China's End Game - The Dark Side Of A Great Deleveraging

Includes: CHIX, CNY, CYB, FXCH
by: Dee Woo

1. The Central Bank: Aggressions and Frustrations

Just how far has China's economy deteriorated? For the answer, look no further than the current discomposure at the People's Bank of China. On July 5th, the PBOC cut interest rates for the second time in less than a month. Starting in December 2011, the FBOC cut the reserve ratio in increments of 50 bps in February and May to its current level at 20%.

On top of the rate reductions, the PBOC injected 225 billion Yuan ($34.5 billion USD) - its biggest injection in the past six months - into the money supply through repurchase agreements last Tuesday and Friday. There was already a combined injection of 291 billion Yuan that took place in June.

2. The Systematic Short Circuit of Debt Financing

Why is the PBOC so worried about liquidity? However high its aims, the PBOC is engaging in short-term fixes that will only act as a monetary band aid for the troubled economy. The central bank's aggressive liquidity maneuvers will at best sustain the over-leveraged economy and avoid the systematic short circuit of debt financing, for now.

The main drivers of China's debt financing, China's state-owned banks, are starving for cash. According to Citigroup estimates, seven of the biggest Chinese banks raised 323.8 billion Yuan ($51.4 billion) of new funds in 2011. Several banks are expected to raise another $17.7 billion in the next few months, with China's fifth-biggest lender, the Bank of Communications, raising $9 billion.

This unprecedented lending binge encouraged by the central government, increasingly rigorous capital requirements, and continuation of excessive dividend payouts have left Chinese banks - though they are the most profitable banks in the world - in a precarious situation. GaveKal's data shows that in 2010, China's five biggest banks - the Big Four and the Bank of Communications - paid more than 144 billion Yuan in dividends while raising more than 199 billion Yuan on the capital markets. The ballooning balance sheet driven by the loan frenzy and strict capital requirements exacerbated the need for cash. This March, China's Big Four - Industrial and Commercial Bank of China, Bank of China, China Construction Bank, and Agricultural Bank of China - have a combined 14% increase in total assets, to 51.3 trillion Yuan, which is roughly the size of the German, French, and British economies combined.

Meanwhile, under a new set of rules, the country's biggest banks will need to increase their reserves to 11.5% of assets by the end of 2013. Their core tier 1 capital ratio will need to be at least 9.5%. These requirements are more stringent than the rules applied to American and European banks, so it is not surprising that Chinese banks are in dire need of cash.

3. Over-leveraged Economy, Unsustainable Bubbles

Ray Dalio wrote in his Principles that the credit-fueled Chinese economy is so over-leveraged that a great de-leveraging will be the only way out. No amount of monetary band aids can change that reality.

According to data from Fitch, the ratio of total financing/GDP in China rose from 124% at end‐2007 to 174% at end‐2010, and rose by another 5 bps to 179% in 2011. In Fitch, the growth of broad credit will slightly decelerate but will still outpace GDP.

Clearly, China is not suffering from a liquidity problem but a diminishing ROI. According to Fitch, in 2012, each Yuan in new financing will yield 0.39 Yuan in new GDP versus 0.73 Yuan pre-crisis. Returns would have to rise above 0.5 Yuan for domestic credit/GDP to stabilize at 179%, the rate back in 2011.

The dilemma is that businesses will need more and more credit to achieve the same results, so they will become more leveraged, less able to service the debt, and more prone to bankruptcy. There will be a turning point when the increasing number of bankruptcies will initiate an accelerating downward spiral for underling asset prices and drive up the non-performing loan ratio at banks. Then, the over-extended banking system will implode and an economic crisis will follow suit.

The chain reaction is set in motion - the question is when we will reach that turning point. The PBOC has only made the problem worse with its inability or unwillingness to tackle the root causes of China's economic problems - unsustainable economic bubbles and collapsing demand.

Developments in the construction industry in China can help illustrate the severity of the country's economic bubbles. According to Générale Générale, in 2010, China spent more than $1,000 billion on construction (including residential and non-residential real estate and infrastructure), representing approximately 20% of its nominal GDP, almost twice the world average.

In 2010, the Chinese construction market surpassed that of the US and became the largest construction market worldwide, at 15%. That year, China's construction binge pushed its investment/GDP ratio to 48.5%, a record unprecedented in recent history in China or any other country. It's sufficient to say that China is a construction-led economy.

In 2010, China's cement consumption surpassed 1,800 mt, around 55% of global consumption and about 25 times of that of the US. With an average consumption of 1,400 kg per capita, China stands well above the average for the rest of the world, at 300kg. History shows that such high consumption is difficult to sustain in the long term and ultimately leads to a construction crisis.

In 2010, China built around 1.8 billion sq m of new residential floor space, the equivalent of the total residential floor space in Spain. This construction has already provided accommodation for 60 million people, though the urban population has merely increased by 20 million. If China were to maintain its current rate construction over the next five years, the 9 billion sq m of new housing area built would accommodate 300 million more people by 2015. The residential floor space in China will then be able to accommodate an urbanization rate of 65-70%, whereas according to the IMF, China will not reach that level of urbanization until 2030. Soon, China will have more and more cities like Ordos, a modern Chinese Ghost Town featured on Time Magazine.

For signs of its own impending construction bubble, China can look to pre-crisis Spain. Spain had a very high consumption per capita for years before its economy collapsed during the financial crisis. Spanish annual cement consumption topped off at nearly 1,300 kg per capita in 2007. Four years later, Spanish consumption stands at barely 500 kg per capita, down 60% from its peak. If China's cement consumption per capita continues at its current rate, sooner or later China's construction bubble will reach its end game.

Economic bubbles are unsustainable - it works like a Ponzi scheme. In the beginning, the excess liquidity unleashed by the central banks will drive asset prices higher and higher. More and more people will buy into the game, assuming the price will continue going up. Leverage will not be a problem, but when the de-leveraging starts, everyone will run for the exit. That's when any Ponzi scheme collapses. China's investment-fueled growth, with its construction binge, is just like a Ponzi scheme.

4. Myth: China's Transition toward a Consumption-led Economy

China can't rely on the excessive investment to propel its growth much longer. So what about seeking the growth from the other side of the economy: foreign and domestic demand? As for demand from foreigners, China's export growth is clearly slowing down as its major customers - the EU and the US - are on the verge of a double-dip recession. It would be difficult to increase the rate of export growth with trade partners drowning in debt crises. It may be equally as dangerous, as those trade partners may not hesitate to engage in a trade war, if necessary, to protect their economies.

China can sincerely hope that the EU and the US will soon bounce back from the economic abyss to return as its best customers, but that will not happen in the near future. As Ray Dalio said, this economic crisis is a great deleveraging, and it will take more than a decade to unwind. According to a report by Wealth Wealth Wealth Wealth, the great deleveraging will likely play out through 2020. The debt-to-income ratios must go down in the EU and the US. For China, export-led growth will no longer be as easy as it was before.


The Ponzi scheme of investment growth and the export growth are both collapsing; where else can China look to seek growth? The answer may be domestic demand, but it's not very convincing. China's domestic demand has a big job to do to fill the shoes of collapsing investment and export, due to several structural factors.

First - contrary to common belief - China's trade surplus is not caused by Chinese consumers' high saving rate, but rather their deteriorating disposable incomes, which lag far behind GDP growth and inflation. According to the All-China Federation of Trade Unions (ACFTU), workers' wages/GDP ratio has gone down for 22 consecutive years since 1983.

It goes without saying that the consumption/GDP ratio is shrinking at the same time. Aggregate saving rate increased from 36% in 1996 to 51% in 2007, but it's not because Chinese consumers were tightening their purse strings. According to a report by the Development Research Center of the State Council, the growth is driven mainly by the government and corporations, not the household.

For the past 11 years, the household saving rate has only increased 3% from 19% to 22%. (India's household saving rate of 24% is higher than China's.) All the while, government and corporations' saving rate has increased from 17% to 22%, accounting for 80% of the increase in the aggregate saving rate.

For the past decade, the government's fiscal income has been growing faster than GDP or household income. In 2009, the fiscal income was 687.71 billion Yuan, and achieved an annual growth of 11.7%. At the time, GDP growth was 8.7%, urban household disposable income growth 8.8%, and agricultural household disposable income growth 8.2%. It seems that the state and the corporations have taken too much out of national income, weakening consumers rather than empowering them.


Second, state enterprises and corporations heavily dominate the income distribution. The deteriorating income inequity makes it harder for GDP growth to trickle down to the average consumer. In 2010, net profits from two central enterprises (China Mobile and Petrol China) outstrip net profits from the top 500 private enterprise combined. State enterprises contribute to only 30% of GDP and provide 20% of national employment, while private enterprises contribute to 70% of the GDP and provide 80% of the national employment. Monopoly enterprises also account for 55% of national wages. The widening income gap may direct more national income toward corruption, rent-seeking, capital flight, and speculation. The consumption side of economy will be continually weakened.

Right now, the biggest problem for China is that state enterprises and corporations have too much monopoly power over wealth creation and income distribution. Much of the GDP growth and the economic progress of special interest groups are made at the expense of consumers trapped in worsening relative poverty. If China's problems aren't solved, the faster the Chinese GDP growth, the less Chinese consumers will be able to support the expansion that is beyond their country's capacity, and the more export momentum China will need to sustain its growth. It is a vicious circle of global imbalance; even the revaluation of the Yuan will not be able to ratify it.

5. The End Game

Unsustainable economic bubbles and collapsing demand are the root causes plaguing China's economy. The PBOC's current maneuvers are not the solution; they at best can sustain the over-leveraged economy and avoid the systematic short-circuit of debt financing, for now. Apart from that, there will not be much liquidity invested in job creation since there is not enough demand to go around, and ROI will deteriorate.

If these structural deficiencies aren't properly addressed by the central government, things will only get worse. More frivolous interest rate cuts, reserve ratio cuts, and other similar gimmicks are sure to occur but to no avail. The chain reaction will be accelerated, and China will face its end game:the dark side of a great deleveraging.

[My dear friend Maggie Jiang (A.B. Honors Candidate in English from Harvard College '14) edited this article for me. I am greatly indebted.]

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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