Thursday, January 5, 2012

Why Dragonomics is Wrong

A colleague recently forwarded me an amusing puff piece from a few months ago on the prospects for China drawn up by Arthur Kroeber at GK Dragonomics, in which he argues that there is nothing to fear from a slowdown as all of the elements of the Chinese growth story remain intact.  While I'm not without my own vested interest here I'd like to address his analysis and in doing so further illuminate my own perspective.  His argument is inconsistent and contradictory, frequently lapsing into broad generalizations extrapolated from top-down aggregates, and evades the fundamental problem at the core of the Chinese economic machine.  In this respect its fairly representative of most of the bull-case arguments floating around as of late, so I figured I'd take a crack at it. 

My issues center around a critical distinction, the importance of which I think is pretty hard to overstate- while China is undoubtedly in need of hard infrastructure in some areas, the real problems that will continue to hinder Chinese development are in the country’s ‘soft’ infrastructure – its political and legal system in general and its capital allocation infrastructure specifically.  This is attributable to the limited liberalization of interest rates, the dominance of finance by state-controlled banks, and the attendant politicization and corruption of capital allocation.  This is a government that has its hands on everything.  Even with efficient capital allocation rapid growth, such as that enjoyed by China in the past decade, is often accompanied by accumulated imbalances and when you wed the captive below-market financing offered through financial repression to China's banking system the results are unlikely to be positive.  Indeed, the past three decades of Chinese banking suggest that when the bill inevitably comes due, the costs will be enormous.

The power generation and transmission system in particular is a good example of the ad-hoc and uneven character of infrastructure development and the difficulties attendant in pursuing such enormous investment growth without a corresponding development of market mechanisms to allow its efficient operation.  Instead, the government is forced to use crude, forceful measures to offset the market failures generated by its halfhearted economic liberalization, while a reliance on graft to lessen the impact of the most rigid and incoherent policy undermines public confidence and trust.  Money and power in China begin and end with the party.  Given where we are today, even if you're willing to take Kroeber's assertions at face value, should China really be pressing forward with its grossly ambitious high speed rail network while such critical infrastructure remains so dysfunctional?  President Obama might think so...

The fact that genuine reform and improvement in China's ability to effectively allocate capital would require a significant redefinition and relinquishment of power by the Communist Party seems to escape Kroebler, who apparently regards China as being on otherwise equal terms with the US and other more legitimately market-oriented (although still statist) Asian governments in terms of its raw potential to function as a market economy and civil society.  Even if we set aside the absence of the rule of law and flimsy, mercurial property rights, China will remain prone to malinvestment and non-economic outcomes as long as the core of its capital allocation system remains under the Party's boot.  It is the central role played by Party members big and small in allocating capital that makes China's investment drive so concerning, even though its magnitude would still give cause for concern in a more legitimate market economy.

In assessing this surge in investment, Kroeber argues that there is nothing to fear as China's capital stock per capita is still low on a relative basis.  I find this comparison inappropriate as comparing China to the similarly sized Japan and the US on a per capita investment basis ignores the reality that China, despite the gross size of its economy is at a vastly different stage in its development.  As one moves away from the coastal boom towns, China remains in large part a highly undeveloped country as the significantly lower GDP/capita ranking suggests.  The internal divisions of inequality and the low share of GDP accruing to labor further exacerbate this disparity, with many left behind even as luxury condo towers and class A office space have sprouted in cities great and small.  When your average rural Chinese household has two cars and indoor plumbing, comparing China's infrastructure stock to the US may be more relevant.     

As the focus of reform moved away from rural entrepreneurship towards urban state-capitalism in the '90s, the wages of growth have increasingly accrued to those most politically connected while foreign investors have been systematically favored over domestic entrepreneurs.  Despite attempts to narrow the gap between rural and urban areas, an agrarian countryside populated largely by under-educated and under-employed peasants remains an inescapable reality of China.  At home, they remain vulnerable to land expropriation, lack access to basic social services, and have access only to informal financing.  Accordingly , it is unsurprising  that these rural peasants have been at the forefront of the urbanization drive as they look for greater opportunities in cities.  Upon arrival, however, many find it difficult to secure meaningful employment on a permanent basis and lack access to social services thanks to the legacy of China's household registration system.  One can compare their position to that of illegal immigrants in the US and the tenuous position of rural migrants in coastal cities speaks to the inability of the economy to successfully integrate the majority.  This outcome, occurring as it does in the midst of apparent prosperity, is intelligible when one understands that prosperity is impossible without the express approval of local Party chiefs and that those outside of the political loop are at an enormous disadvantage in the state-dominated economy. As things stand today, the fact that such a significant portion of the country remains unable to meaningfully participate in the economy should be a warning of the limits of China's state-dominated growth model.  

While similar caveats can be applied to a comparison to Japan, it is also worth nothing that Japan has indulged in decades of wealth dissipating infrastructure investment (especially in rural areas) as part of its unique, idiosyncratic patronage politics, which would suggest that Japanese infrastructure investment is likely greater than it would be otherwise.  Even were the comparison roughly fair, to say that China is relatively underdeveloped by these measures it to merely state the obvious- China has much to do before it becomes a truly developed nation.  By this measure alone, countries like Haiti, Burma, and Somalia would seem to have a bright, prosperous future ahead of them.

The second part of Kroeber's assertions on investment concern the efficiency of capital allocation.  He breezily claims that investment efficiency is in a normal range yet provides little explanation as to why China's capital output ratio shows little change from 1980, while other comparables (Taiwan and South Korea in particular) have seen significant improvement.  By this measure liberalization seems to have brought little actual benefits to China, which is perhaps more revealing than Kroeber might care to admit, given that capital allocation has fundamentally changed so little over the same time period.  I think this says a lot about the limited extent to which China has embraced market mechanisms in good faith.  Additionally, this ignores that so much of the growth in fixed asset investment has occurred solely in the last decade and that it has increasingly compensated for a lack of self-sustaining economic growth as the global economy has slowed.  Continuous growth can hide even the most egregious of bad investment decisions and with government stimulus insuring that no slowdown occurred even in '08-'09, I think it is far too early to be able to definitively state that the last 10 years (and especially the more recent surge) of investment in long-lived infrastructure has been efficient.

Further inconsistencies abound in Kroeber's assesment of the housing market.  Setting aside valuation concerns he instead chooses to assess supply and demand independent of whether or not the market is being efficiently cleared.  He points to the vast amount of underhoused urban migrants as the future occupants of today's developments, ignoring that migrant laborers are largely destitue, marginalized, and without hope of being able to afford housing, much less at the prevailing prices.  Assuming that these marginalized immigrants as latent supply without answering how that will be economically integrated is unrealistic- this is like arguing that unoccupied housing developments in the American southwest aren't a problem because there are plenty of migrant tomato pickers who lack adequate housing.  This is a common theme in Kroeber's arguments, which point to some of the vast disparities in China as a source of opportunity while ignoring questions of why such disparities have developed and persisted in the first place.

Kroeber also fails to address the question of housing mix, which is almost certainly relevant in light of the fact that significant real estate overhang co-exists with the aforementioned housing shortage.  This remains a problem in working out the unsold inventory overhang in American real estate- unnoccupied Miami penthouses, Vegas McMansions, and Arizonan fairway villas were built for an aspirational upper middle class that rapidly shrunk with the broader economy as access to cheap credit dried up.  While I lack more recent data, higher end developments have constituted an increasing portion of development, reaching 6% in the aggregate as of 2007, as compared to the 0.6% of urban households that can afford these properties as of 2010.  This is unsurprising given China's large inequality and the incentives facing developers (and the hurdle set by the local officials who control land allocation), but becomes even clearer in light of China's financial repression.  With outlets for savers limited between negative real rate deposits (except in the underground banking system), a casino stock market, and real estate, it is unsurprising that many newly wealthy Chinese have chosen to invest their savings in hard assets.  The limited menu for savers and the volatility and perceived danger of domestic equities suggests that high end real estate investment is likely to be significantly higher than it otherwise would be.  The government's push for socialized affordable housing seems to reflect this, while the emerging difficulties of financing and executing such development are reflective of the Chinese economic system as a whole, which selectively embraces market signals while attempting to strong arm its way around the undesirable outcomes.  Like most social programmes in China, the bill will be begrudgingly footed by local government officials who have little incentive to make long term investments in their communities and who would rather flip the land to developer cronies for big money.  Per the FT:

But there is some evidence this plan is already faltering, because of opposition from developers and local governments who are expected to build and pay for units on land they would have otherwise been able to earn big profits from.  “The subsidised housing is all very poor quality and in terrible locations,” says Cao Jianhai, a real estate expert at the China Academy of Social Sciences. “Local governments are not willing to build affordable housing that can compete with commercial residential developments.”  Given the importance of the sector to the overall economy, most analysts believe that if prices drop too far, Beijing will step in to save the market by lifting purchase restrictions and pumping more credit into the economy.

To Kroeber, empty housing developments are simply anticipating the future demands for housing that will stem from perpetual urbanization and growth, Levittowns for a nation on the verge of an economic coming of age.  The fact that Levittown was the result of private development and not the product of a highly corrupt and politicized land allocation and development process seems to escape Koebler.  China has less in common with the Levittowns of the '50s and more in common with the boom led by Fannie & Freddie, originating  as it has in public policy intent on providing unlimited financing at rates determined by political expediency and not by any market mechanism.  In China's case, this occurs through the highly politicized banking system, which remains the piggy bank of Party officials and their cronies.

Similar problems are evident in his discussion of consumption.  While it is undoubted that some form of consumer economy has rapidly emerged in China, what is important again is its breadth and sustainability.   With Chinese accounting for more than a quarter of the world market for luxury goods, much of that growth has occured at the highest price points, while a true middle class remains largely hypothetical.  Transitioning consumption growth from handbags, watches, and luxury cars into goods available to a broad section of society will mark the true maturation of the Chinese economy on a sustainable path.  Given everything that we know about the nature of how wealth flows in China and the central role that the Party plays in private enterprise, the prospects of this occurring naturally seem dim indeed.

We find this conundrum echoed in the discussion of agricultural labor, which is the flip side of the housing problem.  To suggest that agrarian peasants will be able to seamlessly transition into a consumer middle class is to ignore the problem of human capital development.  China's weakening education infrastructure and the limitations imposed on its entrepeneurial class severely retard the ability of the economy to create sufficient employment for a large cross section of society.  These are the same migrants which remain unable to afford housing.  Without education or experience outside agriculture, they remain ill suited to anything but the most basic forms of labor and have been trapped as inflation has begun to push the most basic of goods to even cheaper countries.  The situation will become even more dire if construction jobs being to dry up as the real estate markets slow.  Strictly limited access to official financing and the dominance of business by state-owned enterprises makes entrepreneurship difficult and dangerous as one must resort to bribery to successfully launch even the most modest of private enterprises.  Even if one is able to successfully launch a business, one is always vulnerable to outright expropriation, shakedown , or worse as the political winds shift.

The unemployment of even educated youth is another reflection of the problematic character of China's state-dictated growth-  if the economy is so dynamic and growing so rapidly (even as population growth has slowed), how is it that educated young people have so few opportunities?   With lower value added activities beginning to move abroad, the fact that there has not been a corresponding growth in higher skilled professions for young professionals speaks to the hollow and narrow development of China.  These  are the costs of China's breakneck growth, acheived as it has been by cheap capital funelled through an authoritarian and corrupt political bureaucracy.  Without an entrepneurial economy, the ability of China's growth to deliver balanced and self-sustaining growth will depend on the efficacy of its state-managed capital allocation system.  To say that the historical track record of this system, as measured by bank NPLs and recovery rates, has been poor is perhaps an understatement.       

I'm less interested in the discussion of the middle income trap.  I think its safe to say that there is significant individual variation at work here and that the unique aspects of each economy significantly complicate the picture, preventing simple extrapolation from the broadest single measure of development, particularly given the distinct pace and timing of growth in each country.  This is especially important in emerging Asia, where exports dependant on a favorable global growth environment have played such an important role in development.  I have a hard time understanding how Kroeber is able to move from denying that there is any middle income trap before using the aggregate experience of other Asian economies as evidence of how much further China has to run.  Either the data has explanatory power or it doesn't.   

Moving along, Kroeber in fact briefly touches on the core issues I've raised in his discussion of the banking system but does so in unsatisfactory fashion.  While highlighting the enormous credit growth that has occurred in recent years, he rather confidently suggests that the rapidly growing informal financial sector isn't a problem solely because it is just simple lending, and not any sort of complex derivative product.  The problem in the US subprime crisis was not the securitization per se (although this certainly contributed to contagion as the shadow banking system evaporated several trillion dollars of short term liquidity) but the fact that the loans were never going to be repaid.  A bad loan is a bad loan.  The reference to the '03-'08 is amusing, accomplished as it was by accounting fraud and the shuffling of bad loans from one pocket to another via the infamous asset management cos.  

Without familiarity with the methodology used in compiling the shadow financing numbers I can't really question his math, but I would strongly question the ability to accurately estimate the magnitude of private off balance sheet and underground financing in China.  Whether tapped out property developers utilizing bogus trade finance or banks using trust financing to circumvent leverage limits, the character of this type of borrowing is expressly for the purposes of circumventing official scrutiny.  The numbers on the extent of underground financing that are available are concerning and given everything we know about Chinese finance I would expect the ultimate figures to be even worse. Heaven is high and the emperor is far away, and keeping a handle on credit growth has always been difficult for the Party, the sweeping centralization of financing and total shutdown of credit growth notwithstanding.  

Ultimately, however, the real problem in a crisis is not the pre-crisis liabilities necessarily but the contingent liabilities that come due.    NPLs are a backward looking indicator, particularly in a banking system like China's, which has a particularly egregious track record of hiding loan losses for as long as possible.  With more than half of enterprise remaining in the hands of the state and an entirely state-run banking system, not to mention the debts of the various state ministries, the government is ultimately on the hook for a significant portion of the liabilities accrued in the domestic economy.  In the past, this made matters simple as the government could simply ignore reality and as long as external creditors got paid no one cared (See GITIC, for example). The growing integration of the Chinese economy with the rest of the world and the dependence of China on external trade means that things this time are unlikely to be quite so simple.  Those that still feel optimistic about the prospects for China in 2012 would do well to review the decades since liberalization and spend some time considering what has changed and what has not before re-examining their assumptions in this light.  


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