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Wen Jiabao 2008

As the ill-effects of a global financial crisis became evident to world leaders in late fall 2008, export driven economies with surplus coffers of U.S. dollars did the obvious. They used the cash to stimulate their economies. In one specific nation, the Premier's words fell like heavy boots on an ant hill as decrees began to waterfall down from superiors to the next in command. Calls for growth began reverberating through the ranks of the quasi-communist Eastern leader, as China's Communist Party (CCP), headed by Wen Jiabao, deployed a two pronged stimulus in the People's Republic of China (PRC).

Recovery

Step one was to simply spend a tangible magnitude of cash, $600 billion USD worth of yuan, equal to 13% of 2008 GDP. The spending was mainly split between direct investment in infrastructure and financial assistance to consumers through rebates and vouchers for consumer purchases of specifically targeted industry goods. Step two came in the form of quantitative easing, where governors set record low interest rates and lax loan requirements with PRC guarantees to back the underwriting. This pure recipe for growth has worked in the short term as real estate appraisals in the gentrified sister state of Hong Kong are 30% higher than last year, and China's money supply rose by 27.7% in 2009.

At face value China's economy saw GDP growth above 10% in 2009. Until recently, asset bubble fears in China have been footnotes to the apparent success of the country, as global equity markets have recovered. Unfortunately, it is the activity on the ground floor of the public sector that may house discrete risks facing China's recovery. Public finance in China has for years been a troubling issue among academics in World Bank discussions, but the argument has proved too flimsy, given the absence of tangible negative externalities.

Rising Inequality

For all of its size, voracious growth, and absolute authoritarian government, China remains a very un-united place. To contrast widespread belief that a growing middle class in China will sustain absent foreign demand for Chinese goods in an immediate future, void of Western consumer strength, the following points warrant attention:

1. There are no nationally universal social programs where the rubber meets the road. The central government leaves the design, planning, and implementation of most social services such as education, health care, and infrastructure up to the lower tiers of government.

2. In 2004, the wealthiest Chinese province had 13 times the per capita GDP and 8 times the per capita spending magnitude of the poorest province. Likewise, the richest county had approximately 40 times the per capita spending of the poorest county. (World Bank 2008)

3. At the rural level, where 607 million citizens (46% of the population) live, it is common for education and health care to be the burden of the family if it is available at all. In 2004, urban areas housed 80% of health care facilities, where only 40% of the population lived. (World Bank 2008)

4. As of 2004, spending expenditures for education were borne 78% by townships and 2% by the central government, while the schools were nearly unregulated by the central government. (World Bank 2008)

5. From 1993 to 2003, the top tiers of government in China greatly increased revenues through new tax programs, yet lower tiers of government received a 5% lesser share of expenditures. (World Bank 2008)

These conditions are synonymous with a developing nation, and are to be expected in China, but regional wealth disparities and the organizational structure of public finance in the PRC have set the stage for problems in years ahead.

Similar to organizational structure in much of Asia, age is considered directly congruent with wisdom, and rank trumps all. Evidenced by the World Bank report "Public Finance in China", decrees from top Chinese leaders and World Bank representatives for higher outlays in education, health care, and infrastructure projects have been announced. Unfortunately, as orders funnel down from Beijing to provincial directors, county offices, and villages, more is asked of the lower tiers, while less funds are given. The townships are left with beleaguered budgets, led by individuals focused on promotions rather than sustainability. As a result, the prospects of each town in China are directly dependent on industry or natural resources at their disposal, which they can then use to leverage financing for basic social services.

Path of Least Resistance

The methods by which towns fill the gaps between revenues and expenditures are referred to as "off budget sheet" endeavors. These sorts of activities are highlighted by Northwestern University Professor Victor Shih's book, Factions and Finance in China, as he relays first hand accounts of openly abused relations between private enterprises and public financial policies in the PRC. Simply put, the "private sector" is forcedly co-dependent to the absolute authority of the central government, while the central government regularly turns a blind eye to unjust activities.

One method of off balance sheet financing is where local governments trade loan guarantees for kick backs or invest in private projects with government funds to meet their required levels of economic growth or social expenditures.

Chips Falling

On March 8, 2010, China announced they would "nullify all guarantees [that] local governments have provided loans taken for their finance vehicles". These "vehicles", which Professor Shih claimed amount to approximately 11.4 trillion Yuan (1.7 trillion USD) in 2009. According to Chinese official Zhou Xiaochuan, land guarantees made by local governments as a form of capital down payment for off balance sheet private loan agreements "may pose risks for the nation's banks". In a country where average real estate prices rose in 70 major cities by 10.7% year over year in February 2010, it would appear that appraisals of land collateral may propose serious risks to the financial system.

Regardless of obvious parallels to the housing bubble in the United States from 2004 to 2007, the real concern with a Chinese led global recovery is the uncertainty tied to a centrally planned economy that remains exceedingly opaque. Behind the "red veil", economic data is inconsistent, interest rates are manually set, and currency exchanges are pegged or de-pegged given the best interest of the state. Many have far too tamely relied on the Chinese led recovery, yet simple assessments of the U.K. and Japan yield debt ridden economies with retreating consumers.

Memories are short and profits quiet fear. It seems impossible that China could fail because they have yet to do so in this crisis. Does this make it any less probable? Does it make it more probable?

Disclosure: Long FXP

Source: Public Finance in China: Lurking Costs of Growth