CHINA: A True Story and the pending danger

China: A True Story and the pending danger 

Since opening up to foreign trade and investment and implementing free-market reforms in 1979, China has been among the world’s fastest-growing economies, with real annual GDP  growth averaging up to 9.5% through 2018, a pace described by the World Bank as “the fastest sustained expansion by a major economy in history”

As China’s economy has matured, its real GDP growth has slowed significantly, from 14.2% in 2007 to 6.6% in 2018, and that growth is projected by the IMF to fall to 5.5% by 2024

Now that much has been written, discussed and read about the flourishing Chinese economy, let’s take a close look at the challenges China has on its hand which are seldom reported by the media. 

Policies that were employed in the past to essentially produce rapid economic growth at any cost were very successful. However, such policies have entailed a number of costs (such as heavy pollution, widening income inequality, overcapacity in many industries, an inefficient financial system, rising corporate debt, and numerous imbalances in the economy) and therefore the old growth model is viewed by many economists as no longer sustainable.   

This appears to indicate that the government accepts and allows the use of free market forces in a number of areas to help grow the economy, but the government still plays a major role in the country’s economic development.

Industrial Policies and State Owned Enterprises (SOE) 

China has become one of the world’s most active users of industrial policies and administrations. China’s State Council has said that they currently continue to dominate a number of sectors (such as petroleum and mining, telecommunications, utilities, transportation, and various industrial sectors); and are shielded from competition;  and are the main sectors encouraged to invest overseas and dominate the listings at the Chinese Stock Markets. 

There are more than 150000 State Owned Enterprises (SOE) at the central and local government level employing about 57 Million people. 

China’s SOEs may account for up to 50% of non-agriculture GDP.

One study found that SOE constitutes 50% of the 500 largest manufacturing companies and 61% of the top 500 service sector enterprises. 

Not only are SOEs the dominant players in China’s economy, many are quite large by global standards.

Fortune’s 2019 list of the world’s 500 largest companies includes 119 Chinese firms (compared to 29 listed firms in 2007). Of the 119 Chinese firms listed, Fortune identified 80 % of these are SOE. Together, these 80% firms in 2019 generated $8.2 trillion in revenues. 

State-Dominated Banking Sector, Excess Credit, and Growing Debt 

China’s banking system is largely dominated by state-owned or state-controlled banks. The managers of China’s state banks are drawn from the ranks of the Chinese Communist Party cadre system, which enables the party and government leaderships to exert influence over bank lending. In 2019, the top five largest banks in China in terms of assets were state-owned entities. banks (including the five large state-owned banks), the three government policy banks, joint-stock commercial banks (where government entities are a major stockholder), together accounted for 68.5% of total bank assets in China. Foreign participation in China’s banking system is relatively small accounting for 1.25 % of the total bank assets.

SOE’s are believed to receive preferential credit treatment by Government banks, or private firms must pay higher interest rates or obtain credit elsewhere. The Chinese banking sector is the largest in the world with a total assets of US40.1 Trillion. SOE’s are having a lion's share of the bank advances. It is often estimated that SOE do not repay their loans, which may have saddled the banks with ever increasing non performing loans. Many analysts contend that one of the biggest weaknesses of the banking system is that it lacks the ability to ration and allocate credit according to market principles, such as risk assessment. 

China Chengxin International Credit Rating reckons the magnitude of hidden local government debt was roughly $6.5 trillion in 2019, up from about $6 trillion in 2018. This year, analysts at Chengxin International figure it could rise toward $7.2 trillion 

The Chinese central government uses the banking system to boost credit in order to help meet its GDP growth objectives. However, China’s debt levels (in both dollars and as a percentage of GDP) have risen sharply within a relatively short time, which some have speculated could spark an economic crisis in China in the future. From 2006 year-end to mid-2016, China’s total non financial sector debt as a percentage of GDP increased from 143% to 254% (up 111 percentage points). In dollars, China’s corporate debt rose from $3 trillion to $17.8 trillion (up $14.8 trillion) and currently greatly exceeds U.S. corporate debt levels. Several observers have warned that China’s credit growth may be too extensive and could undermine future growth by sharply boosting debt levels, causing overcapacity in many industrials (especially extending credit to firms that are unprofitable to keep them operating), contributing to bubbles (such as in real estate), and reducing productivity by providing preferential treatment to SOEs and other government-supported entities.

Local government debt is viewed as a big problem in China, largely because of the potential impact it could have on the Chinese banking system. During the beginning of the global financial slowdown, many Chinese subnational government entities borrowed extensively to help stimulate local economies, especially by supporting infrastructure projects. The Chinese Government has a reported 

debt of $5.48  trillion as of 2020. Efforts have been made over the past few years by the central government to restructure local government debt and restrict local government borrowing, with mixed success, according to some press reports, because of pressures on local Government to maintain rapid economic growth

Many economists blame China’s closed capital account for much of China’s debt problems. The Chinese government has maintained restrictions on capital inflows and outflows for many years, in part to control the exchange of its currency, the renminbi (RMB), against the dollar and other currencies in order to boost exports. Many argue the Chinese government’s restrictions on capital flows have greatly distorted financial markets in China, preventing the most efficient use of capital, such as overinvestment in some sectors (such as real estate) and underinvestment in others ( such as services)

Environmental Challenges

China’s economic growth model has emphasized the growth of heavy industry in China, much of which is energy-intensive and high polluting. The level of pollution in China continues to worsen, posing serious health risks to the population. The Chinese government often disregards its own environmental laws in order to promote rapid economic growth. China’s environmental challenges are illustrated by the following incidents and reports.

2018 report by ExxonMobil estimated that China contributed about 60% of the growth in global CO2 emissions from 2000 to 2016, and that its emissions would surpass the combined CO2 levels of USA and EU by 2025

More than 80% of underground water in China is heavily polluted. According to statistics reported by the Chinese media, more than 80% of the underground water in large river basins of mainland China is unfit for drinking or bathing because of contamination from industry and farming.

Air pollution is estimated to contribute to more than 1 million premature deaths in China each year.

The Chinese government has indicated that it is taking steps to reduce energy consumption, boost enforcement of environmental laws and regulations, reduce coal usage by expanding the use of cleaner fuels (such as natural gas) to general power, and relocate high-polluting factories away from large urban areas, although such efforts have had mixed results on the overall level pollution in China . In addition China has become a major global producer of clean and renewable technology In January 2017, the Chinese government said it would spend $361 Billion in renewable energy power generation by 2020.

Corruption and the Relative Lack of the Rule of Law

The relative lack of the rule of law in China has led to widespread government corruption,

financial speculation, and misallocation of investment funds. In many cases, government

“connections,” not market forces, are the main determinant of successful firms in China. Many

U.S. firms find it difficult to do business in China because rules and regulations are generally not

consistent or transparent, contracts are not easily enforced, and intellectual property rights are not

protected (due to the lack of an independent judicial system). The relative lack of the rule of law and widespread government corruption in China limit competition and undermine the efficient allocation of goods and services in the economy. A New York Times article reported that (former) Chinese Premier Wen Jiabao’s family controlled assets worth at least $2.7 billion. One study estimates that between 2001 and 2010 , China was the world's largest source of illicit capital outflows of USD 3.8 Trillion. A 2012 survey by the Pew Research Centre’s Global Attitudes project reported that  50% of respondents said that corrupt officials are a very big problem ( up from 39% in 2008) 

Chinese officials often identify government corruption as the greatest threat to the Chinese communist party and the state. 

The Chinese government anti corruption watchdog reported that 106,000 officials were found guilty of corruption in 2009. Since assuming office in 2012, Chinese Xi Jinping has carried out an extensive anti corruption drive. China has reportedly sought cooperation with the United States to obtain extradition of 150 alleged corrupt who have fled to the USA. However many analysts contend that the anticorruption campaigns are mainly used to settle political scores with out-of-favor officials. Some analysts contend that President Xi's anti-corruption drive is more about consolidating his own political rather than instituting reforms . 

In addition, there are some indicators that the current anti corruption campaign may be having a negative impact on the Chinese economy, due to hesitancy by some local officials to pursue projects they feel will lead to scrutiny from the central government.

Many observers argue that meaningful progress against government corruption cannot occur without greater government transparency, a system of checks and balances, a free press, Internet freedom, and an independent judiciary. In October 2014, China held its fourth Plenum of the 18th Party Conference. The meeting focused on the need to enhance the rule of law in China, but emphasized the leading role of the Communist Party in the legal system. 

China maintains a weak and relatively decentralized government structure to regulate economic activity in China. Laws and regulations often go unenforced or are ignored by local government officials. As a result, many firms cut corners in order to maximize profits. This has led to a proliferation of unsafe food and consumer products are being sold in China or exported abroad. Transparency International’s Corruption Perception Index for 2019 ranked China 80th out of 176 countries and territories up from 72nd in 2007.

Demographic Challenges

Many economists contend that China’s demographic policies, particularly its one-child policy (first implemented in 1979), are beginning to have a significant impact on the Chinese economy. For example, according to a McKinsey Global Institute study, China’s fertility rate fell from about 5.8 births per woman in 1964 to 1.6 in 2012. This is now affecting the size of the Chinese workforce.

The existence of a large and underemployed labor force was a significant factor in China’s rapid economic growth when economic reforms were first introduced. Such a large labor force meant that firms in China had access to a nearly endless supply of low-cost labor, which helped enable many firms to become more profitable, which in turn led them to boost investment and production. Some economists contend that China is beginning to lose this labor advantage. According to the Chinese government, the size of its working age population (ages 16 to 59) peaked at 925 million in 2011, but then fell for seven consecutive years to 897 million in 2018. The Chinese government projects that its working age population will drop to 830 million by 2030 and to 700 million by 2050. If these projections prove accurate, the Chinese working age population could drop by 225 million individuals (2011-2050).

The one-child policy has also resulted in a rapidly aging society in China. According to the Brookings Institute, China already has 180 million people aged over 60, and this could reach  20 % by 2020 and 27% by 2030. 

With a declining working population and a rising elderly population, the Chinese government will face challenges trying to boost worker productivity (such as enhancing innovation and high-end technology development) and expanding spending on health care and elderly services. 

Credits: Wayne M Morrison, Bank for International Settlement , Economist Intelligence Unit , OECD, China National Statistics office , Bloomberg,

ZERO INTEREST RATES POLICY (ZIRP) WHERE ARE WE HEADING TO?

What is ZIRP?

 Zero interest rates policy (ZIRP) is when a central bank sets its target short-term interest rate at or close to 0%. This is the base rate which the Central Bank pays to financial institutions that hold money and what it charges them to borrow. Basically, it means a world where savers are penalized, and borrowers rewarded. The goal is to spur economic activity by encouraging low-cost borrowing and greater access to cheap credit by firms and individuals. ZIRP is a method of stimulating growth while keeping interest rates close to zero.

Japan - The first country in the world to implement ZIRP during the years in 1990’s.

Japan was officially in an economic bubble during the years between 1986 to 1991 when Real Estate and Stock prices were highly inflated. By 1992, the bubble in the asset price had burst and the economy stagnated. The bursting of the Japanese asset price in 1992 led to huge accumulation of non-performing assets loans (NPL), causing difficulties for many financial institutions. Equity values plunged 60% from late 1989 to August 1992, while land values dropped throughout the 1990's, falling an incredible 70% by 2001. The Bank of Japan (BoJ) decided to bring an unconventional monetary policy such as quantitative easing to increase the monetary base. As a result, since the 1990's interest rate policy in Japan increasingly moved toward the zero-lower bound. Three decades later, the country is still stuck in a zero-interest rate and has never been able to raise the rates again.

(For comparison, US data is provided in the image above)

What triggered ZIRP in Japan?

After World War II in 1945, it took Japan about 15 years and from the 1960's to 1980’s it became the envy of the world. Japan caught up economically with the Western world. The economic growth of this period was to go down in the history books as Japan's post-war economic miracle. Companies such as Sony, Panasonic, Toyota, Mitsubishi, Hitachi became increasingly feared international competitors. They knew how to take over key technologies from abroad, improve them continuously, and conquer international market share step by step. Japan grew at an average annual rate (as measured by GDP) of 3.89% in the 1980's, compared to 3.07% in the United States.

The BoJ started to worry about inflation and asset prices in the 1980’s and decided to put the brakes on the money supply in the late 1980's. This may have contributed to the bursting of the equity bubble and as equity values fell, the BoJ continued to raise interest rates because it remained concerned with still-appreciating real estate values. Higher interest rates contributed to the end of rising land prices but also helped the overall economy slide into a downward spiral. In 1991, as equity and land prices fell, the BoJ dramatically reversed course and began to cut interest rates. The innovative products of Japanese manufacturers that grew rapidly in the 1960's and 1970’s started to fade in the late 1980’s.

When the economy becomes stagnant and Zero Interest Rates Policy fails to stimulate the economy, there comes a huge social effect on the population of the nation. During normal times, the goal of a Central Bank is to increase corporate investments and consumption by lowering the interest rate but could end up in a Liquidity Trap. So, what exactly is a Liquidity Trap? During an economic crisis, such a policy might lose its potency: Instead of stimulating economic activities, lowering the interest rate may end up stimulating a higher demand for cash-like assets. And why cash like assets? Because the Govt and Central Bankers want the Investors to spend, but Investors want to avoid investments during uncertain times and rather do not mind parking money under Govt Notes even if it means losing some amount of the capital.

What does uncertain economics do?

During uncertainty, the country loses its economic power and economic culture. This loss of economics further spirals down to loss of Power of Innovation. Power of Innovation is the key linking companies directly to progress and market leadership in most industries. The power of innovation spreads further than breakthrough solutions – it spreads to the people as well. Zero interest rates counteract the power of innovation. Three decades after Interest rates started going down, the country is still stuck in a zero-interest rate trap and the magic and innovative power of Japanese companies has diminished considerably. The opportunity costs of this zero-interest rate policy are also reflected in the dwindling innovative strength and productivity.

 ZIRP impact on Society

The zero and negative interest rates have not only paralyzed the innovative power of Japanese companies, but in the same breath they have also affected the working population. Younger people have been hit the hardest. As recently as 1992, 80 percent of young Japanese workers had a regular job. In 2006, half of all young workers were in part-time jobs with lower wage levels. Only 2 percent of non-regular workers in Japan move to regular work each year. Most of today's young workers are unlikely to find a regular job. Once a country embraces Zero interest rates policy for a long duration, the change in the culture shifts from Economics to Social for a near permanent period. Zero and negative interest rates are a reality in Europe and will soon be in the US as well.

In the West, the first "signs of resignation" are beginning to appear, particularly among millennials and younger generations. A growing proportion of them seems to be subconsciously realizing that they have to adjust to an increasingly stagnant life. Stagnation in the economy leads to decline in total output, flat or slow growth. Stagnation results in flat job growth, no wage increases, and Consistent unemployment. Once there is lack of development, advancement, or progressive movement: a stagnant economy. inactive, sluggish, or dull pushes people to resort to means of earnings from riskier activities like Day Trading in Stock Markets. Due to Lack of regular full-time jobs, flat industrial growth, Artificial Intelligence (AI), and Automation have led to loss of income and a rising inflation hand in hand leads to social unrest and means of earning from speculative trades. It is estimated that less than 10 % of the population who indulge in day trading are successful, which means real earnings from speculation is only a myth.

Once real earnings are not visible for a long time it will lead to a full-blown social unrest which further will be directed towards anger and frustration against which more and more people take to the streets in demonstrations. In Japan, people are withdrawing more and more from civil society and the public sphere into their own four walls. According to the OECD. Japanese workers sleep less than their colleagues in other Western economies, averaging 442 minutes per twenty-four hours. In the USA, for example, this average is 528 minutes. These are warning signs and they are about to increasingly happen in Europe and the US. If the consequences of ZIRP are not taken seriously by the authorities, it may lead to people's growing hatred of people who will be directed at the wrong culprits. In addition to the economic consequences, the social consequences must be considered, as these often weigh more heavily in the long term.

Credits: Pascal Hügli