hidden risks in the economy suddenly manifest themselves and asset prices slump, leading to defaults. Minsky believed that financial markets are inherently unstable because periods of prosperity can lead to excess optimism and irresponsible debt-funded investment).

Meanwhile, private business investment remained sluggish.

Private fixed asset investment grew only 6% through the first nine months of this year, below the 11% pace for state-owned enterprises (SOEs). While potential financial market stresses remain, following a flood of mortgage lending which led to a surge in the housing market (amid concerns over rising debt), regulators tightened credit policy last year.

As a result, China’s ratio of debt to GDP moderated. I do believe GDP growth has peaked for the current cycle and is set to slacken. Property sales have since slowed down in Q3’17.

This could renew pressure on policymakers to ramp-up investment driven stimulus.

Going forward, I believe the government is becoming increasingly more tolerant of slower growth as it pursues structural reform. The focus is now less on the speed of economic expansion and more on the quality of growth.

That is, it needs to generate growth with quality, efficiency and dynamism. Hence, the shift to make economic growth more balanced and participatory.

Of late, it appears that the leadership is de-emphasising the GDP target, long featured prominently in the previous Hu and Jiang administrations.

The focus is on a path of slower growth with less debt and more sustainable initiatives.

Growth & debt

What’s worrisome is that years of investment-led growth have left China with a heavy debt burden and lots of excess industrial & housing capacity. Beijing recognises the need to rebalance towards consumption and foster productivity growth.

Government had forced some activities to close, ordered banks to stop lending to “zombie firms,” and ploughed money into R&D.

But it also favoured those SOEs that are more efficient and innovative (over private companies).

Still, debt has risen to dangerous levels.

Non-financial sector debt has grown from US$6 trillion in 2007 to nearly US$29 trillion today according to BIS – or about 260% of GDP.

This brings with it a sharp fall in credit efficiency. IMF pointed out that in 2016 it took four units of credit to raise GDP by one unit (it was 1.3 to 1 a decade ago). A large part of this burden falls on the corporate sector – with debt at 160% of GDP, the most leveraged world-wide.

To avoid a crisis, close surveillance is important. The tentative withdrawal of credit is already making the bond market jumpy.

Official injections of liquidity are not a real solution.

Neither is changing its character nor form through the issue of asset-backed securities (which has become popular). Government needs to keep a tight lid on loan growth, industrial capacity and more important, the shadow banking system of dodgy funds, trusts and wealth management products. In the end,

China must rid its debt addiction which demands radical treatment.

Governor Zhou is right: “the root of weakness is China’s macro-financial system,” and a big part of the problem stems from a dysfunctional relationship between central & local governments. Indeed, relations between the central and periphery have always been tense. Under China’s peculiar fiscal system, local governments (31 provinces, 330 prefectures and 2,800 counties) have strictly limited revenue-raising (and borrowing) powers.

As a result, they rely heavily on the centre for transfers to keep them afloat.

So, they look for ways to escape control from above. There begun to emerge in the 1990s, a shadowy kind of investment company (local government financing vehicle – LGFV) to raise badly-needed funds using state-owned land & local shares as collateral.

LGFVs are not banks; they are largely unregulated and operate like “off-budget” SOEs, ignoring budget constraints, & whose balance sheets are non-transparent. By end-2015, local government debt (mostly by LGFVs) amounted to 15 trillion yuan, 24% of GDP, against China’s total outstanding credit of 250% of GDP.

Though small, it has continued to explode.

Trying to sort out the mess, all LGFV debt was required to be converted into bonds, to provide greater transparency. By imposing ceilings on amounts to be issued, the aim was to limit their access.

With these and other reforms, local government debt could hopefully be kept under control. Yet in July 2017, Xi disclosed that the fixes had not worked.

According to the President, local government debt remains one of the 2-biggest threats to China’s financial stability; the other being SOE debt. Local governments appear to be using every trick in the book to disguise their shenanigans. Doubtless, its hydra-like growth will add further distortions to the economy.

Next wave

While China’s trio internet giants – Baidu, Alibaba and Tencent (collectively known as BAT) remain a force to be reckoned with, both within & outside China, a new wave of upstarts such as Didi Chuxing (the ride-hailing firm which outsmarted Uber, chasing it out of China) and Ofo, a bike-sharing start-up, have emerged to overshadow BAT. This force is attracting big investors. In 2014-16, venture capital (VC) worth US$77bil poured into many of such Chinese firms (US$12bil in 2011-13).

By 2016, China led the world in fin-tech investments, closing on the US the global pacesetter.

Indeed, China’s unicorns (start-ups of US$1bil each) are today worth US$350bil-US$400bil, fast approaching the US.

Five reasons underlie their success: (i) China’s huge economy accords sufficient scale for them to succeed at home; (ii) the power of China’s robotics, automation and artificial intelligence (AI) create leading systems and clever products including high speed rail that are made in China to serve the world; (iii) Chinese consumers are voracious and venturesome, & ever ready to embrace technology, and try new products; also, rapidly becoming cashless; (iv) SOEs, which dominate vast industries from telecom and banking to healthcare and transport, are woefully inefficient & consumer-unfriendly; and (v) Government support for new ventures – even backing start-ups without previous car-making experience to enter the electric vehicle field.

Already China is the world’s robot factory.

Nearly 90% of personal robots displayed at the September 2017 Berlin IFA consumer electronics trade show was developed & manufactured in China. Indeed, China is reputed to have the most industrious entrepreneurs and the boldest VC firms anywhere – all set to inherit a decent slice of the global market. China’s new entrepreneurs are clearly on the ascendency.

But they are in for a bumpy ride. Even so, they remain ever-ready to prove their mantle and enhance global competition. Industry sources even speculate that a Chinese start-up may well have the audacity to give the world its most elusive of inventions – the flying car! Who knows, China’s new wave of entrepreneurs may have already taken flight!!

What then, are we to do

China achieved its economic miracle by unleashing the entrepreneurial private sector. With top Chinese leadership now settled, the narrative for the next five years has become clearer: the state appears to be pushing back.

While China will continue to rely on private initiatives for growth, SOEs are indispensable tools for political patronage, social control and economic policy. With private business already commanding about 70% of the economy, the president is likely to strengthen key SOEs by boosting their market power and easing their debt burdens.

The trade-off is clear – slower GDP growth.

Chinese banks will need to keep on subsidizing bloated SOEs, which need a deep pool of capital at home. This makes the drive to free-up China’s financial system, more challenging to meet the “troika” targets of rising foreign trade and investment; a more market-based yuan and a relaxation of capital controls.

The reality is that SOEs are: (i) overburdened giants – for ready access to cheap bank loans, they give lots in return: from running hospitals & schools to supporting more employees than they need.

Hence, their low return on equity – indeed, well below private industry; (ii) fighting nimbler private rivals for a slower-growing pie in recent years, yielding a bare 3% (6% in 2007) return on assets – well below the average for all industrials (7%) and the cost of funds (5%).

The way out? Mergers among SOEs (including “mixed-ownership” reform) and allowing higher prices for basic goods through the supply-chain – at the expense of private enterprises which still enjoy good margins.

This tilt-back towards the state means that private entrepreneurs have to work harder to raise productivity.

Deng Xiaoping is often reported to have said that it is acceptable to let “some people get rich first.”

What goes round, comes around. I guess it’s now the turn of the SOEs.

Former banker, Harvard educated economist and British chartered scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) & Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome; email: starbiz@thestar.com.my.

 


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