China's change of tack slows global growth

Economist Andrew Hunt says changes in the way China finances its economic growth may have a big impact on the global economy. He says this could lead to world growth remaining subdued for the foreseeable future.

Tuesday, October 7th 2014, 9:23AM

by Andrew Hunt

According to China’s official economic data, around 90% of all investment conducted within the economy over the last two years was carried out by local governments.

In practice, we have some (considerable) doubts about the accuracy of this data but at face value at least this data suggests that around 35% of China’s total GDP growth over the last three years, and over 45% of the economy’s growth since the global financial crisis, was attributable to the actions of Chinese local governments.

This further implies that almost US$2 trillion of the perhaps $10 trillion increase in global GDP since the GFC may be attributable to the activities of the Chinese local governments and that, in effect, the Chinese local government economy has expanded by the equivalent of the entire Italian economy over the last five years. It would appear that China’s local governments could easily be a G20 country on their own.

Unfortunately, there are significant question marks regarding the exact character and economic efficiency of this massive state sector expansion.

It is of course well-known that China’s local governments have relied hugely on credit to finance their headlong expansion. Indeed, China’s financial system has been adding each year the equivalent of the entire US banking system to the country’s stock of debt – the US took a century to amass as much debt as China and in particular its local governments seem to be amassing each year at present.

There is also the question of whether some of the new towns, airports, roads, bridges and property developments were really needed at this time.

Moreover, some have wondered just what the motive for some of these projects was from the point of view of their sponsors and there has been more than a whiff of corruption and bribery associated with some of these projects.

The state sector of any country has not usually been associated with the wisest of investment decisions and in particular we note that many of the new towns and infrastructure have been built on what had previously been prime agricultural land, something which we regard as being of huge significance.

If China’s economy has a structural impediment to its growth, then we would argue that it is in its agricultural sector. China’s farmers farm their land incredibly intensively with the result that yields per hectare are notably high by international standards.

This has largely been achieved via the use of a great deal of relatively low productivity labour, however the headlong expansion of the local governments has implied that the agricultural sector has probably witnessed a decline in the area that is available to it to farm (a situation not helped by climate change & pollution).

At the same time, it has witnessed a 25% reduction in the number of people working in the sector. The result of this expansion of the cities has been predictably enough to see a stagnation in food output.

Indeed, we find that marketable rice production is only up by 6% over the last years, while grain production is up by 8% but cotton, beets and many other core products have actually witnessed falls in output. At the same time, the country’s urban population has increased by almost 20% with the result that food supplies within the cities have failed to keep up with demand and hence food prices have naturally increased significantly.

Admittedly, we find that China’s official CPI data suggests that food prices have been stable but with the value of food sales expanding by a multiple of food sales volumes, this seems an unlikely assumption.

Indeed, we suspect that a combination of rising food prices and soaring accommodation costs (which have of course also resulted from the credit / local government sponsored property boom that has occurred since 2009) will have significantly raised the cost of subsistence within the economy and thereby squeezed household real incomes to a much greater extent than many analysts realise.

China may have witnessed very significant nominal wage inflation since the late 2000s but we suspect that much of this has been offset by rising subsistence costs and this is one of the reasons that the much hyped Chinese consumer boom has so far failed to broaden out beyond a few key cities.

Of course, the Chinese agriculture ‘problem’ has been of benefit to foreign food exporters such as New Zealand but for China’s economy the food issue remains one of the economy’s primary Achilles’ Heels.

However, the situation is changing. The authorities have become increasingly aware of the increasing costs of the country’s local government sponsored boom. Aside from the massive increase in indebtedness to which we referred earlier, as well as the rise in the effective cost of living for ordinary households and even the loss of economic efficiency, there has also been the question of increased pollution levels and environmental degradation.

Moreover, the growth in the local governments and the growing prominence of the ‘Tigers’ that run them also seems to have displeased the new Chinese Administration and in particular President Xi, who clearly wishes to solidify his place as China’s paramount leader.

Consequently, Beijing has been making it harder for the local governments to borrow from the banking system (instead, they must now issue bonds to finance their growth) and it has also launched an aggressive anti-corruption drive.

Indeed, reliable sources tell us that the scope and ferocity of the anti-graft drive is unprecedented in the modern era and it seems that one of the major casualties of this purge has been local government investment intentions. China’s investment ‘animal spirits’ have clearly been subdued by Beijing’s high profile ‘Tiger Hunt’ and although while this may ultimately give rise to a more efficient and less boom-bust prone economy in China, the short term implications for the global growth rate could of course be quite negative given the importance to the Chinese local governments on the global stage.

It therefore seems to us that not just China but also the global economy has lost a major source of economic growth over recent months.

With the Euro Zone and even Japanese economies still spluttering – and perhaps even flirting with new recessions – it seems that world growth will remain subdued for the foreseeable future.

This is of course ‘good news’ for interest rates and those hoping for more quantitative easing from the world’s major central banks but China’s now more severe economic slowdown is already badly impacting the economies of many of the commodity producers (particularly the industrial commodity producers such as Australia, Chile, Brazil and Indonesia) and of course the shipping companies.

Moreover, we would also argue that China’s economic weakness, and its more aggressive form of politics, could lead to some downward pressure on China’s currency which could further heighten the risk of global trade price deflation returning.

China is after all a price-setter in some consumer goods markets and a weaker RMB could have a profoundly deflationary effect in these markets given the still sluggish state of global demand.

Andrew Hunt International Economist London

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