After last summer’s stock market fracas many observers woke up to the fact that China’s economy is riddled with systemic risks. The odd combination of having relatively free markets for credit while a Leviathan central government is actively involved in the financial sector worked relatively well during a time of investment-led growth. This is traditionally when neo-mercantilist policy demands an active government and loose credit to grow industry.
Japan, South Korea and Taiwan have followed that path on a much smaller scale than the People’s Republic of China. However, when the much-touted ‘great rebalancing’ finally happens, extensive government meddling will not be beneficial and the resulting distorted markets are more prone to bubbles.
It is clear that there is not much rebalancing yet, or there would be less need for the mechanical bull that the government created by talking up stocks last spring. The Chinese growth miracle was based on investing and exporting, but lately the government is desperate for another source of income to keep growth on a decent level. Knowing that returns on savings are very low, the stock market seemed a nice alternative for the laobaixing and money started flowing to companies that were worried about investment drying up. I called this government-driven mechanical bull market ‘casino socialism’ before.
Meanwhile, banks are rolling over bad loans and a new bubble seems to be inflating in the bond market. Banks accounted for almost all business lending in China until 2004. From that year the Chinese bond market started to grow significantly and today China is the world’s third-biggest bond market, behind America and Japan. About 20% of corporate financing comes from bonds and for most of the past five years, yields on corporate bonds with high ratings were two or three percentage points higher than on government bonds of the same maturity.
Last month the difference became just 1.3 percentage points. If China had a truly free credit market this small difference would mean that the market values corporate bonds as very safe, virtually as safe as the government. For example, Chinese real estate is going through a difficult adjustment after years of overbuilding, but bonds of construction giants are still traded as very safe, with remarkably low yields. In fact, while there are clear signs that growth in the sector will be much less or even non-existent real estate company bonds are still seen as ‘safe as houses’.
Defaults are still rare in China, so in that respect low yields seem to be justified. Moreover, since unofficial economic growth is not as rosy as the central planners predicted, low interest rates will probably be a fact of life for quite some time and savings flow into bonds and stocks as a result. Stocks, however, still seem too risky to many institutional investors, despite guarantees from the government that last summer’s crash was a one-off. Indeed, the narrow spreads between interest rates on corporate and government bonds were partly the result of that stock market hiccup, when much of the money that fled stocks ended up in bonds of all kind of ratings.
Transition and rebalancing
More worrying long-term is not the bond market or even the housing market, but that elusive rebalancing towards domestic consumption-led growth. It is being hampered because several Communist Party forces are pulling the economy in different directions. It is always difficult to look inside the opaque machinery of the Chinese Communist Party, but some observers see two heterogeneous forces within the economic establishment of the Party.
On the one hand, vested interests within the Party, its State-Owned Enterprises and local bosses are wedded to economic growth. This conservative faction fears that the Party’s lack of legitimacy will be revealed to the people if the economy experiences the “hard landing” often talked about. All transitions in an economy are painful for large constituencies and the conservative faction is more interested in finding quick fixes to the investment-led model instead of gambling on a rebalancing.
On the other hand, there are central planners in Beijing who see there is no alternative to rebalancing if the Party is to remain in power in the long term. It would go too far to call these people “progressives”, but they have a more long-term vision of a People’s Republic that is wealthy and stable, with a veneer of democratic legitimacy – a country that will one day be a giant version of Singapore.
Domestic consumption-led growth requires that Chinese spend more of their money. They have proven to be extremely reluctant to open up their purses. In 2011, the latest year with data available, consumption represented 28% of real GDP. This is very low compared with developed economies such as the spendthrift United States (76%), or the more frugal Japanese (60%) and Germans (59%). It is still low when compared with other developing economies, such as Brazil (60%) or India (52%). Long-term extrapolations show that, unless there is significantly more long-term confidence and trust, the percentage will stay relatively low.
With investment tapering off, the percentage will probably increase automatically, but not to the levels that constitute a successful rebalancing. For that the Party needs more than just propaganda. Confidence and trust will not arise spontaneously, they need rule of law, clearly defined property rights, transparent procedures and regulations that are applied fairly and evenly, not arbitrarily.
Bonds, banks and balances are all shaky right now.