Sizing up a Chinese wobble: Kohler

After a couple of days in Shanghai I can report that I am now an expert on China. Ask me anything. No, really… I am assured by those who live here that your moment of maximum knowledge about China occurs at the end of two days, after which it’s downhill all the way. The longer you stay, the less you know about the place.

I have met 20 and 30-year broken-down veterans who are completely puzzled by this county and, yes, I had to take them aside, arm around the shoulder, and quietly explain a few things about it.

Seriously, China is overwhelming – at once confusing and exhilarating. Also, I’m quite aware that Shanghai is not China. It couldn’t possibly be: a nation of 1.3 billion people like this? The idea is enough to drive you mad.

I came here with many unanswered questions about the Chinese economy from watching dubious statistics from afar and reading lots of ill-informed bumf, and having been there for the requisite two days I can now confidently answer them. Here they are:

1. How can fixed asset investment keep growing at 25% per annum while GDP grows at 10 per cent? Doesn’t it show that China is becoming over-built and over-leveraged?

Capital stock per capita in China is about $US10-12,000. In the United States it is $US129,000 – more than 10 times as much.

Now, you have to be careful with per capita numbers in China – as Premier Wen Jiaboa once said, if you divide any figure by 1.3 billion you get a very small number.

But that said, China has a long way to go before it has too much capital stock. It’s true there is at least one ghost city, and quite a few that become ghost cities at night, plus one or two ghost shopping malls and the odd freeway that goes nowhere. But as one expat told me: when you’re growing this fast and doing this much, there are bound to be mistakes.

Also, the figure that is reported as fixed asset investment each month is not calculated in the same way as our capital expenditure numbers and is not consistent with conventional GDP accounting. Chinese FAI includes the price effect as well as land and asset transaction values, while our figures do not.

The capital investment number that is consistent with GDP and with western measures of the same thing is actually growing at about 11% – not much more than China’s GDP growth.

2. Is there a property bubble about to burst and cause a hard landing for the economy?

The conditions are falling into place for a property bubble and bust at some point, but not yet, and busts always take a lot longer to happen than anyone expects. Also, China’s won’t happen in the way we normally see them.

China has a very high savings rate and at the moment most of the savings sit in low-interest bank deposits. The speculation on real estate is happening on loan-to-value ratios of 50% – it’s not all based on high leverage as was America’s and, dare I say it, ours.

Demand for urban housing will fade eventually and, given the size and importance of construction, that will be a big deal. If it fades enough, the economy will have a hard landing.

Property represents about 30% of the economy. If values fell by, say, between a quarter and a third, demand would likely dry and that part of China’s economy would collapse. That assumes, by the way, that any property collapse would be properly measured and reported, which can’t be assumed.

But however you measure it, too much of China’s economy is being diverted into real estate and it is becoming unbalanced. The conditions are there for a blow-out and bust.

3. Is the local government sector in China like Europe’s periphery – that is, too much debt and no hope of paying it back?

Well, yes and no.

Total local government debt is about RMB 11.5 trillion, or 30% of China’s GDP and about three times Greece’s debt. Eighty per cent of the money is borrowed from banks and the municipal debtors are undoubtedly having cashflow problems – almost all of the money was borrowed on three to five-year terms to finance very long-term infrastructure projects that are not providing any cash flow yet.

It’s widely expected that about RMB three trillion of this debt – or about 5%qqqq of banking system’s total loan book – will go non-performing before long.

But the banks are owned by the central government and the municipals will be given time to repay – they will not be allowed to default. It’s very unlikely, therefore, that the banks will have to write off much of this debt at all.

4. How big a problem is inflation, really?

GDP grew at an annual rate of 9.1% in the year to September yet in the month of September, inflation fell from 6.2 to 6.1%, so inflationary pressure is still there.

But after 20 years of 10% plus economic growth, China is always worrying about inflation, and every time it is the end of the world and a recession is obviously around the corner. It never is.

Whether that’s due to China’s suspected ability to reverse engineer the statistics (the statisticians are told what the inflation rate will be this month) or because inflation genuinely never does get out of hand is impossible to say.

However, there are some new things going on: food prices are rising at more than 13% per annum and there is no sign of food inflation declining yet, and more importantly wages are rising at double-digit rates, and as much a 20% in some cities.

The food supply shock will no doubt abate next year, but the wage pressure will not. Chinese families are under a lot of pressure and are demanding to be paid more. This has only just begun. Against that, though, is the fact that productivity is rising rapidly through automation – there are a growing number of robots in factories here.

Also, the prices of inputs such as energy costs have been held down by government decree, but these distortions will have to end.

“Normal” inflation, if there is such a thing as normal in China, will probably be 4-5% in future rather than the 2-3% that prevailed before the food and energy shock of 2008-09.

If that’s all that happens, there would definitely not need to be a major monetary policy response from the authorities.

Yes, I know – typical economist answers: on one hand, and on the other hand. The problem is that nothing like this has ever happened before – that is, a nation of 1.3 billion rapidly moving up the per capita pay scale.

Nobody knows what’s going to happen, and if anyone says they do – you know they’ve been in Shanghai for two days.

This article first appeared on Business Spectator.