In a note on China’s medium term prospects in February 2011, I noted that: ‘…China has largely followed the pattern of extensive (i.e. input driven) growth similar to that experienced by the Soviet Union from 1946-65, Brazil from 1964-1980 or Japan from 1960-73 when GDP grew by 10% a year (and recall that Japan in its boom years was often admired as ‘central planning that works’) Both the Soviet Union and Japan gradually ran out of growth as that model suffered the impact of a declining labour force and marginal productivity of capital.’ As that view has become consensus over the past three years, the implications have undermined GEM assets, as the country’s growth ‘glide path’ has continued to descend, and indeed sparked periodic investor panic. Fears of a deeper slowdown in China as reflected in the latest PMI data were certainly one factor behind the latest GEM selloff, particularly for commodity exporters, but a threatened default of the RMB 3bn ICBC trust product this week has been avoided via yet another opaque rescue deal. ICBC told investors that they could sell their rights in the product to an unidentified buyer while China Credit Trust announced that it had agreed to sell the shares it had acquired in the insolvent coal miner behind the original loan. We may never find out who these mysterious ‘third parties’ were, but this was an officially sanctioned bailout driven by fears of a systemic crisis in the wider shadow finance system. However, the cost of delaying financial reform is less the feared Lehman style collapse than ever slowing productivity and GDP growth trends, as diminishing returns become entrenched.
Productivity is the key to long term per capita real income growth and China’s progress since the early 1990s has been impressive – it has overtaken Thailand within Asia for instance, in terms of productivity relative to the US (and Thailand’s structural problems on that score were covered in an October note). However at barely over 7% y/y in 2013 on Conference Board data, China has seen a steadily declining productivity growth trend from well over 10% before the 2009-12 investment and credit surge; overall productivity growth last year was the slowest in over a decade while total factor productivity growth (i.e. efficiency gains from technical know-how etc.) stalled, compared to 3.1% annual growth from 2007 to 2011 and 0.6% growth in 2012. With productivity at less than a fifth of US levels, restoring this ‘catch up’ productivity momentum is crucial to sustaining even mid-single digit GDP growth rates through end decade. China bears claim that with aggregate credit/GDP now well over 200%, the majority of trust loans cannot be repaid, will eventually require substantial bailouts and lead to a collapse in the banking system and a wider economic crisis. Even if the assets are cash generative, huge liquidity risks exist given the known duration mismatch between trust loans and their underlying investments, echoing the genesis of the US subprime and Eurozone peripheral crisis. The key difference of course is that China remains a largely closed financial system, and as noted many times only its domestic bank depositors can make a ‘margin call’ on the system, a process that has started as they seek higher yields in wealth management products/money market funds, now far easier to access thanks to new online financial sector entrants such as Alibaba and Tencent.
It is unclear when the recently announced shadow banking audit will finish, but it needs to be swift and mark a decisive turning point in the on-going trust/WMP saga – the ‘pretend and extend’ policy of rolling over maturing debt seems to be the default (or rather no default) option until its outcome. Once regulators know the extent of shadow banking activities and how interconnected the formal banking sector is to the shadow banking sector, managed defaults have to be finally allowed to impose appropriate credit risk and begin to adjust trust/WMP investment practices. In the meantime, ever more credit growth will be absorbed in extending existing loan duration, exacerbating the impact of a steadily deteriorating capital-output ratio on trend GDP and productivity. Something will have to give, which may well be the now very fully valued RMB.