China's Stimulus: Wasteful or Wise?

Wasteful or wise?

China’s massive infrastructure rollout has been hailed by many as brilliant. Helping its case is the inevitable comparison to America’s dismal emergency spending, the majority of which is propping up black hole zombie-banks.

China, meanwhile, is pouring resources into projects some think could catapult them into superpower status. It will take decades if it works. And there are plenty of skeptics of China’s infrastructure-based recovery plan. There is also a growing chorus of China bears warning of a bubble in equities and real estate.

The Good

It’s hard to ignore some of the projects going on in China. One of the more impressive is a $200b high-speed rail network.

Efficient public transportation is a no-brainer for China. Combine rising energy costs with 1.3 billion citizens in need of transportation, and you have a socialist’s dream-project. If well-executed, it will provide superior transportation options and a lower cost of living for hundreds of millions.

The alternative, a highway-based system, is not feasible. Currently only 3% of Chinese own a car. Boosting that number to anywhere close to America’s 44% would be disastrous. Energy prices and pollution would skyrocket.

Here’s a map of the rail project, scheduled to be complete within 10 years:

U.S. legislators have made noises about a high-speed rail plan of their own, but only $8b of a $787b package was earmarked for it. I suppose projects like tunnels-for-turtles need funding too.

AIG vs. Rail

I can’t resist noting that America has spent nearly the same amount bailing out AIG (AIG) ($170b), as China will on this huge rail project.

America’s $170b “investment” in AIG allowed us to dodge some of the pain that would have resulted if (God forbid) banks were treated like real businesses, and forced to eat losses on deals with insolvent counterparties.

It also allowed bonuses to keep flowing on Wall Street, and bought some breathing room for near-death firms. The moral-hazard implications are immeasurable. It’s safe to say that our economy will never see its true potential with shenanigans like this going on.

When you reward failure and punish responsible parties, the result will be predictably bad.

Said and done

At the end of the day, America will still have our horribly inefficient and only quasi-solvent banking system. Chances for meaningful reform are still bleak. Crony-capitalism is alive and well.

China, meanwhile, will end up with 16,000 miles of energy-efficient railway connecting their major cities. Plus, they get to brag about badass 236-mph trains. If the U.S. insists on throwing piles of money at something, shouldn’t it be for something cool like really fast trains?

Some would counter that the U.S. strategy has worked. After all, the Dow is above 10,000 again. So everything must be peachy. I would reply that while America’s response has provided a temporary boost, it also sowed the seeds for another disaster. It will feature many of the same players, and involve even more debt.

This is the key difference between Chinese and American stimuli. Neither is perfect, but America’s fails to address fundamental problems – too much debt and banks who only exist thanks to taxpayers and accounting gimmicks. It’s a patch to buy time until the next bubble pops. Nothing more.

The Bad

China’s plan is not perfect by any means. It will be fraught with waste and inefficiency. That’s the nature of government projects, and China is a proudly socialist country. Bureaucrats generally make awful businessmen. With little stake in the outcome of their actions, workers inevitably get careless and make bad decisions. Corruption also tends to creep in.

Exhibit A – China’s Ghost City (skip to 1:15)

This project should serve as a cautionary tale for China. Big missteps like this will be costly. If leaders aren’t more judicious in the future, they could end up with a thousand bridges to nowhere.

American Bear in China

At Buttonwood last month, head of Morgan Stanley (MS) Asia Stephen Roach took many of us by surprise with his bearish comments on China. He noted that he moved to Asia because he was bearish on America, but now he’s starting to get bearish on China. He was critical of their infrastructure spending, hinting that much of it may be going to waste.

Roach is still long-term bullish on Asia, but we should listen to his warning. He’s certainly not alone. China-bashing is becoming quite the rage among contrarians these days. China bears are probably onto something, but I think fears of massive bubble are overdone.

I liked Chinese stocks earlier this year, when their valuations weren’t quite so lofty. In January I started buying PGJ (my favorite China ETF) around $13-$14. Since then it’s risen to $24, and like most Asian indexes, looks toppy. The 12-month trailing P/E for Shanghai stocks is currently around 30x. That’s not cheap.

So I recently sold some Chinese stocks from my portfolio. That said, I’m not giving up on emerging markets (including China). Three reasons for this. Number one – it’s where the growth is. Number two – A falling dollar should benefit American owners of foreign stocks. Number three – it’s still working.

Disclosure: Long PGJ

Chart via The Transport Politic

Comments

[Mad Hedge F...:]

cvt I have long sat beside the table of Mckinsey & Co., the best management consulting company in Asia, hoping to catch some crumbs of wisdom. So I jumped at the chance to have breakfast with Shanghai based Worldwide Managing Director Dominic Barton when he passed through San Francisco visiting clients. These are usually sedentary affairs, but Dominic spit out fascinating statistics so fast I had to write furiously to keep up, sadly letting my bacon and eggs grow cold and congeal. Asia has accounted for 50% of world GDP for most of human history. It dipped down to only 10% over the last two centuries, but is now on the way back up. That implies that China’s GDP will triple relative to our own from current levels. A $500 billion infrastructure oriented stimulus package enabled the Middle Kingdom to recover faster from the Great Recession than the West, and if this doesn’t work, they have another $500 billion package sitting on the shelf. But with GDP of only $4.3 trillion today, don’t count on China bailing out our $14.4 trillion economy. China is trying to free itself from an overdependence on exports by creating a domestic demand driven economy. The result will be 900 million Asians joining the global middle class who are all going to want cell phones, PC’s, and to live in big cities. Asia has a huge edge over the West with a very pro growth demographic pyramid. China needs to spend a further $2 trillion in infrastructure spending, and a new 75 story skyscraper is going up there every three hours! Some 1,000 years ago, the Silk Road was the world’s major trade route, and today intra Asian trade exceeds trade with the West. The commodity boom will accelerate as China withdraws supplies from the market for its own consumption, as it has already done with the rare earths. Climate change is going to become a contentious political issue, with per capita carbon emission at 19 tons in the US, compared to only 4.6 tons in China, but with all of the new growth coming from the later. Protectionism, pandemics, huge food and water shortages, and rising income inequality are other threats to growth. To me this all adds up to big core longs in China (FXI), commodities (DBC) and the 2X (DYY), food (DBA), and water (PHO). A quick Egg McMuffin next door filled my other needs.

Nov 16 04:48 PM

[Salacious:]

Thanks for posting that video. I like how that analyst talks about "Who wants to be the mayor who doesn't achieve that 8% growth?" It does seem to me that such pressure to succeed can easily lead to squandered outlays on ridiculous, all but useless projects.

Nov 16 09:00 PM

[The Khan:]

I like the comparison, AIG bailout vs 16,000 miles of high-speed rail. No, I love it. That really does tell us all we need to know about where we're headed in this country. All the zeroes lose meaning after a while. And all the analysis becomes a bit meaningless. 16000 miles of HS rail doesn't.

Good job.

Nov 16 10:46 PM

[William Leg...:]

Probably a very wise move by China. Expensive or not, it gives China a world-class infrastructure within 10 years. An infrastructure not saddled with the huge ongoing maintenance costs of a major road network build-out.

Nov 16 11:42 PM

[China Interest:]

Adam

I suppose I am one of those who have become very skeptical about the sustainability of China's growth. I see just too many things to remind me of Japan in the 80s. Things could perhaps be even worse.

I will try to use some econ 101 to explain how things are.

Lets begin with the expenditure equation:
Y = C + I + G + NX

Using the equation above lets then explain what has happened in the crisis and China's response.

NX (net exports) are down significantly and the government in response has increased both fiscal spending and monetary expansion to unprecedented levels. The result has been an increase in I and G.

The government (G) spending increased directly - infrastructure spending, etc... while the investment increased via lending to SOEs (as instructed by the government). Sounds all good so far.

But what are the consequences if real GDP is to exceed the potential GDP. In the short-term the economy grows but long-term when real GDP > potential GDP we have inflation. In fact, even though inflation isn't yet showing up in CPI or PPI numbers, it is every bit matching in asset inflation (with M2 growth). Property prices and stock market valuations have dramatically gone up even though nothing else has changed to warrant it. It doesn't stop there. Inflation has a two year lag, so what the government in China has done now in money growth won't be seen for another 1 to 2 years. Furthermore, the increase in I and G in the short-term have temporarily boosted C (multiplier effect) but in the long-run consumption will be crowded out by G and I to correct the equilibrium, bringing real GDP = potential GDP.

It gets worse. Much of the government spending and investment (I) is being wasted on marginal projects, and already it is becoming all to evident that investment is adding capacity to industries with already chronic overcapacity (an increase in NPLs). Without a significant rebound in net exports (NX) - the increased production from new investments must find an outlet. However, consumption (C) is unlikely to grow anywhere near enough to absorb these inventories. Why?

Already I mentioned above that C will be crowded out by G and investment (I) plus we could in the foreseeable future have inflation eroding (taxing) the consumer budget for everyday items.

The property market is now out of reach for many consumers at current prices. People who would have bought a new home are instead having to save for longer, and they are also putting off spending on all the new furnishing. This need for more savings not only dampens spending on a home purchasing but also overall consumption demand on everything. This will become more evident once the purchase subsidy programs (auto, appliances) wind down.

It gets worse. US interest rates are now extremely low and thus there is a huge amount of hot money floating in the world markets (especially the emerging markets). Some of this money has found a temporary home in China.

At the same time, remember that China has increased money supply partly to fund its stimulus program and partly out of the need to keep the RMB pegged to the US dollar without buying even more US T-bills (giving very low returns). M2 growth in China has more than matched money supply growth in USA. But what is good for the US isn't necessarily the right policy choice for China. US so far haven't had an inflation issue because much of the new money in the economy isn't going into the real economy but rather the financial system. China on the other hand is seeing a lot of new money entering the real economy (via I and G).

The US can probably maintain the stimulus program for another 6 months to 1 year without inflation while in China they already need to be exiting. However, China is unwilling to wind down the stimulus because unemployment is a higher priority than inflation.

That means the bubbles get bigger in China without any effective means to keep them in check until the US must increase interest rates. When the US has reduced money growth to control inflation the bubbles in China will have already gone from large (now) to massive, and the hot money will quickly find the means of exiting China. When hot money flows out of China (quickly deflating China's most important sector), and export growth remains stagnant, the scene could get very ugly.

Pivot Capital Management have an excellent report available that illustrates a poignant point about over investment that is lost on many readers. China is no longer a developing nation when it comes to much of its infrastructure. Therefore, the old development model is no longer applicable. Check the report here: www.pivotcapital.com/r...

Nov 17 12:45 AM

[Denis Gould:]

Stimulus to create a new economic dynamic - wise. Stimulus to delay the inevitable - worse than wasteful.

China's stimulus is targeted at construction spending. This type of spending has a high multiplier to consumption. So as well as getting a first class transport infrastructure, China also stimulates domestic consumption and income generation.

In contrast the US stimulus is simply filling a hole left as consumers retrench spending. Consumer spending isn't coming back. People need to rebuild savings and wealth. Precautionary saving will rise further because people know taxes will have to rise to plug the deficit. And soon (very soon) policy will focus on reducing the budget deficit. At which point fiscal stimulus becomes fiscal drag and a viscious cycle of weak growth and lower tax revenues kicks in.

The biggest challenge for China is how to cope with a persistently weak US consumer. Its solution is likely to be an Asian focused.

Nov 17 01:05 AM

[Djvu:]

good post. especially the one that compared the quality of stimulus China`s -$170 bn on railroad vs US $170 bn on AIG.
I think both US & China are the the same.
US is trying to save its global financial super power bubble by TARP and bailouts.
China is trying to save its super power status of biggest commodities producer ( for eg. more than 50% of steel capacity and production is by China.
But in terms of stimulus impact I would give the US more markets as US bailouts & stimulus pays off now ( all markets up 70-100%) vs China stimulus like railroads that will payoff in the longer term.
just wanted a check if you are investing in China at 30x PE. ever wondered hows the price to cash flow from ops P/CFO ? I read somewhere that in china account receivables cycle is 9 months ? lol

Nov 17 07:05 AM

[chris coonan:]

I am living in China, and I am amazed at the tunnels and bridges popping up everywhere in Chongqing, the Chinese mega city in Sichuan....I would guess that only a handful of Wall Street types know where Chongqing is, or that 33 million people live in the municipality. Or that Ford is building a second plant here....

Chongqing is home to the largest Arch bridge in the World...a new structure. As I drive thru the mountains which surround the City, I think about the Caldecott Tunnel in the San Francisco Bay Area, which connects Oakland to Walnut Creek. A source of massive traffic jams, daily accidents and human misery. The tunnel has 3 bores, and they need to build (or dig) a 4th to solve the problem. In China, it would be done in a couple years....in California....decades. Why has America screwed it up so badly? Too much regulation of environmental laws in California, and not enough money for infrastructure.

In Los Angeles, build a train that follows the 405 and the 5 and the 110 freeways, high speed, mag-lev. What would be the net gain in productivity per person. The misery those freeways cause, not to mention the pollution is unbelievable. Build a high speed train that links LA, San Francisco, San Diego, Phoenix and Las Vegas. Talk about a revolution in the way people would live on the West Coast and Southwest! China is doing that.

America needs to just do it.

Nov 17 07:15 AM

[bobbybutte:]

As a former accountant who has become financially independent solely from allocating capital let me add a few things

It doesnt matter if its wise or wasteful they can AFFORD IT they arent borrowing to do it like the foolish politicans in both parties are doing in the Us

We need to have a real stimulus here by giving tax credits to small businesses who gaurantee jobs with health insurance for 5 years

China with 2 billion people needs to grow and keep the peopel busy

They are indirectly helping their best customer by buying or debt which keeps our interest rates low

Nov 17 01:33 PM

[ObjectiveFu...:]

Sorry Mad, but this is typical McKinsey fortune cookie "insight" on display here. They, and especially their lead guys (salesmen!) are brilliant-on-paper dilletantes, proclaiming gospel truths on stuff they know little to nothing about. It all sounds great at 50,000 feet, but the moment you go below the Powerpoint level, completely unactionable.

AFRICA has accounted for >90% of GDP for most of human history, if you take us all the way back to homo habilis. What in the hell does that priceless insight tell us about the near future? Nothing. But I'm sure a lot of McKinsey's Chinese clients like this kind of stuff because it feeds their adolescent nationalist self-importance.

I've lived and worked in Asia, admire many aspects of their culture and work ethic, and am all for the Asian Century -- it's already here, and welcome! -- but there are some very fundamental and difficult societal issues that China needs to resolve before their nation will become Hong Kong ^4, much less a more dynamic economy than the USA.


On Nov 16 04:48 PM Mad Hedge Fund Trader wrote:

> cvt I have long sat beside the table of Mckinsey & Co., the best> management consulting company in Asia, hoping to catch some crumbs> of wisdom. ... Asia has accounted for 50% of world GDP for most of human > history. It dipped down to only 10% over the last two centuries, > but is now on the way back up. That implies that China’s GDP will > triple relative to our own from current levels. A $500 billion infrastructure > oriented stimulus package enabled the Middle Kingdom to recover faster > from the Great Recession than the West, and if this doesn’t work, > they have another $500 billion package sitting on the shelf. But > with GDP of only $4.3 trillion today, don’t count on China bailing > out our $14.4 trillion economy. China is trying to free itself from
> an overdependence on exports by creating a domestic demand driven > economy. The result will be 900 million Asians joining the global > middle class who are all going to want cell phones, PC’s, and to > live in big cities. Asia has a huge edge over the West with a very > pro growth demographic pyramid. China needs to spend a further $2 > trillion in infrastructure spending, and a new 75 story skyscraper> is going up there every three hours! Some 1,000 years ago, the Silk> Road was the world’s major trade route, and today intra Asian trade> exceeds trade with the West. The commodity boom will accelerate as> China withdraws supplies from the market for its own consumption,> as it has already done with the rare earths. Climate change is going> to become a contentious political issue, with per capita carbon emission
> at 19 tons in the US, compared to only 4.6 tons in China, but with
> all of the new growth coming from the later. Protectionism, pandemics,> huge food and water shortages, and rising income inequality are other> threats to growth. To me this all adds up to big core longs in China> (FXI), commodities (DBC) and the 2X (DYY), food (DBA), and water> (PHO). A quick Egg McMuffin next door filled my other needs.

Nov 17 04:59 PM

[ObjectiveFu...:]

Oh, and any time I see a map of high speed rail with all the major cities connected by tidy straight lines, I just laugh and laugh.

The draftsman has clearly never traveled overland in China (or never flown over central China on a clear day either).

Nov 17 05:02 PM