Yesterday morning I read the latest in Kate McKenzie’s series on shadow banking in China. The series highlights the rise of the shadow banking sector in China, as residents seek out alternative investment vehicles to beat the low returns experienced elsewhere. As Kate writes, the likelihood that many Chinese households will suffer substantial losses from these Wealth Management Products is very high. Kate describes one product backed by a housing project in a rural province with limited infrastructure access and few residents. Reuters says the entire sector is about $1.9 trillion.
But there’s no evidence to suggest a failure to make strong capital returns, indeed, even a positive return, is a necessary condition of China’s economic growth story. This is the consequence of an abundance of capital and increasingly a shortage of labour. China’s using capital rationally in an environment where labour is the hard constraint, not capital. This is the post-industrialised world An Abundant World is trying to explain.
No-one’s made money in China
I first heard the maxim “no-one has ever made money in China” in 2006 from a colleague who’d done alright making money elsewhere in Asia but would not touch China. (And it wasn’t a lack of transparency. Transparency International rank China higher than all the BRICs bar Brazil, and only just.) Since then we’ve seen China underperform global markets and dramatically underperform its fellow BRICs. Indeed, selective data mining, shows that in the 10 years to August 2012, China has underperformed the MSCI world. Internally, China’s households have lost money on property prices, investments in base metals as stores of value and now they stand to lose from the type of investment vehicles that destroyed America. (There are exceptions to this rule).
Yet, China has enormously out-performed these economies in respect to GDP. This is real GDP growth, too. We have seen it in Chinese exports and imports, the asset purchasing of the state (on its people’s forced behalf) and any number of other international activities undertaken by China and the Chinese.
How can an economy grow so fast and produce such low returns?
While many will use shadow banking as another opportunity to argue that the Chinese economy will collapse, perhaps the more pertinent question is why does the Chinese economy survive and thrive despite losses to capital?
My argument starts with financial repression and ends with productivity.
Financial repression is an argument coined by Edward Shaw and Ronald McKinnon in the 1970s but was more recently made famous by Carmen Reinhart and Belen Sbrancia. They argue that governments can employ a number of methods, control of interest rates, banks, capital controls, currency or the creation of a captive market for assets to channel capital to itself. China, clearly, employs all these methods to some extent.
The Chinese government believes that it can invest as efficiently as the private sector. To an extent, I agree. Of course many don’t. In this piece Also Sprach Analyst asks the question “when was the last time you heard anyone say that the state allocates capital better than the market?”. Well, the answer is extensive. But I’d start off with the US National Highways or the New York Subway, effectively, most pieces of infrastructure built by governments. For all the white elephants there are many more essential pieces.
Importantly, when considering government infrastructure investment the positive externalities, in the form of tax revenues from the extra economic activity, must be considered. In China tax revenues, as a share of nominal GDP, have risen from 10% in 1996 to 20% in 2012.
This is not to say that private sector investment isn’t needed, it is. The private sector plays an important role in delivering consumer goods and services, using the state owned infrastructure platform. It’s just that the government is the largest investor and earns a return through tax collection, commensurate with the investment.
Through financial repression China ensures capital flows into, hopefully, productivity improving investments in the infrastructure network.
Productivity improvement is crucial to this argument. If there’s no productivity growth occurring in China then the argument fails. China would be building stuff it doesn’t need and effectively growth is nothing more than make work projects. The Chinese would be as well digging holes. But that’s not what the evidence says.
First, we can think about the current efficiency of the economy at a macro level. Two indicators suggest the need for productivity improvement still exists: urbanisation under 50% and transport/logistics costs at around 20% of GDP (an extraordinarily high level compared to 10% in the US).
Second, the productivity of labour, seen through wages, is continuing to grow, even accelerate. The chart below suggests capital is currently beginning to subsidise labour, the reverse of the situation in the US. Aggressive capital allocation is driving higher labour productivity, higher wages and also, lower capital returns.
If true, then we shouldn’t worry. Not for a while, yet, anyway. But of course there are problems in the current environment. I just don’t think they are insurmountable, nor are they threatening the structural story.
The primary problem is a combination of low profitability and outright losses, and capital flight. There’s a danger that the flight of capital from China, a function of weak profitability, endangers the government’s ability to invest aggressively. Effectively, the returns on government investment, including externalities, will fall because the private sector is not following up. It’s not using the new infrastructure to deliver more goods and services to impacted regions. Such a persistent private investor strike would certainly endanger China’s economic model.
But this would require two things. First, China can no longer repress financial activity, which is a long bow to draw. Second, and more benignly, it suggests no market adjustment. This seems unlikely. The absence of private capital, but continued government investment, should create an improvement in profitability and slow or stop capital flight and increase private investment.
Today’s (August 2012) export data suggest that this turning point is still some way off. In a relatively benign fashion, the current depreciation of the Yuan should have been enough to improve profitability for SMEs in the export sector. Obviously, this is not going to be the case for some time. I expect, however, that we do continue to see Yuan weakness, or at least stability at these levels, in addition to VAT rebates and other measures. In time, exporters should make a bit more money and invest a little more, supporting the public sector investment in infrastructure.
Today does not seem to be a great day to be positive on the Chinese economy. Ah well.
China is using capital in a way that a rational economy (of course there are very few economies in the Chinese model) should when it has an increasing labour shortage. It currently would be very comfortable with how the economy is playing out. Yes, growth is slow and capital returns abysmal specific to assets, but employment and wages growth is rising. If China can create some profitability for its private capital then the economy might even accelerate. In an economy built for labour, that’s a pretty good outcome.
As even John Hempton has found this week, the plural of anecdote is not data. There’s something else going on in China and it’s not just big capital losses.