China's miracle

With Chinese Premier Wen Jiabao in town after a tour of the sub-continent, the usual paeans of praise for China’s spectacular growth performance have once again begun, with the natural corollary of India’s poor performance, and we can expect this to intensify in the days ahead. That India has been a big under-achiever is obvious, as is the slow pace at which certain critical reforms are taking place.

But what’s not heard as often is that despite the huge manufacturing success seen so far, China’s road ahead is pretty rocky and tenuous as well. (Indeed, if you go by the now famous Goldman Sachs BRICs report, while China’s dollar per capita GDP growth is projected to fall from 9.2 per cent in 2000-2005 to 5.4 per cent in 2045-50, India’s is projected to rise from 3.7 to 7.6 per cent.)

While China’s inefficient use of capital is well known (its 50 per cent investment-to-GDP ratio yields an 8-9 per cent GDP growth, as compared to India’s 23 per cent investment, giving a 6 per cent growth), a recent seminar organised by the CII and the ministry of commerce and industry was an eye-opener with one participant arguing it would in fact take a miracle for China to sustain its current levels of growth.

Professor Xiaonian Xu of the China Europe International Business School in Shanghai prefaced his comments by saying that while it is politically incorrect to ask what’s wrong with China’s growth, it was a fair academic question to ask.

Xu then traced the change in China’s spectacular GDP growth directly to investment growth, which rose from around 25 per cent of GDP in the early 1980s to over 55 per cent today, pointing out that this was precisely the same model followed by the east Asian countries right from Japan—without a commensurate rise in productivity, Xu said, Professor Krugman had predicted the east Asian collapse and that’s exactly what happened.

Xu then presented figures for all listed companies which showed how earnings before interest and tax (EBIT) plunged from 12 per cent on assets in 1992 to under 4 per cent in 2003—today, he said, the return on assets is below the cost of capital. Xu, in fact, pointed out that the bulk of investments were made by government firms and that private investment was still very low—FDI, for instance, comprises just around 7 per cent of all Chinese investment.

In real terms, that is after adjusting for inflation, China has a negative interest rate today, and that is what has fuelled the investment boom where the credit-to-GDP ratio has risen from 87 per cent in 1995 to over 166 per cent today.

With negative interest rates, government-owned banks remain the main source of funds (investment firm CLSA estimates that 96 per cent of funds raised by Chinese firms in 2003 were from the banking sector), and all manner of absurd but grandiose investments get made.

In August last year, for instance, much was made about the $2.4 billion Guangzhou international airport that, by 2010, will be able to handle 80 million passengers annually—what was missed out, however, was that this airport was a two-hour drive away from the Hong Kong one and both were competing for the same traffic, and that Hong Kong’s Chek Lap Kok airport was even considering opening a check-in centre in the Pearl River Delta, which both airports are catering for! China’s full of such stories—the city of Zhuhai spent $833 million on an airport but never received Beijing’s permission to land international flights and so handles fewer passengers in a year than Hong Kong does in a week (see my column, August 23, 2004).

While such dubious-quality investments create their own problems for a banking system whose non-performing loans are seen as anywhere between 13 and 33 per cent of assets, another serious problem relates to the huge property bubble in China—bank exposure to such loans is believed to be around 10 per cent or more.

While many believed the Chinese authorities were trying to control this by reducing land supply last year, analysts such as Andy Xie at Morgan Stanley are of the view the overheating continues. In Shanghai, for instance, according to Xie, new property projects of 39 million square metres were begun last year and these had a value equal to 43 per cent of its GDP—the figures for Beijing are even higher.

Since Xie believes that more than half the demand is from speculators—he argues that since the labour surplus is large enough to ensure wages don’t rise too fast, demand will never near the supply—and that anywhere between a third and half the new flats sold remain vacant, the property bubble remains one of China’s biggest problems today.

Add to this the pressure on the Chinese to revalue their currency, which would rob China of much of its competitive strengths—in real terms it depreciated against the dollar from 100 in 1971 to around 375 today, while the yen appreciated to 50 and the Korean won remained steady—and it’s clear China has more than its fair share of worries as well. As Professor Xu concluded, “To get rich is glorious”, but “It may take a glorious revolution to get richer.”