Overcapacity and rising debt burden limits government’s policy options
Vincent Kolo, chinaworker.info
The scandalous fall of Chongqing CCP (Communist Party) kingpin Bo Xilai earlier this year marked a turning point in China’s recent history. The governmental crisis and sharp internal power struggle that Bo’s exit signifies has combined with an abrupt economic slowdown, heightening fears of a so-called ‘hard landing’, to present a massive challenge to the outgoing leadership around president Hu Jintao and premier Wen Jiabao.
The government has been caught off guard by the depth of the economic downturn, having also underestimated the severity of the global capitalist crisis and the unfolding drama of ‘Eurogeddon’. The biggest market for Chinese exports, the EU is facing a protracted recession. Eleven EU countries are officially in recession (negative growth). The situation is enormously aggravated by savage austerity policies dubbed “sado-monetarism” by sections of the media.
Not surprisingly, the European crisis has translated into falling demand at Chinese factories, with the HSBC purchasing manager index (PMI) showing the manufacturing sector contracted for an eighth consecutive month in June. Whereas earlier this year many commentators anticipated a short downturn, with the economy picking up again by the second quarter, most now expect second quarter growth to fall below the first quarter’s 8.2 percent. International forecasters are also downgrading their estimates for the full year. Citigroup cut its 2012 forecast for GDP growth (gross domestic product = the value of everything produced in an economy) to 7.8 percent from 8.1 percent previously, while JP Morgan predicts growth of 7.7 percent this year. Even these figures are open to question given the notorious unreliability of official statistics in China (see below).
Overcapacity and falling demand
Chinese forecasters are generally more pessimistic. Shi Xiaomin, vice president of the China Society of Economic Reform, a government think-tank in Beijing, predicts GDP growth will slow to around 7 percent this year, down from 9.2 percent in 2011. “I cannot see a bottom in economic growth. The general slowdown trend may not change anytime soon,” he told Reuters (25 June 2012).
Weaker demand in export markets is not the only problem, as China’s domestic market also shows signs of a sharp slowdown. “Most of the recent weakness has been in domestic rather than foreign demand,” noted London-based Capital Economics. An important factor is the scaling back of investment in infrastructure and other fixed assets by debt-laden local governments and state-owned companies. The combined debt of local governments soared to 10.7 trillion yuan last year from almost nothing prior to the 2008 global crisis (these figures probably understate the real situation). With property prices falling, housing construction has also slowed sharply.
“Developers across the country have responded to the drop in prices by abandoning the longstanding practice of floodlighting construction sites and working around the clock. They have cut back to one daytime shift, sharply reducing the demand for construction workers,” reported the New York Times (24 May 2012).
The downturn in the property sector, which accounted for 13 percent of GDP last year, has dragged down growth in more than 40 industries including cement, steel and heavy machinery. The sale of bulldozers fell 50 percent in March compared to the same period a year ago. The steel sector, a poster child for industrial overcapacity, suffered a record combined loss of one billion yuan (US$160 million) in the first quarter of this year.
At 110 million tons, China’s idle steelmaking capacity exceeds the total production of Japan, the world’s second largest producer. Despite this, new steel plants are among the 200 investment projects recently fast-tracked by the government as part of its ‘mini-stimulus’ package to counter the economic downturn. Overcapacity, as in other sectors, has led to a price war that has wiped out profits.
“The money earned by steel mills from the steel business every year isn’t even as much as depositing money in the bank,” complained Zhou Jicai, head of the state-owned Jiyuan Iron and Steel in Henan province, referring to the 3.5 percent yearly interest rate on bank deposits.
A similar picture emerges in the car industry, which shot past the US in 2009 to become the world’s largest. After years of double-digit growth, car sales declined 1.3 percent in the January-to-April period from one year ago. Car dealers have slashed prices but still report record stockpiles. “Unsold cars are crowding dealer lots in cities from Guangzhou in the south to Xian in the west,” declared Su Hui, a top official at the state-owned China Automobile Dealers Association. “It’s like a contagious disease that will spread.”
Yet carmakers, both Chinese and foreign brands, are aggressively expanding their production base, with some analysts forecasting overcapacity of 10 million cars by 2015.
The shipbuilding industry – the world’s largest – is in the midst of a full-blown crisis, with the head of the government’s China State Shipbuilding Corporation, Tan Zuojun, saying 50 percent of domestic shipyards are likely to go bankrupt in the next two to three years. This is yet another example of an industry swimming in excess capacity, pumped-up by unprecedented levels of credit as part of the 2009-10 stimulus measures (when loans to the shipbuilding industry rose by 500 percent). This has since given way to a credit squeeze as the government has sought to contain an explosion of local government and corporate debt and wasteful investments (in already over-invested sectors).
The rapid expansion of the shipbuilding industry has helped create a worldwide glut of low-tech vessels – the sector that China dominates – and this in turn has driven down shipping freight rates to less than one-tenth of their 2008 level. With cargo lines facing a profits squeeze, new orders to Chinese shipyards halved last year and have continued to slump this year.
Even new industries are suffering from extreme overcapacity. As a result of the mega stimulus package of 2009-10, a credit injection worth 60 percent of GDP over two years, China’s solar power industry has catapulted into a position of global dominance. Half the world’s solar photovoltaic cells were made in China last year, up from just one percent in 2001. But this has created global oversupply and a collapse in prices (down 48 percent last year) and company profits. Suntech Power Holdings, the New York-listed Chinese company that is now the world’s largest maker of solar panels, reported a net loss of US$1 billion last year.
China’s solar panel manufacturing capacity reached 50 gigawatts in 2011, which is almost double worldwide demand (27 gigawatts of panel installations last year). This example illustrates the crazy logic of capitalism, where ‘demand’ is not determined by the real needs of society, but by the (in)ability of the capitalists to create a market and make profits. Who can dispute the need for a far greater expansion of solar and other forms of clean energy? But under capitalism, fossil fuels like oil and gas are more profitable, leaving governments (public funding) to shoulder the main responsibility for investments in alternative energy. It is precisely the rolling back of government programmes, especially in Europe, which has cut the global market for solar panels just as massive new capacity has become available in China. Public ownership and democratic control of the entire energy sector is the only way to cut through this chaos and develop an integrated plan towards a carbon-free economy, as part of a wider socialist reorganisation of the global economy.
GDP figures unreliable
Vice-Premier Li Keqiang famously stated that China’s official statistics – especially GDP figures – are “man-made” and therefore “unreliable”. When he was head of Liaoning province, Li confessed to following electricity consumption, rail cargo volume and bank lending statistics as a better guide to economic developments. In a year’s time, Li will almost certainly take over the running of China’s economic policy from Wen Jiabao. If one so senior expresses such scepticism towards government statistics, then we should also approach them with caution.
In the current slowdown the debate over the credibility of Beijing’s statistics has intensified. With a once-in-a-decade leadership changeover underway, officials at every level of government are jostling for promotion and therefore have an added incentive to ‘air brush’ their economic results. Many commentators point to stagnant or falling electricity consumption and other key indicators as evidence that official figures hide the full gravity of the situation. In January, electricity consumption fell by 7.5 percent year-on-year, the first such fall on record. Subsequent monthly figures for electricity generation in March (0.7 percent year-on-year growth), April (1.5 percent) and May (3.2 percent) suggest a sharp industrial downturn. Coal producing regions report a record build-up of coal inventories because power plants are burning less coal in the face of falling demand for electricity.
Commenting on the increasing disconnect between GDP estimates and “the reality on the ground,” Patrick Chovanec, an associate professor at Tsinghua University’s School of Economics and Management in Beijing, warned the Chinese economy “is perhaps experiencing a contraction right now.” Speaking to Bloomberg News in April, Chovanec pointed to the slowdown in investment, especially in big infrastructure projects such as railways and expressways, due to government cutbacks and credit tightening measures introduced over a year ago.
“If investment merely remains stable compared to last year, you could lose 5 percentage points of GDP growth, bringing it to 4.5 percent,” he warned. This is a scenario for a so-called hard landing – a recession with ‘Chinese characteristics’.
Credit demand slips
The recent slowdown in bank lending also points to a more severe slowdown than official GDP figures suggest. The ‘Big Four’ banks (ICBC, China Construction Bank, Agricultural Bank of China and Bank of China), which account for half of all lending, reported almost no loan growth in April. New loans increased in May as a result of the government’s ‘mini-stimulus’ (see above), but the effect of this will be limited without a bigger government package. The twin problems of the ‘debt bomb’ planted by the last stimulus package, and a rapidly deflating property bubble, have left the central government reluctant, and probably also deeply divided, over such a move. In June, Fitch Ratings predicted that total new credit could fall this year for the first time since 2008.
There is a crucial difference in the situation today compared to the past two years, when the government imposed curbs on bank lending to rein in speculation (in property and raw materials), surging inflation, and rising local government debt (all by-products of the 2009-10 stimulus package). “We believe that there is a sea change in China. The constraints to growth have shifted from policy restrictions to demand limitation,” Credit Suisse analyst Tao Dong told the South China Morning Post (28 April 2012).
Chinese companies – in both state and private sectors – have become more wary about taking on new loans. This is due to the limited scope for profitable investment amid falling demand and the continuing restrictions on property speculation. As The Wall Street Journal (16 May 2012) reported:
“According to data from Wind, a Chinese data provider, the average return on invested capital for mainland-listed companies has fallen from 11.6% in 2007, to 6.7% in 2011. With China’s one-year lending rate currently 6.6%, the cost of capital for some Chinese companies is higher than the return they can expect to generate.”
Bursting in slow-motion
The current economic downturn is not like 2008. The government has fewer policy options due in no small part to the blowout from the last big stimulus package, and especially the bursting of the property bubble. “This year is different from 2009. Banks won’t have the same financing capacity,” warned Lian Ping, chief economist at Bank of Communications.
The bubble in land prices was a vital component of the stimulus programme, allowing local governments to raise huge amounts of funding for infrastructure projects through land sales to developers, and bank loans using land as collateral. Land sales accounted for up to half of local government income during this period. This involved highly speculative activity, with local governments in league with property developers favouring infrastructure projects that would push up land prices, generating higher revenue and more speculative deals.
This is no longer possible. House prices fell by an average 15 percent across major cities in 2011, according to research firm Dragonomics. The volume of land sales by local governments has dropped more sharply, as financially stressed property developers hold back on new investment. This has forced local governments to cut infrastructure spending and mothball unfinished projects. Banks are being forced to roll over loans (as happened in Japan following its property collapse two decades ago) rather than face a potentially contagious string of defaults by local governments and the thousands of financial platforms they set up to tap the easy credit of the stimulus era. Land sales by the Shanghai city government were 80 percent lower in the first quarter than in the same period last year. A drop of 30-40 percent in the volume of local government land auctions is reported across the country.
There is a growing mood of insubordination amongst local governments towards Beijing’s property controls, imposed at the end of 2010 to head off a full-blown collapse and bring about a ‘controlled’ decline in house prices. Even if the government succeeds in this aim, which is by no means certain, falling land prices are already having a significant negative impact on the wider economy. “A tug of war is going on between the central government and local governments as the latter, particularly small cities, are in dire need to raise revenue,” the chairman of one property company told the South China Morning Post (21 February 2012).
But even as Beijing recalibrates its monetary policies, to ease credit in order to avert a hard landing, it has so far not budged over property restrictions. “We must never allow property controls to suffer a setback,” declared Wen Jiabao in May.
“Even a pig can fly!”
Beijing may succeed in engineering a Japanese-style “burst in slow motion”, rather than the collapse in property prices experienced in the US and many parts of Western Europe. But even if the pace has been more gradual, with the Japanese government ordering banks to extend new loans to distressed ‘zombie’ companies, property prices in Japan are nevertheless 60 percent lower today than at their peak in the late 1980s. China’s economy could suffer similar effects – of a prolonged deflationary period – dragging down investment and corporate profits and worsening bad loan problems within the largely state-owned banking system.
“China’s real estate bubble is undeniably the biggest in history,” admitted Yi Xianrong of the China Academy of Social Sciences. An average apartment in Shanghai or Beijing costs 2 million yuan (US$315,000) – 28 times annual average household income (two income earners). This compares to average house prices at 7 times annual average household income in London and 6 times in New York.
In the period since 2008, companies across the economic spectrum – including most of the giant state-owned enterprises (SOEs) under central government control – dived into the property sector. They chased the ‘drug’ of quick and spectacular gains through property speculation, as their ‘core businesses’ were largely loss-making or saddled with massive overcapacity.
Lenovo, for example, the world’s second largest maker of personal computers, reported that 60 percent of its profit in 2009 came from ‘asset investment’ (property speculation) and only 40 percent came from manufacturing. Challenged about this, Liu Chuanzhi, the chairman of Lenovo, summed up the attitude of the Chinese corporate elite: “When the typhoons come, even a pig can fly in the sky. Everybody is profiteering from this. Why can’t we?”
The central government, fearing the explosive social and political effects of extreme house prices, but also the impact of a burst financial bubble on companies and banks, imposed limits on home purchases and other measures to combat speculation. This, however, drove the speculators into other sectors (smaller cities, commercial property, shadow banking and commodities such as metals). However, these sectors are now also affected by the general downturn. Speculative capital is currently flowing out of China into overseas markets at the rate of 100 billion yuan (US$15.8bn) every month. Chinese are now the second-largest foreign buyers of US homes.
Increased Chinese consumption, long held up as the ‘saviour’ for China and for world capitalism, has failed to materialise. Consumption’s share of GDP continues to shrink, to just 35 percent last year (compared to 46 percent in the late 1990s), and is set to fall further. With half of all household wealth tied up in the housing market, the property slump has triggered a ‘negative wealth effect’ similar to that in developed economies, with middle-class households (the only segment that could possibly sustain a consumption boom) less inclined to spend. The low level – or complete absence, in the case of around 150 million migrant workers – of basic welfare provisions such as pensions, unemployment insurance, medical insurance, also acts as a powerful brake on consumer spending.
The Economist in a recent report (26 May 2012) compared China’s economy to the antique ‘penny-farthing’ bicycle, because of the disparity between the ‘big wheel’ of mostly state-led investment on one side and the ‘small wheel’ of household consumption on the other. Last year, investment’s share of GDP swelled to a record 49 percent. Top leaders, not least Wen Jiabao, have often repeated that such a high level of investment is “unbalanced” and “unsustainable”. The investment-to-GDP ratio in Japan and South Korea for example peaked at just under 40 percent during their own industrialisation drives. But the government’s efforts to rebalance economic growth – from investment to consumption – have failed, with the economy becoming even more “unbalanced”.
Consumer spending is crimped by the combined effects of low wages, inflation, and the crippling cost of housing, education and healthcare. A survey by McKinsey (13 March 2012) forecasts that even in the year 2020, consumer spending will only account for 39 percent of GDP, a very low ratio even compared to other developing economies. If the bursting of the property bubble pushes China into a period of deflation (falling prices), symptoms of which we see already, this will further constrain consumption.
Splits in the CCP regime
Wen and his government find themselves caught in a deep contradiction. The falling property market has become a barrier to government attempts to counter the slowdown through looser monetary policy (interest rate cuts and increased lending). New stimulus packages are likely, especially if the global crisis deepens, but they are unlikely to reach the scale of the 2009-10 package and their effects will be more limited. The more difficult economic situation has accentuated the CCP’s internal power struggle. The downfall of Bo Xilai, standard-bearer of the more statist ‘left-wing’, has emboldened Wen and the liberal wing, which favours faster liberalisation especially of the financial sector, and the partial break-up of government monopolies.
This is only one of the battles being fought out inside the ruling party. The Bo Xilai affair has inflicted huge collateral damage on all wings of the CCP, with the ruling party’s legitimacy questioned by more and more people. The revelations from Bo’s case about the conduct of so-called ‘naked officials’ – CCP leaders who send their children and spouses abroad to conduct business – has deepened public scepticism to the entire government. Recent revelations that president-in-waiting Xi Jinping’s family control business interests worth U$376 million in China, Canada and Hong Kong, have poured fuel on the fire. Bloomberg News, which published the Xi findings in English, was immediately blocked by Chinese censors. Xi and Bo are both ‘princeling’ members of CCP dynastic families, but their families’ moneymaking activity is not exceptional. Of the nine members of the current Politburo Standing Committee, six have children who are fabulously wealthy, including both Hu Jintao and Wen Jiabao, who are non-princelings.
Those who favour faster liberalisation argue this will check the power of the ‘princelings’ and limit corruption. The recent package of measures to liberalise the financial sector, partially legalising shadow finance, allowing banks greater leeway in setting interest rates, and boosting the role of hedge funds and derivatives traders, are promoted as steps to make capital allocation (investment) more efficient and market-orientated.
That such policies will not help, and can actually aggravate the crisis, should be obvious to anyone watching the catastrophe of European capitalism, not to mention the crisis in the US. The Chinese economy is therefore entering a new period of crisis and slower growth, weighed down by extreme levels of overcapacity, squandered investments and mounting debts. The only solution is a socialist one; to break the grip of the corrupt princelings, bureaucrats and capitalists over the economy, and place economic decision-making and control in the hands of the working class, through its own democratic mass organisations.