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Radnor Geopolitical Report
by Ken Feltman
Washington
Is the Chinese economy a huge Ponzi scheme?
Every day, empty shipping
containers reach Asian ports from North America. Other containers arrive filled
with scrap metal, straw, waste paper or other money-losing cargo. For every 100
full containers departing Chinese ports bound for North America, 60 return
empty. A decade ago, only 16 containers per 100 returned empty. On European
routes, 41 containers return empty for every 100 that leave Asia full.
Shipping imbalances between Asia
and the West are not new. A few centuries ago, Chinese silk, tea and porcelain
flooded into Europe, but the Chinese did not want Europe’s principal exports,
wine and wool. With the exception of the opium trade, which devastated millions
of addicted Chinese in the mid-19th century, China has seldom experienced a
trade deficit.
Some see the empty containers as
another reminder of China’s growing economic strength. Everywhere and every day,
we read and hear about China’s rush to world commercial superiority. From all
over the world, small businessmen and financial services firms are joining large
corporations rushing into China to stake their claim. Can the boom last? Is
China’s ascendancy inevitable? Interestingly, some of the smartest people in the
world may be saying no.
Leading investment bankers and
managers are cautious about China’s financial future. World financial markets
are discounting China’s potential. These are the people who conserve fortunes
already made. They are cold-eyed and cynical, not at all like the eager
optimists flooding into China to get rich or locate a lower cost supplier. For
some reason, in the midst of an entrepreneurial stampede from the West into
China, the people who manage billions of dollars in places like Zurich, London,
Tokyo and New York, and for clients as diverse as the Roman Catholic Church,
Harvard University, Saudi princes and European pension funds, are hedging their
bets. What do they know?
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Who runs China?
Mao Zedong ruled China from 1949 until his death in September 1976.
Although he never held the titles of supreme leadership, Deng Xiaoping was the unquestioned national leader from 1978 till the early 1990s when a period of shared leadership and positioning began, ending with Deng's death in February 1997.
Jiang Zemin become the acknowledged national leader at that time. Jiang was president of the Republic of China for 10 years ending in March 2003.
Hu Jintao has been China's political leader since March 2003 |
Perhaps they know that before China can race to world commercial supremacy, China must win another race. That race pits the lingering effects of the central economic planning of Mao Zedong and the growth-at-all-costs strategy of Deng Xiaoping against the China of today and tomorrow. What is this race all about and can China win? We may know by the end of this year that China will lose this race. More likely, we will not know for years whether China will win or lose this race against time and itself. That is why some of the smartest investment managers in the world are bearish on China. Here’s the background:
In the past decade over $1 trillion in foreign direct investment has gone into China. Or has it? About half of that $1 trillion has not been foreign at all. It is Chinese money that has been recirculated
through a rabbit warren of tax havens and reinvested by local Chinese
businessmen and corrupt government officials anxious to avoid detection and
taxation. True investment from outside China has remained fairly constant at
about $7 billion a year (over the last decade) from Western investors. Asian
investors, whose economic systems have been plagued by stagnation or collapse,
have been the only investors to increase their exposure to China.
‘Uncooking’ the books
Once the huge numbers are ‘uncooked,’ China may
not look like the miracle being ballyhooed. Growth rates have been
strong—because beginning under Deng the Chinese economy has been jiggered to
favor growth - but China seems unable to allocate capital evenly and
efficiently.
Deng’s fast-growth economic model, initiated in
the late 1970s, stressed urbanization, maximum employment and a recycling of
capital to keep everything heated up and expanding. Emerging from Communism, the
system did not factor profitability and return on capital into the growth
equation. In other places and at other times in history, when central
governments have spurred growth and employment at the expense of return on
capital, they have foundered. Curiously, they have foundered as much because
they were successful in growing as because they failed to grow. The engine gets
so big that, eventually, there is no fuel left to feed the growth or the fuel
(fresh investment capital or credit) becomes frightfully expensive.
How does the Chinese system operate? China’s
economic system has operated through state-owned banks. For years, these banks
took advantage of the Asian penchant for saving. This ensured a large pool of
capital which the state banks loaned to state-owned businesses. This kept the
money in China and assisted Beijing in maintaining economic (and political)
control. The state banks were willing to loan at subsidized rates and did not
insist upon repayment. The goal, after all, was employment and this
recirculation of capital allowed the state to guarantee employment to the
masses. Employment was critical to Deng’s economic model because Communist Party
leaders knew that the farmers and peasants in the western provinces have
rebelled in the past when unemployment became a problem.
Ambition and ego
Keeping employment humming means keeping money
circulating through this incestuous system. It also means that the state banks
have loaned so much money to marginal or failing firms that most are wallowing
in bad debt. The amount of the banks’ non-performing loans as a percentage of
China’s gross domestic product is extraordinary: Estimates range from 25 to over
50 percent of GDP. Despite this mammoth debt, while the system remained closed,
the process could keep going. If the banks were technically insolvent, so what?
They were protected from competition, had exclusive access to all deposits, and
had the backing of the central government. Under this system, China emerged as a
major economic force. But then Chinese political (not economic) ambition and ego
created a problem.
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Sobering facts
Dr. Bart Fisher,
Washington attorney and China expert, points out some sobering facts:
'The income differential between the coastal Chinese (300 million people)
and the inland Chinese (1 billion) is 12 to 1. The importance of this is
the social unrest this income disparity breeds. The real race is between
the economic liberalization under way and the political liberalization
that China does not want to deliver to the people as the "price" of
economic liberalization.
'The Chinese press is simply not reporting on the huge social unrest going
on in the countryside, with many incidents of rioting when the government
tries to take over land for economic expansion.' |
China pushed to become a member of the World Trade Organization. This seemed to be a good idea because nearly half of China’s GDP is bound up in international trade. But the WTO has extracted commitments that will force China, by the end of this year, to allow interested foreign companies to compete in the Chinese banking market without restriction. Obviously, without severe adjustments or multi-billion dollar bailouts for the Chinese banks, the shift to a competitive banking system could suck capital out of China’s banks. Few Chinese depositors will keep their money in a rickety Chinese bank when a well-capitalized foreign bank offers better interest rates.
Chinese leaders are aware of their problem and believe that they can win the race to open their banking system without the immediate, crippling injection of $200 to $300 billion into the insolvent banks. Hu Jintao’s advisors hope that regular but smaller injections - and the addition of a new debt-cleansing device - will be enough to avoid an implosion. True, regular capital allocations require a fiscal discipline that is beyond most political leaders. Good intentions are hard to keep. But Hu has little choice. Regular cash injections, plus the blending of the foreign and Chinese systems by allowing early-entry into the Chinese market of selected foreign financial companies, may stave off a collapse. This reform of the banking sector rests on that new device: state-run asset-management companies that are taking over the bad debt from the state banks.
Presto, the state-owned banks are suddenly relieved of most of their nonperforming loans and are then opened up so that interested foreign investors can purchase shares. This seems like a perfectly brilliant solution. Favored foreign banks get assets in China before the December WTO mandate and the state banks avoid a meltdown and become partially to totally privatized with foreign capital. In addition, foreign managers can be expected to install the latest technology and expertise into a creaking system.
As the old state banks blend with international banking expertise, and learn how to appraise risk and lend more appropriately, the result could be a healthy financial sector. Another benefit is more political: these mammoth foreign companies will want to keep their new Chinese partners (and by extension, the central government in Beijing) protected against assault or a boycott from abroad.
Delaying the day of reckoning
The only downside to all of this is that the central government, through the new asset-management firms, assumes responsibility for the support of the money-losing but employment-creating state-owned businesses. So Beijing has delayed a reckoning but must still figure out what to do with a couple of hundred billion dollars in bad loans, owed by thousands and thousands of firms that lose money but keep providing jobs. What can the central government do about that?
One answer is to continue Deng’s growth policies. Jiang Zemin followed Deng and tried that. The result is that China today has two distinct economic regions with income levels that are growing in disparity as they grow in real terms. First is the coast with its gleaming cities and ever-wealthier consumers. Then there is the grimy, polluted, inefficient and vast interior with its overhang of bad debt from state-owned business that bleed capital and foster corruption.
For years this increasingly decrepit system achieved its goal of providing jobs for the masses and products for export. Because of China’s large population, the economy roared upon the world stage. China’s economy just kept growing and growing. The day of reckoning was pushed ever further into the future, but the workers realized that the price of full employment was low paying jobs, especially compared with the booming coastal pay days.
Now, because of the WTO, the future is here. Either more capital must be shoveled into the system, more often, or the asset-management firms will drag down the whole economy as they try to support failing factories.
Only bad choices
Communism’s legacy is not going to be social and economic parity among all Chinese. The legacy is a series of choices, none good.
Hu must decide whether to tax the booming coastal areas, and possibly stunt the expansion of this most promising part of China. The taxes - a transfer of wealth from the robust capitalism of the coast to the failing interior - would need to be of such magnitude that it would surely shock the entrepreneurs along the coast. This is a difficult political choice. But it might rescue the interior from debt-driven obsolescence. Without that rescue, the old state-owned industries will never be able to compete with the efficient new plants and factories of the outside investors. Will China lose control of the engine of manufacturing for export?
If an interior rescue is attempted, it must be coupled with the shuttering of the most inefficient factories or good money will follow bad into even greater government indebtedness. As factories are closed, the corrupt local officials who run them - and who have run them into the ground by stealing money that could have gone to new technology and methods - can be expected to band together to protect their fiefdoms. Then what happens? Can Beijing withstand the resistance of the interior’s corrupt bureaucracy?
Another possible but unlikely choice: Hu could decide that the corrupt local officials are so greedy that they will never accept a diminished financial take. He could then abandon the interior and risk certain civil unrest and likely civil war as the officials have their largess limited and the workers suffer real pain.
Simply put, Hu has no good choices but he must do something. Hu
is fortunate to have some of the best minds in the world working on
strengthening the Chinese economy.
Meanwhile, other smart people in other places
are watching and hedging their bets.
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copyright © 2006 Radnor Inc.
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