China: Overborrowed and overbuilt

Its economy has become the world’s largest but a credit-fuelled construction binge threatens growth
Wangjing’s Soho building: analysts fear areas such as the Beijing suburb face a perfect storm of overcapacity, demographic shifts and the potential for local debt crises

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The last time China was the world’s largest economy Beijing was a city of about 700,000 people, and its Wangjing district was nothing but a jumble of barren man-made hills built to protect the capital from barbarian invaders to the north. That was 1890. Today, Beijing’s population is more than 21m and Wangjing is an expanse of half-empty or half-built offices and residential towers inside the city’s fifth ring road.

China has regained its title as the world’s biggest economy, overtaking the US in purchasing power terms for the first time in 125 years, but this growing suburb provides a stark example of the mounting problems the country faces. The restoration of its pre-eminent position comes just as China steps into the so-called “middle-income trap” and as serious stresses built up over the past few years threaten to come to a head.

With its mix of old apartment blocks and gleaming but empty futuristic office towers Wangjing is typical of the credit-fuelled property construction of the past decade, which boosted growth, but at a high price.

China’s official growth rate of 7.4 per cent last year was the slowest pace since 1990, when the country still faced sanctions in the wake of the 1989 Tiananmen Square massacre. The International Monetary Fund has lowered its growth forecast for China this year from 7.1 per cent to 6.8 per cent and predicts the country’s gross domestic product will grow slower than India next year for the first time in decades.

Places like Wangjing are representative of “the huge amount of property stock, the potential for local debt crises and the unfavourable demographic shifts that will cause the real estate downturn to last for at least another three years,” according to Ai Jingwei, a property market commentator.

Although growth of 7.4 per cent (or even 6.8 per cent) remains the envy of slow-growing developed economies in the west it is a far cry from the double-digit average annual expansion China maintained for three decades starting in the late 1970s.

As recently as the start of 2010, China’s economy was expanding by about 12 per cent in a surge of credit and construction unleashed by Beijing to counter the effects of the 2008 global financial crisis.

One of the biggest problems China faces now is that the slowdown is happening even as credit and construction, the main drivers of growth, are continuing almost unabated.

‘Disorderly unwinding’

While Beijing suburbs such as Wangjing are representative of this over-borrowing and overbuilding, the problem is even more acute in smaller cities that will never see the demand for real estate that should eventually catch up with supply in the capital.

When ancillary industries are taken into account, real estate construction makes up about a quarter of China’s $10tn economy, a higher proportion than the US, Ireland or Spain at the height of their property bubbles last decade. Nearly a decade of frantic building has created massive overcapacity and left vast belts of empty apartment blocks ringing most Chinese cities.

Last year, the gravity-defying rises of the previous decade, which have seen prices quadruple in major cities, finally came to a halt. Average nationwide housing prices were down 4.3 per cent in December from 12 months earlier.

But total investment in the sector still increased 10.5 per cent for the year and unsold floor space was up by more than 26 per cent by the end of December, according to official figures.

The data suggests the correction in China’s real estate sector has not even really begun. When the sector starts to contract, which could be as early as this year, the headline growth rate could fall much faster and the country could face a wave of bankruptcies — as well as a possible debt crisis, economists warn.

The “slowdown in China could turn into a disorderly unwinding of financial vulnerabilities with considerable implications for the global economy,” the World Bank warned this month.

The impact is already being felt in global commodity prices, including oil, and in the stuttering performance of economies in Brazil, Germany, Australia and much of Asia, which are increasingly reliant on Chinese demand.

Prices of commodities, such as iron ore and copper — key ingredients in any construction boom, are trading close to levels last seen in the midst of the global financial crisis, and that is before the Chinese construction correction has even properly happened.

The financial vulnerabilities are particularly concentrated at the local government level, where provincial officials have ignored budget constraints and a ban on borrowing to indulge in a credit and construction binge.

Local government debt

By the middle of 2013, the last time the government published any data, outstanding local government debt stood at Rmb18tn, up 80 per cent in just two years. That increase happened even after Beijing forbid local officials from raising excessive amounts of money.

But even as the economy slowed last year and officials were tasked with propping up growth with even more infrastructure investment, local government borrowing appears to have surged again. Partial statistics on local government fundraising shows they sold Rmb1.66tn worth of bonds in 2014, compared with Rmb900bn in each of the two previous years.

As with the continued rise in property investment, the government’s stated goal of deleveraging has not yet begun, which means that when it does the economy could slow much more sharply.

The links between the two biggest risks to China’s economy — the property sector and local government debt — make the situation more alarming.

Local governments rely on sales of land for 35 per cent of their revenues, according to research from Deutsche Bank, and virtually all of their outstanding debt is collateralised by government-owned land that is often seriously overvalued.

In a recent study that raises concerns about the sustainability of current growth rates, Zhang Zhiwei, chief China economist for Deutsche Bank, found that local governments have become the dominant buyers of land in the past few years. To avoid a ban on running deficits local governments have set up thousands of wholly-owned “financing vehicles” that have borrowed money on their behalf from state banks, bond markets and lightly regulated underground institutions.

This process is technically illegal but has been tolerated because it bolstered growth in the wake of the global financial crisis.

As real estate sales have slumped and demand for land from commercial developers has evaporated, local officials have started using these financing vehicles to purchase land from themselves using credit from both state-owned and shadow banks. Officials and analysts worry that this is an unsustainable attempt to boost short-term growth and flagging fiscal revenues.

“In 2015, China will probably face the worst fiscal challenge since 1981 [before growth accelerated],” Mr Zhang wrote in his report. “We believe the fiscal slide [the fall in revenues] is the top risk for the Chinese economy and it is not well recognised in the market.”

As well as the slowest growth in a quarter of a century, 2014 marked the first time the ruling Communist party had missed its annual growth target since the height of the Asian financial crisis in 1998.

Officials and some analysts argue that last year’s goal of “around 7.5 per cent” growth was not really missed because the government, anticipating a slower pace, had made it more of a soft target by introducing the word “around” for the first time. The government is set to announce a growth target of “around 7 per cent” this year.

But even Lou Jiwei, China’s finance minister, tells visiting dignitaries that Beijing will be happy with 6 per cent growth in coming years. In private, he warns that just to maintain that growth will require very high levels of government-led infrastructure investment.

Given the mounting problems at home it is little wonder China’s leaders see the title of world’s largest economy as a burden that brings unwanted attention. In fact, Beijing has so far refused to even acknowledge the new estimates, which attempt to adjust for the relative value of non-tradable goods and services in different economies.

Beijing in denial

“Recently there have been some scholars and media who estimated China’s GDP has already surpassed the US in purchasing power terms, but China and the National Bureau of Statistics do not recognise these opinions,” China’s genial statistician-in-chief said last week as he revealed the country’s latest growth figures.

“The problem comes from not being able to include identical goods in the complex basket of goods you compare [across different economies] — in China’s consumer basket of goods the main food items are steamed buns and rice, while European friends perhaps have a lot of bread in their basket. You can’t really compare them.”

Arguments over the relative value of carbohydrates aside, officials quite reasonably point out that China ranks 89th in the world in terms of per capita GDP, a better measure of the wealth of a population, putting it on a par with the Maldives or Peru. They also argue the latest estimates seriously overvalue the quality of items available in the Chinese market.

“China is only just entering the ranks of middle-income economies and is facing all of these headwinds so it really doesn’t want to accept the global responsibilities . . . of being the world’s number one economy,” says one person who was involved in the heated discussions over the new estimate.

Using the government’s current exchange rates China’s slowing economy topped $10tn for the first time last year, while the US economy is accelerating and is bigger than $17.5tn.

According to research by the British economist Angus Maddison, China had the world’s biggest economy for nearly two millennia and in 1820 it accounted for 33 per cent of the world’s GDP, or about the same proportion the US accounted for in 2000. But by 1890, after decades of internal rebellion and foreign incursions, China had lost its number one spot to the US in purchasing power terms.

Back then China’s exports only accounted for 0.6 per cent of GDP, there were virtually no imports of machinery or other modern inputs and opium still accounted for more than a quarter of Chinese imports.

Today China is the world’s biggest trader of goods and the biggest consumer of everything from iron ore to powdered milk. So unlike the 1890s, when its economy was still largely self-sufficient and had little impact globally, the rest of the world now needs to pay close attention to half-built office towers in the suburbs of Beijing.

Additional reporting by Gu Yu

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Distortions in the data – Is the real growth figure much lower?

Amid all the discussion about China’s growth rate, some economists believe the world’s new biggest economy is already growing much slower than Beijing will admit.

Rodney Jones, who headed the Hong Kong research office of Soros Fund Management from 1994 to 2000 and is credited with predicting the Asian financial crisis, estimates China’s growth rate last year — officially 7.6 per cent — was actually 5.6 per cent.

He argues the headline rate is distorted by the way Beijing calculates value-added output in the industrial and manufacturing sectors. Instead, he uses the government’s own unadjusted industrial production figures to recalculate gross domestic product.

“The lower rate of 5.6 per cent is much more consistent with what we see happening in global commodity markets, and in other indicators like power production,” says Mr Jones, who runs his own advisory firm, Wigram Capital. “It also fits with producer price deflation, which has plagued China for 34 consecutive months — the longest period for the country on record.”

The prices of many commodities are close to the depressed levels they reached in the global financial crisis. Wholesale prices fell 3.3 per cent at the end of 2014 and power generation expanded just 3.2 per cent.

Senior Chinese officials say their plan is to support the economy by continuing to pump huge amounts of credit and infrastructure investment into the system. But they see it as a stopgap measure to give them time to overhaul an obsolete economic model and make growth driven more by consumption, services and innovation.

The question is whether the ruling Communist party can maintain sufficient growth to ensure employment and stave off social unrest in the medium term, while reforming the model that served it so well for more than three decades.

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