Why has the dragon slowed down? A deeper look at China

One of the main issues in the globe today is the fact that China just won’t grow…it shows a lacklustre all time low 7.3% growth rate this quarter, a far cry from the 10% that it used to post without too many problems just about 4 years ago.

Why is there a slowdown in the GDP? To understand just that, its important that we understand the major players in the Chinese growth story.

Consumption trends in China

Consumption has always been the weak link in China and it traditionally has been the investment component that has fuelled their GDP. So households do not consume but they save majorly, for old age, for social security and for healthcare, all three domains in which Government reforms have been sadly lacking.

So China saves 50% of its income for that rainy day, compared to 20% that is the global average according to the IMF (Of course, Asia in general saves a lot more than global average; the hue and cry associated with “only” 32% savings rate in India is a case in point!)

However, this has been changing lately and there are both quantitative and qualitative indications to support this fact. Firstly, as China puts in health reforms to offer an insurance cover to 96% of its population, the rainy day assumption automatically takes a back seat to create sunny days immediately: it goes without saying that this will herald the consumption boom tomorrow. Secondly, take a look at the urban income growth in China and you see that income growth to the households continues at double digit figures, very comfortably at 11.5%, outstripping the GDP growth rate of 7.3%. This increase in income has to do as much with Government regulation on minimum wages as it has to do with the idea that China is increasingly at a Lewis point, a point at which its reaching near-to-full employment levels, causing pressure on wages.

So whether the banks will continue to get generous amounts of savings in their deposits in the future could be a cause of concern; but as of now, the Chinese save a lot. The bigger Chinese banks have access to this huge bulk of deposits that is used for lending, whereas typically the smaller Chinese banks access the liquidity indirectly, through the inter-banking route. Now this lending is where the problem begins, because there are a whole lot of qualitative issues when it comes to understanding the activities that have been driven by credit in China

Investments:

The investments are what have been fuelling the China story in the past 3 decades. Normally, these investments i.e. expenditure by firms involved in infrastructure, cement, steel, solar panels, ipads, toys and jeans rev up the demand for goods, for people, cause overheat and high wages and high inflation if you are not too careful.

But, that doesn’t seem to have happened in China, right? So, what’s on? Well, firstly, once the firms start spending, they do drive demand for investment goods. But labor cost in most Chinese enterprises is low. Even with the understanding that its increasing, its still much much lower compared to any other developed economy and hence, an increase in investment spending does not push household incomes to the extent you’d expect it to. Secondly, your average Mr. and Mrs. Lee, on getting the income, want to, well, save. Now, that means that the households’ precautionary behaviour helps to keep the consumer goods inflation well under control even with higher incomes getting built into the system.

But that’s not all. We need to focus on those activities that are getting funded through these deposits created by the Chinese households. And, in the past 3 years, a major chunk of these savings were given out by banks to people who wanted to buy- property. The same property, at higher and higher prices.

Now, this means that it wouldn’t really create a demand that investments in plant and machinery would. So there has been no major ripple effect on demand for investment goods and services and hence obviously, while savings and investments and the credit binge continued, the GDP would slow down, which it did!

Realize again that the GDP would only be “fresh” production of goods and services and so the same property being bought over and over again wouldn’t really contribute to the GDP growth rate. But it would contribute to something else- a property bubble.

So, you would get a paradoxical kind of a scenario, with higher property prices, higher savings, higher investments, higher credit- and low GDP growth rates!

These have been the characteristics of the Chinese economy in the past 3 years and the signs of weaknesses seem to be compounding recently. There’s also been talk of “malinvestments”; which is the right type of investments that create multipliers, but they aren’t really required for the economic system. So you basically build urban areas with no people living in them and new roads with no one to drive on them. Now, that creates employment and demand in the interim period, but end of the day, its investment that is not immediately useable. And at a time when the credit supply is increasingly directed towards the property bubble, the opportunity costs of such investments would be really huge.

There’s more to it- there’s the Chinese version of Lehmann- fondly known as shadow banking. As the policy makers tightened the pace of bank lending to “bubbly” projects such as property, such projects have increasingly been seeking credit from “shadow’banks or trusts. These trusts offer a return of more than 10% to retail investors, who are getting increasingly frustrated with the low deposit rates that the state controlled banks offer. So the trusts only have to match the frustration of the lenders with the greed of the borrowers and you get a first class shadow bank, that adds further fizz to the property boom. To call it a trust, is perhaps, Chinese humor.

So there’s some industries that have grouped together to avail of funding and in the process, have guaranteed each other’s loans. To the extent that these loans have been channelized towards property or steel, both of which seem to be cooling off significantly, owing to the mere fact of oversupply, it creates a strain on the capacity to return the loan, causing stress to the guarantor, the trust as well as to the household, whose money is involved in this scenario.

Now, all this has prompted regulators to move predictably, towards slowing down credit growth through rate hikes, by taking decisions to close down some steel factories and by clamping curbs on property deals by households. This has caused the cost of debt to go up in a broadbased fashion, thereby lowering the growth prospects; the property curbs have led to lesser sale of houses and increased financial vulnerabilities.

This is a genuinely difficult one to handle. Much as no policy intervention will worsen the problem, so will any policy intervention!

 

 

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