Two Prisms for Looking at China’s Problems

Posted on August 15, 2012

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CHINA is confronting some serious economic problems, and how Beijing does — or doesn’t — respond to them could bend the course of the global economy.

First, China’s real estate bubble is deflating. But its economy also seems to be suffering from what we economists call excess capacity — an overinvestment in capital goods, whether in factories, retail stores or infrastructure.

So what now? The answer depends in part on your school of economic thinking.

Keynesian economics holds that aggregate demand — the sum of all consumption, investment, government spending and net exports — drives stability, and that government can and should help in difficult times. But the Austrian perspective, developed by the Austrian economists Ludwig von Mises and Friedrich A. Hayek, and championed today by many libertarians and conservatives, emphasizes how government policy often makes things worse, not better.

Economists of all stripes agree that China may be in for a spill. John Maynard Keynes emphasized back in the 1930s the dangers of speculative bubbles, and China certainly seems to have had one in its property market.

Keynesians would argue that Beijing has the tools to stoke aggregate demand. It could, for example, adjust interest rates and bank reserve requirements, instruct state-owned banks to maintain lending, or deploy some of its $3 trillion in foreign exchange reserves. The government also appears to have many shovel-ready construction and infrastructure projects that could help the economy glide to a soft landing and then bounce back.

The Austrian perspective introduces some scarier considerations. China has been investing 40 percent to 50 percent of its national income. But it is hard to invest so much money wisely, particularly in an environment of economic favoritism. And this rate of investment is artificially high to begin with.

Beijing is often accused of manipulating the value of its currency, the renminbi, to subsidize its manufacturing. The government also funnels domestic savings into the national banking system and grants subsidies to politically favored businesses, and it seems obsessed with building infrastructure. All of this tips the economy in very particular directions.

The Austrian approach raises the possibility that there is no way for China to make good on enough of its oversubsidized investments. At first, they create lots of jobs and revenue, but as the business cycle proceeds, new marginal investments become less valuable and more prone to allocation by corruption. The giddy booms of earlier times wear off, and suddenly not every decision seems wise. The combination can lead to an economic crackup — not because aggregate demand is too low, but because the economy has been producing the wrong mix of goods and services.

TO keep its investments in business, the Chinese government will almost certainly continue to use political means, like propping up ailing companies with credit from state-owned banks. But whether or not those companies survive, the investments themselves have been wasteful, and that will eventually damage the economy. In the Austrian perspective, the government has less ability to set things right than in Keynesian theories.

Furthermore, it is becoming harder to stimulate the Chinese economy effectively. The flow of funds out of China has accelerated recently, and the trend may continue as the government liberalizes capital markets and as Chinese businesses become more international and learn how to game the system. Again, reflecting a core theme of Austrian economics, market forces are overturning or refusing to validate the state-preferred pattern of investments.

For Western economies, the Keynesian view is much more popular than the Austrian view among mainstream economists. The Austrian view has a hard time explaining how so many investors can be fooled into so much malinvestment, especially given the traditional Austrian perspective that markets are fairly effective in allocating resources. But China has had such an extreme and pronounced artificial subsidization of investment that the Austrian perspective may apply there to a greater degree.

The optimistic view is that Chinese excess capacity and overbuilding are manageable — that the current overextensions of investment will be propped up, but they won’t have to be propped up for long. In this view, the Chinese economy will fairly soon grow rather naturally into supporting its current capital structure, and its downturns will be mere hiccups, not busts.

The pessimistic view is that the problems are so large that the government’s attempts to prop up its investments with further subsidies could so limit consumption, and so distort resource allocation, that the Chinese economy will stagnate. In this view, the political means for allocating investment would grow to dominate market forces, the proposed “economic rebalancing” of the Chinese economy toward domestic consumption would become a distant memory, and China would have an even tougher time opening its capital markets and liberalizing its economy. Given that China already faces competition from nations where wages are lower, and that its population is aging, the country might not return to its previous growth track.

THE jury is out. But to my eye, we may well find a significant and lasting disruption, closer to what the Austrian theory would predict. Consider a broader historical perspective: How often in world history have countries enjoyed 30-plus years of extremely rapid growth without a major economic tumble somewhere along the way? One can be optimistic about China for the long term and still be fearful for the next turn in its business cycle.

In any case, China has surprised the world many times before — and is likely to surprise it again.

Tyler Cowen

China’s Debt Bomb

Half an hour from Beijing, the potential ground zero of the Chinese real estate meltdown.

TIANJIN, China — The Binhai New Area in the municipality of Tianjin looks like a cross between a desolate stretch of the New Jersey Turnpike and the bottom of the ocean. Half-built residential high-rises shimmer in the sun-baked distance, so far apart that even thinking about walking between them is exhausting. Construction workers in yellow hard hats cross the road gripping sledgehammers; they look like schools of weary-eyed fish.

“That’s an indoor rain forest,” Dong Cui told me as she waved toward an I.M. Pei-style glass pyramid through the window of her silver Audi A6. “This is a cruise port,” she said later, pointing at a curvy postmodern edifice many miles down the highway. “That over there will be a Hilton.” Dong is a manager of San’Ai Business Exchange Co., a private organization that takes investors and government officials on driving tours of the area. On a hot day in early July, I was her only client. “This place is a kind of miracle,” she told me. “It shows that our government can accomplish whatever it wants.”

Welcome to Tianjin, China’s sixth-most populous city and perhaps its biggest property bubble. A half-hour train ride from Beijing, a 200-mile-an-hour straight shot through open farmland and industrial sprawl, Tianjin was long known as a shipping hub with uncommonly tasty steamed pork buns. It is now considered a “dual-core city.” Its old quarter is quaint and tree-lined, sprinkled with European and American architecture built in the late 19th century, when the city first opened up to foreign trade. Its other “core” is the Binhai New Area, an 876 square-mile swath of salt pan, wetlands, and old fishing villages now home to 2.48 million of the city’s 11 million inhabitants.

Binhai’s scope is difficult to fathom. The area is home to the largest cargo airport in northern China and the fourth-busiest seaport in the world. Slightly inland is the 12 square-mile Tianjin Eco-city, a $22 billion Sino-Singaporean joint venture where the area’s white-collar workers will live in wind- and solar-powered homes. Along Binhai’s 95-mile coastline is a $3.82 billion Israeli-madedesalinization plant and an artificial beach, its sand imported from the southeastern province of Fujian. Docked nearby is the Kiev, an old Soviet aircraft carrier that has been converted into a theme park and a five-star hotel. Three yacht marinas are under construction. The Binhai New Area “is already the country’s third engine of economic take-off after the Shenzhen Special Economic Zone and the Shanghai Pudong New Area,” one high-level Binhai official stated in a promotional pamphlet last year.

Binhai officials have borrowed upwards of $64 billion to finance their vision, and their strategy seems to be working. Tianjin’s GDP officially grew by 16.4 percent in 2011, the highest in China (tied with the municipality of Chongqing) and faster than any country in the world except Qatar. Much of this growth was driven by Binhai. Tianjin’s per capita income is now close to Beijing’s, a major coup for the city that has long been considered Queens to Beijing’s Manhattan. But shady accounting schemes could mask major financial risks lurking just beneath the surface. “If you look at the local debt to local revenue ratio, one of the largest and worst debt bubbles exists in Tianjin,” Victor Shih, an expert on Chinese financing, said in an interview with the bank Credit Suisse in March.

In 2008, the central government issued a $586 billion stimulus program to help China weather the global financial crisis, and local governments were suddenly awash in easy credit. They splurged on subways, airports, luxury condominiums, and five-star hotels — anything that would boost short-term GDP growth. According to China’s National Audit Office, local governments had amassed about $1.7 trillion of debt by the end of 2010, about 27 percent of the country’s GDP — but other estimates put the number at almost twice that. Tianjin took out more loans than any other Chinese city in 2009, increasing its outstanding debts by 47.2 percent, far above the national average.

Like other local governments, Tianjin officials typically borrow money through shady financing companies to skirt borrowing regulations, making the city’s balance sheets difficult to assess. Tianjin officials insist that their companies — often called “local government financing vehicles” — are on solid financial ground. Last September, Vice Mayor Cui Jindu said that the city’s financing vehicles had paid off over 80 percent of their loan principle due in 2011. He added that Tianjin should be able to clear its debts, with one caveat: “If we end up not getting a single new loan, there could be problems,” he said.

China’s financial system might well weather an explosion of defaults, even as the country enters into its worst economic slowdown since 2008. Yet loads of bad debt could also result in inflation, a prolonged economic slump, or even a financial meltdown. “You don’t know where debt risk is going to rear its head,” said Patrick Chovanec, a professor of economics at Tsinghua University in Beijing. He mentioned Cui’s remarks as possible evidence of pandemic check kiting, a type of fraud. “You basically keep the game going by writing more and more bad checks,” he explained, “which disguises the fact that you have nothing in your bank account.”

Binhai New Area officials say that the area is poised for success. After all, it’s close to Beijing, it’s home to a thriving seaport, and it has strong support from the central government. They envision its highways choked with cars, its hotels booked to capacity, its office towers generating strong returns. Yet the city’s goals could be too big to achieve. The mammoth state-owned enterprise Tianjin Infrastructure Construction and Investment Group Co. recorded over $45 billion of debt in 2011, more than any other local government financing vehicle in China. Another local financing vehiclerecently sold control of a $1 billion securities firm to a state-owned bank to help minimize its debts. If the area’s investment pipelines dry up, Binhai could end up a ghost town, its half-built high-rises forever uninhabited.

Locals point to the thriving Tianjin Economic-Technological Development Area (TEDA), a special administrative zone within Binhai, as an indicator of the area’s potential success. TEDA was established in 1984 with approval from then-paramount leader Deng Xiaoping. An impressive list of Fortune 500 companies has established offices there, including Nestlé, Motorola, and Airbus. A TEDA promotional booklet boasts that the area has attracted residents from over 30 “overseas regions” and countries. “You are welcome to get a taste of this melting pot of cultures, languages, customs, peace, and harmony,” it says.

An exhibition hall in the TEDA government office is a testament to the strange aesthetics that arise from coupling stodgy officialdom with a sleek corporate ethos. One room is outfitted with a table-sized touch screen displaying animated butterflies in a grassy meadow. An exhibition hall staff member told me to rub one of the butterflies. When I did, it unfurled into a photograph of TEDA officials at a formal reception holding award certificates and placards. My tour ended in a small theater, where I put on 3-D glasses and watched a computer-animated movie about the area’s long-term plans. It involved a 19th-century schooner floating above a skyscraper-filled metropolis. Its English-language soundtrack was incomprehensible.

Just down the road, the Yujiapu Financial District underscores Binhai’s long-term risks. The district is a 1.5 square-mile, decade-long construction project that authorities say will someday be the largest financial center in the world — a veritable replica of Manhattan, complete with an underground shopping mall, a three-tiered train station, and a homegrown Rockefeller Center. It’s currently a forest of cranes. “For Tianjin to become a major financial center, that would imply that somebody else would move down the ranks, and I can’t see that happening for Shenzhen or Shanghai or Beijing,” said Fraser Howie, the managing director of CLSA Asia-Pacific Markets in Singapore and an expert on China’s financial system. “The chances of bringing people there I think are going to be remote.”

My last stop on the trip was the Binhai International Convention and Exhibition Center — a pocket within TEDA comprised of the exhibition hall, a light-rail station, a shopping mall, and a stadium used by TEDA’s own soccer team. A program director at the exhibition center, Guan Xu, walked me slowly through the cavernous, empty space, and he explained that government subsidies allow it to maintain a healthy cash flow. Analysts explained that recording a healthy cash flow makes the area appear fiscally sustainable; maintaining an appearance of fiscal sustainability could help the area attract additional investment. “As with any investment, there’s an initial period where you’re hungry for businesses, and you can’t say you have a 100,000 square-foot exhibition hall and it’s in ruins,” Howie said.

As we walked outside, Guan admitted that the area’s emptiness could be overwhelming. “In Binhai, productivity is everything,” he said. It was pouring rain, and the puddles reflected a colorless landscape of vast public plazas and unadorned concrete. I asked Guan how he occupies himself on the weekends. He pointed at a collection of white plastic chairs and bright red awnings outside the exhibition hall — a beer garden. I asked whether it was any fun. “Nobody really goes there,” Guan said, shaking his head. “Perhaps they haven’t done enough advertising.”

Jonathan Kaiman

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