World Risk Developments October 2012

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Guangdong postcard

Export Finance Australia’s chief economist, Roger Donnelly, visited Guangdong over 23-27 September. He records his impressions below.

My visit took place at a time of rising difficulties for China. On the economic side, there are struggling exports and a nationwide GDP slowdown (see first two charts on page 2), and on the political side, growing tensions with Japan and a forthcoming Communist Party congress to change China’s top leadership. This changeover has of course been complicated by the sudden downfall of Chongqing party secretary Bo Xilai and his wife, Gu Kailai.

The economy has many strengths to combat these difficulties – notably dynamism and thrift. The dynamism spurs strong underlying economic and export growth, and the thrift, fiscal and current account surpluses and a thick buffer of foreign reserves.

But there are also weaknesses. One of these is well-known – an overdependence on exports and investment. Another is less so – local government ‘funding platforms’ that have invested a vast sum of bank loans into loss-making projects under the umbrella of the national government’s economic stimulus plan during the ‘Great Recession’.

Together these weaknesses pose risks. The export and investment bias leaves the economy prone to a correction that could turn into a ‘hard landing’. And increasing this risk is the funding platform problem. The funding platforms may need bailing out and the banks recapitalisation – again. If so, the government’s much-vaunted control of the economy could turn out to be illusory.

Finally, in the background hovers a longer run structural problem – the labour market is tightening as the population ages and the pool of surplus rural labour drains. This threatens to lower the trend economic growth rate, and in the extreme case, even stop China from ‘growing rich before it grows old’.

It was interesting to get the Guangdong perspective on these issues, because it is the province suffering most from the slowdown, and it is also feeling the brunt of the funding platform problem.

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Economic development with unlimited supplies of labour

Many economists turn to the St Lucian economist, Arthur Lewis, and his 1954 paper, ‘Economic development with unlimited supplies of labour’, to make sense of the Chinese economy. In Lewis’s model, there are two sectors – a modern, urban, industrial one where labour productivity, or more specifically the marginal product of labour, is high; and a backward, rural, farming sector where the marginal product of labour is below the subsistence wage, or even zero. Rural-urban migration puts surplus rural labour to gainful work in city factories. There is in effect a free lunch – no lost farm output, but a big expansion of factory output. So labour productivity and national output growth bound ahead. But wages lag behind, kept down by the countless rural workers grateful for the chance to work in factories at a wage not much above their subsistence one in the countryside.

As this rural-urban migration proceeds, big changes occur. First, the profit share of national income climbs. Second, the saving share of national income climbs along with profits, because profits tend to be saved disproportionately. Third, the investment share of national income also heads up, spurred by rising returns on investment and growing profits.

Thanks to cheap labour, the urban factories develop a comparative advantage in labour-intensive products, and begin to export. An implicit feature of the model is that, if saving rises faster than investment, an exportable surplus of production develops. This can prompt the government to hold down the exchange rate the better to sell the surplus on world markets.

Rising shares of profit, savings and investment in national income. A falling share of consumption. Weak wage growth – and growing income inequality. Rising exports of labour-intensive products. Persistent trade surpluses. A managed, under-valued currency. Sound familiar? This story fits closely the development path China has followed since Deng Xiaoping ushered in the open door policy in 1978.

And it is of particular relevance to the special economic zone in Guangdong where Deng launched the open door policy – Shenzhen. Thanks to an influx of workers from the provinces to its factories,
Shenzhen’s population has grown from 30,000 in 1978 to 15 million now, and its GDP has grown at a staggering 25% a year on average over 1980-2010.

The 'Lewis Turning Point'

But such a path can’t be followed forever. Eventually, the number of surplus rural workers dwindles and the economy reaches what economists call the ‘Lewis turning point’ (LTP). From this point on, labour grows scarce. Factories have to compete with farms for workers. This causes many of the trends in the ‘labour surplus economy’ to go into reverse. Real wages rise both in factories and on farms. The profit, saving and investment shares of GDP fall.

The consumption share rises. Income inequality goes down. As real wages rise, the comparative advantage in labour-intensive products diminishes and the real exchange rate appreciates. In short, the economy ‘rebalances’.

Rebalancing in reality

Something resembling this story certainly seems to be going on in China today. Labour is growing scarce and real wages are rising. Labour-intensive exports are struggling and the real exchange rate is appreciating.

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Granted, there may still be ‘excess labour’. According to the IMF, the number is 150 million people, meaning that China won’t cross the LTP till ‘somewhere between 2020 and 2025’. But as Ross Garnaut of Melbourne University has noted, approaching the LTP is more like entering a zone than crossing a line. He writes about a ‘turning period’ rather than a ‘turning point’, in which the labour market tightens in some cities and rural areas before others.

Guangdong certainly appears to be in this zone. I heard countless stories of factories having difficulty recruiting labour in the face of competition from factories that have established in inland provinces. Wages are also going up in leaps and bounds because of market forces and government increases in minimum pay rates. Because of the pressures on costs and revenues, many businesses are either closing or shifting either overseas or inland. This goes for giant firms, like Foxconn, the Taiwanese assembler of iPads and iPhones, as well as smaller firms.

Where the Lewis model goes astray is in predicting falling investment. Investment has actually been rising rapidly in China, including as a share of GDP (see chart below). The authorities deliberately pumped it up in 2009 and 2010 to fight the post- Lehman export slump that saw 20 million workers lose their jobs.

They succeeded, but have been left with two troubling legacies – first, considerable excess capacity that loses money, and second, an overhang of debt created to fund the investment.

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Hard landing risk

These legacies in turn create the risk that the investment boom turns to slump and that the debt overhang triggers a financial crisis. Needless to say, an investment slump and financial crisis could feed off each other.

How big is the risk of an investment correction? In its recent Article IV consultation, the IMF notes that over-investment has pushed capacity utilisation from just under 80% before the global financial crisis to 60% today, making a ‘sharp correction’ ‘inevitable’ at some point. Beijing counters that this overlooks ‘China’s stage of development, geographic size, regional disparities, demographics, and fast urbanisation from a low base’. Moreover, recent reports suggest that the authorities could be planning to give the economy another investment boost by bringing forward planned infrastructure projects.

The more immediate risk appears to come from the local government funding platforms, of which there are reportedly more than 10,000. These were the chief vehicles through which Beijing delivered its 2009-10 stimulus. According to Roubini Global Economics*, the platforms had by 2011 accumulated RMB 17½ trillion of debt. This is equivalent to 37% of GDP, or 190% of local government revenue. Project cash flows have been nowhere near enough to cover the platforms’ debt service obligations, so they have been making land sales to bridge the gap, or seeking forbearance from their banks. The trouble is, land is growing scarce and local community protests against land sales have been rising. As a result, the platforms may need to be bailed out in 2013 in order to avoid default.

Moves are reportedly underway in Beijing to provide such a bailout, but it is unlikely to be a blanket one. The indications are that the Ministry of Finance will refuse to recognise certain debts, leaving it to the platforms and their banks to do a workout.

This could in turn require Beijing to recapitalise the banking system again to cover the write-offs of the platform loans, and also loans that have gone bad to property developers and stateowned enterprises.

The process should be managed smoothly thanks to the central government’s strong balance sheet and the closed capital account. But it could impose some significant drags on growth. One obvious drag is deleveraging by local governments. A less obvious drag suggested by the Roubini analysis might come through a delay to financial liberalisation. This would allow banks to hold onto
their fat net interest margins and thereby rebuild their equity. But it would mean that households continue to earn negative real returns on their bank deposits – hardly conducive to rebalancing
the economy away from investment towards consumption. The result could be GDP growth in the 4-6% range after 2013, concludes the Roubini analysis.

I got some inkling of how the local government financing issue could create a hard landing on my visit to Dongguan, one of Guangdong’s major industrial hubs. The city has already been hard hit because of its export orientation and the weakness of its foreign markets – its GDP grew at only 2½ % (yoy) in the first half of 2012. To make matters worse, the South China Morning Post reported recently that it could be on the brink of bankruptcy because of a forthcoming need to bail out a large proportion of the villages for which it is responsible – villages that have been suffering from the export downturn, and associated property slump, plus rash promises made to rural voters.**

Long-term trend growth

Most commentators, Chinese and foreign alike, tend to the view that economic growth is bound to slow once the LTP is crossed. They also note that another constraint will start to bite soon – a decline in the labour force from 2015 because of ageing and the one child policy.

Some optimists, however, note that slowdown isn’t inevitable. First, there are still surplus rural workers available. Second, there is ample scope to offset growing labour scarcity by improving productivity and increasing labour force participation. Third, the demographic constraint of a rising old-age dependency ratio shouldn’t be exaggerated – yes, it’s rising, but from a low base.

Global demand implications

I formed the impression that short term hard landing risk does need to be taken seriously. As for the longer term, even if trend growth subsides from the near-10% annual rate of the past three decades, and the commodity intensity of China’s GDP falls as the economy becomes more service-oriented, growth should still be strong enough to keep the demand for Australian commodities, and other goods and services, expanding briskly.

* Adam Wolfe, China’s Local Government Debt Crisis: A Solutions Manual,
May 2, 2012, www.roubini.com
** South China Morning Post, September 28, 2012

Roger Donnelly, Chief Economist
rdonnelly@exportfinance.gov.au

The views expressed in World Risk Developments are Export Finance Australia’s. They do not represent the views of the Australian Government. The information in this report is published for general information only and does not comprise advice or a recommendation of any kind.  While Export Finance Australia endeavours to ensure this information is accurate and current at the time of publication, Export Finance Australia makes no representation or warranty as to its reliability, accuracy or completeness.  To the maximum extent permitted by law, Export Finance Australia will not be liable to you or any other person for any loss or damage suffered or incurred by any person arising from any act, or failure to act, on the basis of any information or opinions contained in this report.