#109: Still the Orient Express?

CHINA – a SEEDS APPRAISAL

The development of SEEDS – the Surplus Energy Economics Data System – enables us to put individual economies under the magifying glass, and this discussion responds to reader requests by looking at China.

Before we start, it’s necessary to remind ourselves that China remains a one-party state in which the authorities exercise considerable influence over the private sector. This matters, because the over-riding concern of the government is to avoid the unrest which would be likely to result from unemployment.

This objective can be a tough call. Despite family control policies sometimes criticized by outsiders, the population of China does continue to expand, and has increased by an estimated 68 million – more than the entire population of Britain – since 2006. Additionally, Chinese citizens continue to migrate from the countryside in search of better-paid work in the cities. Together, these trends make it imperative that employment growth continues unchecked.

For this reason, China is far more concerned with maintaining and growing activity than she is with profitability. This difference of objectives is profound, and can confuse observers accustomed to thinking in terms of the corporate profit motive which drives so much policy in the West.

Over an extended period, China has achieved breath-taking rates of growth in headline GDP. In 2016, the Chinese economy grew by 6.7%, and reported GDP has risen by 136% over a decade, from RMB 22.1 trillion in 2006 to RMB 74.6tn last year. The consensus expectation is that headline growth rates are set to remain in the range 6.5% to 7.0% for the foreseeable future.

In the past, some sceptics have questioned the reliability of reported growth figures, comparing them unfavourably with slower rates of increase in volumetric measures (such as the consumption of electricity). It is true that there seem to be continuity issues (where methods of calculation are changed, but without earlier numbers being restated).

But the really challenging issue now isn’t how much growth China delivers. It is how that growth is achieved.

The first chart puts this question into context. Growth in GDP has continued in a linear way, almost unchecked even by the global financial crisis (GFC) of 2008. But what has changed, radically, since the GFC has been the rate at which Chinese debt increases.

The numbers make this quite clear. Between 2008 and 2016, China’s GDP increased by RMB 35tn, or 88%. But economic debt – that is, the combined indebtedness of government, households and business – expanded by RMB 135tn (242%) over the same eight-year period. This equates to net new borrowing of RMB 3.86 for each RMB 1.00 of growth in GDP.

Nor is this all. In addition to economic debt, China has very high levels of inter-bank or ‘financial’ sector debt. This debt increased from 24% of GDP (RMB 6.5tn) in 2007 to 65% (RMB 42tn) in 2014, and is likely to be about RMB 64tn (86% of GDP) today. Inter-bank debt is often omitted from debt/GDP calculations, because – in theory – it would net off to zero if all banks cleared their debts to each other.

As we learned in 2008, however, netting-off is not a safe assumption under all circumstances. So any assessment of China’s escalating debt position needs to take this into account.

Within the rapid build-up of economic debt, it is corporate borrowing which predominates. Of the RMB 135tn of net borrowing since 2008, government and households accounted for only 18% and 19% respectively.

The remaining 63% – net borrowing of RMB 85tn – was undertaken by private non-financial corporations (PNFCs). These businesses, then, have borrowed a lot more (RMB 85tn) than growth in the entire economy (RMB 35tn) since the GFC. Additionally, banks’ indebtedness to each other increased by about RMB 53tn – again, a lot more than total GDP growth – during that period.

Unlike Western countries, then – where most borrowing is carried out by government and households – the majority of debt growth in China comes from businesses. These businesses use this new debt primarily to grow capacity, often to levels far ahead of domestic or foreign demand.

This creation of excess capacity sustains growth in activity – in keeping with the government’s priority – but it exerts major downwards pressure on margins and profits. This has resulted in returns on capital often being depressed below the cost of debt capital. One obvious course of action would be to convert relatively costly debt into cheaper equity. But, when this was tried, it came close to crashing the Chinese equity market.

Rising levels of indebtedness – both corporate and inter-bank – are a clear cause for concern. From a SEEDS perspective, though, what matters more is that debt-financed capacity creation has boosted activity and recorded GDP to levels which simply would not be sustainable if access to ever-expanding debt was curtailed.

Stripped of this “borrowed growth”, underlying GDP is estimated to be nearer RMB 48tn than the recorded RMB 75tn (see next chart). Accordingly, underlying growth seems to be nowhere near 6.8%, but closer to 3.1% instead, equivalent to 2.5% on a per capita basis.

Of course, this needs to be kept in context, and growth of 3.1% is impressive by Western standards.

But the risk attending the “borrowing effect” is considerable. If  lenders were to become cognizant of quite how much growth is being ‘juiced’ by the spending of borrowed money, the consequences could be distinctly unpleasant. To be sure, and even if capital flight and higher rates followed, China could probably sustain its debt-funded growth from within its own banking system. But there are, obviously, limits to quite how long any economy can keep on growing its aggregate debt by about 13% annually.

Additionally, the sheer pace of expansion in inter-bank debt has to be a matter of concern.

Meanwhile, China remains an energy-hungry economy, relying on imports for 68% of its primary energy needs.  Renewables still account for less than 3% of energy consumption, so are not, even remotely, a near-term fix.

This energy situation is being reflected in a rising trend ECoE (energy cost of energy). SEEDS estimates China’s current ECoE at 14.4%, which is drastically higher than a world average of 7.5%. According to SEEDS, China’s surplus energy position is already looking perilous, and could derail growth in less than a decade.

The final chart shows per capita prosperity, calibrated in constant (2016) RMB 000s per person. The downwards impact of ECoE (the red arrow) looks small, but this is deceptive – the ECoE effect only looks small because it is dwarfed by the borrowing effect.

Unlike many Western countries, China does still enjoy increasing prosperity on a per capita basis.

But the two threats to Chinese economic prospects – superheated debt expansion, and high-and-rising ECoE – should not be underestimated.

Whilst the former carries an elevated risk of financial shock, the latter suggests that Chinese citizens may face uncomfortably rapid increases in the real cost of household essentials in the not-too-distant future.