China’s unasked questions

An awful lot of rubbish is written about China. Such as how China’s property market is overheating, or its exports unbalancing the world economy. So here are a few questions. When did private property ownership start in China? About a decade ago. Who owns most of the land? The Party (which of course gives them an enormous amount of tier 1 capital for the banking system should they need it). How much of China-US trade is shipments inside the same company? About half. What would happen if the yuan was floated? It would go down because money would flood out of China.

And so on. China is still transitioning to capitalism and it has a long way to go.  Nearly all the capital is bank lending, there is virtually no bond market, the stock exchange is big in terms of market capitalisation, but small in terms of the number of stocks (about 800 on the Shanghai exchange), and most of them are government owned.

There is some private banking for the private companies, but it is on the fringe. There is little venture capital. But there is an enormous amount of over-investment – over 40% of GDP – because there is nowhere else to put retained earnings. Put it in the bank and it declines in real terms. Can’t buy bonds, the stock market is a casino, can’t invest offshore, no real venture capital.

In other words, as this McKinsey presentation illustrates, China is nothing like the developed economies of US or Europe. Yet Western analysts persist in seeing it in those terms, wringing their hands about the trade surplus for instance. China cannot be a mercantile nation like Japan or Korea was, and it knows it cannot. The numbers simply do not add up. China must be a continental economy; as should be obvious from the predictions of when it will become the world’s biggest economy (somewhere between 2020-2030). It has opened up its economy to trade in order to suck in Western expertise, not to get rich off Western money.

What really matters in China is what is happening inside China. A furious debate has been going on inside the party about what economic model to use. Some believe the Western model was exposed as flawed by the GFC, others argue it is the best way forward. The argument appears to have been resolved for the latter camp. The transition to free markets will continue.

The most important question posed by China is not what will happen to its exports or property market. It is what will an economic emergence on this scale do to the world economy? This has never been seen before and it will mean an entirely new era of economic activity, perhaps even something beyond the traditional capitalism-socialism dialectic.

Just consider the size. There has been an average 10% real annual growth in China’s economy since 1982 which has now lifted the country and more than 400 million of its citizens from poverty.  China’s massive stimulus package of 16 trillion yuan ($2.5 trillion) of bank lending over the past two years easily matches that of the United States in absolute dollars, including the latter’s ‘Quantitative Easing Package II’ late last year for an economy that is essentially just over one-third the size of the US in nominal GDP terms.

If China can average 7.7 percent growth over the next twenty years. its $4000 per capita income (only $200 in 1982) — then the Chinese economy will be four times its current size in 2030: $US24 trillion. It was only at that projected level of per capita income ($16,000 in 2030) at which US and Japanese steel consumption began to moderate, and fall. That is a long period of demand for iron ore. Last year, China used twice as much crude steel as the EU, the US and Japan combined.

As The Economist discussed recently, China has plans for unimaginably large development. The below for instance is a plan to create a megalopolis in China’s southern industrial heartland, the Pearl River Delta:

The magnitude of this development isn’t going to put pressure only on iron ore supply. As we approach (or pass) peak oil we are also headed into peak supply for an entire range of soft and hard commodities. For this to be sustainable, the world will need another revolution in resource usage if it is to cope. What the CSIRO’s James Bradfield Moody calls “The Sixth Wave”.

Another key question to ask is: what is the cost of capital in China? The answer is not clear, and that suggests the existence of the same weaknesses that emerged in Japan in the 1990s, where the cost of capital was considered an “un-Asian” concept.

We know what happened to Japan when the cost of capital caught up – asset collapse and deflation. China is at a very different stage of development. At the moment, mispricing only really matters in the banking system and the government has a buffer in the form of land ownership. Japan in the 1990s had a developed financial system, which it allowed to be distorted by asset bubbles in property and the stock market, and Japan then made fundamental mistakes (such as not writing off more debt). China is nothing like that.

But the excessive levels of investment in China suggest that the cost of capital weakness is still there, even if disguised. The Chinese leadership realise there needs to be more consumer spending to balance it out, but whether they can achieve it remains to be seen. It will be hard because the Chinese people save heavily for education and health, both of which are not provided by the State and are expensive.


  1. Why can’t the solution as outlined in your last paragraph be implemented to increase domestic consumption ie. provision of health and education by government given its strong financial position ?
    I think the massive stimulus appears to be translating into inflation as M2 is still growing at ~20% with high exports.

    • The Chinese have a strategy, not well publicised, to make their top 100 SOEs globally competitive/dominant and to use that wealth to fund education and health. It is a novel approach to social welfare.

  2. The west and the world needs to go to the free market instead of market socialism, the central bank command economy ponzi needs to be replaced by a gold backed free market without the state involved in money and bailouts. When you hear major corps including mc donalds got bailouts, the system is going down, instead of cutting stores and rescructering they steal money from taxpayers. The income and property taxes should go as well.

  3. Do you work for Treasury?

    This piece doesn’t really ask any questions. Its pretty much the same as all China-boom-will-last-forever pieces, which all regurgitate the same tired lines:

    – China has a lot of people, way more than anywhere else, and therefore cannot fail.
    – China is in the early stages of development, and therefore cannot crash.
    – China has an endless supply of poor peasants who want to move to the city to work in factories, and therefore cannot fail.
    – China’s development is unprecedented, therefore “its different this time”.
    – China is still partially a command-economy and the Party can prevent any crashes.

    None of what you said above addresses the fundamental problem of: THEY’VE BUILT A SH*TLOAD OF STUFF THEY DON’T NEED.

    • The West has to ask itself the question: why did it fail to predict China’s rise? Of course continued growth is not inevitable. And the reason they have built stuff they don’t need is because of the problem of the questionable cost of capital and nowhere to put retained earnings — much like Japan’s asset bubble problems. The point is that if it does go off the rails, and that is very possible, it will not be for Western developed economy reasons. The task facing the CCP is massive.

      • The West never saw China’s rise because for the same reason they’ve spent 13% of GDP stimulating their economy, it’s founded on SFA.

      • The point is that if it does go off the rails … it will not be for Western developed economy reasons

        Ahhh … so what you’re saying is that its different in China. They can build umpteen million empty apartments, a dozen empty cities, and a hundred thousand kilometres of high speed rail and it doesn’t matter because:

        a) They have a lot of people. I mean a LOT of people.
        b) China is at an early stage of development
        c) Millions more peasants want to move to the city
        d) The CCP will stop things falling apart because nine guys in a room can manage the economy better.

        Seriously, does China have different rules or what? Can they flood their economy with credit, issue millions of loads for sh*t they don’t need, and somehow get out of it without consequences?

        Please explain to me WHY China is different.

  4. I’m confused by this blog, this article seems quite contradictory. On the one hand we’ve got the other bloggers saying the government is crazy to assume the terms of trade will be at all-time highs for the next 20 years because china is fraught with risks.

    Now this article says don’t worry people print a lot of rubbish about china, but the fact is theyre going to kick ass, except for some minor weakness with cost of capital.

    So what should we be expecting? Chinese economy controlled by super masterminds who lift them to #1 in the world and they boom forever and make every1 else look poor by comparison? Or yet-another communist ideologically driven government who can’t see the forest from the trees and crashes their system?

  5. You have just said they have nowhere to put retained earnings but why can’t that be used now for provision of social services ?
    I recall a similar situation of over building in the mid 2000’s but after a few years of continued urbanisation, those buildings filled up and newly created roads got driven on etc. I guess this type of cycle can go on for a few times yet as the Western area gets built out.

  6. Endrortsonhousing

    Totally agree with the thrust of this article – too many analysts superimpose their westernised mature economy worldview onto China.
    As for ghost cities Mav, you have linked to photos that remind me of Canberra in the 1960s and 70s- back in the dim distant past when our government used to actually plan for the future and not adopt the user pays approach to infrastructure development. Its not as if there is a shortage of people in China to fill that city.

    • Totally agree with the thrust of this article – too many analysts superimpose their westernised mature economy worldview onto China

      Actually, they’re just applying the same economic rules that apply to everyone else, namely, when you flood you economy with credit, issue millions of loans for stuff that doesn’t produce an income stream, a financial crisis inevitably follows.

      Come on, tell me how things are different in China.

    • And what a nice, planned, vibrant “city” Canberra has turned out to be (my apologies to those who are forced to live there!).

      There is no shortage of warm bodies in China to fill that city, except those warm bodies just need the skills, jobs and money to live there. I am sure the US has enough warm bodies, (including illegal immigrants from Mexico) to fill Detroit, and yet it remains a ghost city. I wonder why.

      Some of these empty houses have already been bought by “investors”. It seems these people think an empty property is a good place to “store” their wealth.

      I am amazed by mankind’s almost insane ability to forget the lessons from the past and over-reach.

      • I can’t confirm this to be true Mav, mainly cause this came over the radio by the “Know Nothing About Everything Finance Blabber Mouths”, whom claim that Chinese investors like their houses in new condition cause that retains their value, and even increases their value. If a house has been lived in, its’ just not the same or worth as much.

        I don’t know. I can’t say if this is true or not but it did make me think….

        …if Australians on the property hunt said, Mate! the house is nice but looks a bit worn in and out here and there, and the price!!! Look Mate, the house just isn’t worth that much and I ain’t buying your debt, its’ just the house I want. I’m sure we would think differently about housing too.

        • Buying a capital asset and never using it because it may depreciate in value?? Can you ever dream of building a brand new factory and never putting it into productive use?

          I think they need to build more mental asylums over there.

          • We need to build them here too, rumour has it Carbon is going to be very expensive soon, and there is tonnes of it!

  7. I guess the same economists wet their pants in the past, when they talked about never ending boom of the Japanese Sumo wrestler economy, The Celtic Tiger economy, the Asian Tiger economies and Dubai’s never-ending sky-scrapers.

    Well, the Sumo wrestler is yet to come out of a 10 year coma, the Celtic tiger turned into a wimpy cat, the Asian paper tigers were blown away by currency speculators like myself and Dubai’s “World” islands are sinking back into the sea.

    • Endrortsonhousing

      Japan’s economy was very good for nigh on 50 years in the post war period. China is Japan squared.
      Ireland and Dubai are obviously not valid comparisons with China.
      Asia is not so much a paper tiger any more.

      • It’s not Japan squared.

        China has, literally, an order of magnitude times more population than Japan.

        While this blog might be ignoring the short term risks, if the Chinese become “wealthy” (at least, as wealthy as many developed countries), then there is a good 50+ years of strong growth ahead. Ups and Downs, for sure, and Australia will catch plenty of colds in the process, but it’s a long process.

        Lorax – you ask, why is it different this time? I would say, it’s exactly the same, but the scale is immense. This is exactly the same as England in the 18th-19th centuries, USA in the 19th-20th, most of Europe in the 19th-20th, Japan in the second half of the 20th. Lot’s of ups and downs, depressions, major recessions, but incredible growth.

        Dubai – 2 million
        Ireland – 5 million
        China – 1330 million

        My personal opinion? Firstly, who cares? Forecasting is for astrologers. Secondly, they’ve overbuilt and are headed for a downturn, followed by many more ups and downs.

        • Lorax – you ask, why is it different this time? I would say, it’s exactly the same, but the scale is immense.

          So you choose answer a) China has a lot of people.

          I fail to see why this makes China immune to over-investment in stuff they don’t need. It doesn’t matter if you have 10 million people or 10 billion people, if you build stuff that never produces an income stream, loans turn bad, and a banking crisis follows.

          • I would say a) and b).

            I certainly haven’t said that China is immune to problems. It’s just a difference in timing. Short to medium term might be very problematic for China. Longer term, though, looks pretty good.

            I agree that it’s not different this time – but is it more similar to Japan in 1980 or USA in 1880?

          • Well … interestingly US GNP per capita hardly moved for 15 years from 1880, so I don’t think that’s the analogy you’re looking for.

            China in 2011 is similar to late 1980s Japan in three ways:

            1. A property market that has lost all connection with reality.
            2. A sky high investment share of GDP (Japan peaked at 33% in 1990, and China 47% today and rising … although Chanos claims its closer to 70%)
            3. Everyone in the West believes Japan (1989) and China (2011) are unstoppable.

            Astonishingly, more than 90% of China’s growth in 2009 came from investment. All that fabulous growth (and all that Aussie iron ore) was building stuff they don’t need.

  8. Japan went belly-up long after its industrialisation was over (oil shocks of early 1970’s) whereas China appears about half way through this process where the economic formula is a well worn path. Once all the infrastructure has been built etc then the society must evolve to compete on innovation and entrepreneurship of which the US seems to lead the world. Japan doesn’t seem to have done that well. Still it is impressive that China has been able to engineer such continuous strong uninterrupted growth over such a long period. GDP growth of the Tigers that have gone before was more erratic looking at historical graphs.

  9. The cost of capital problem is far from “minor” as Peter suggests. It is indicative of China’s being about half way between communism and capitalism — only just got property rights and private ownership of land, not much of a stock market, no bond market, SOEs still dominate etc. That is my point — you can’t read China as if it is a developed capitalist nation, yet many Western analysts do. The thing to watch most is the development of their capital markets, which will be the prelude to floating the yuan.

  10. 60 – 70% of China GDP is tied to construction, they have printed more money than the US, Inflation is on the rise, Cities that are completely empty and food prices are going through the roof. You are going to write and say this is good and China are different. BULLS$%T

    I look forward to the day this all comes tumbling down and people that write S$%T like this are standing there with egg all over their face. Then tell me China is different. No govt can control everything they can try.

  11. As I’ve said before: it all depends on a central government making all the right decisions, all the time. Has that ever happened before?

    I’m always surprised how people who’d normally say that government should get out of the way of commerce will casually assume that a command economy like China’s is immune to failure.

  12. Well ive put my $ against the china and therefore Aussie economies…the commies are doing exactly what japan did, build shit thats not even in demand for the sake of keeping people working like the ozzi crew digging a hole in the night or tram line and the next crew fills it back up in the morning hahaha….noble but its gonna backfire and cause a depression like no other, lets hope im wrong. The markets need liquidating not more debt on top of what people cannot pay. GFC wrong name should be GDC=debt crises. Will be interesting to see how the ozzy banks cope, and wether the good sheep of australia and there kids, grandkids will end up paying or rebelling. pass the tinny love.

  13. As I understand, the argument here is that China is at the same stage of development as UK 200 years ago or USA 100 years ago. In that early stage 60 – 70% of GDP tied to construction is not abnormal as the country needs to build it’s infrastructure from scratch.

    • In that early stage 60 – 70% of GDP tied to construction is not abnormal as the country needs to build it’s infrastructure from scratch.

      Actually, that level of investment in fixed assets is unprecedented. But hey, everything about China is unprecedented, so new rules apply!

      From memory, investment in Japan and Korea peaked in the low 30s. Dunno about the USA in the early 20th Century. I doubt accurate numbers were kept then, but I recall they had a few problems in the late 1920s after a spectacular boom.

    • 60 – 70% of GDP tied to construction is not abnormal as the country needs to build it’s infrastructure from scratch

      Oh, the key word here is needs.

      If China needed all those new apartment buildings to house peasants migrating from the country, one would assume they might be occupied. In reality, they are held empty, sometimes completely unfinished inside, and prices are beyond even upper middle class Chinese.

      Perhaps China needs empty cities as well. Who knows? New rules apply to China.

  14. Wait I’m not sure I understand. Analysts are fully aware of historical crises within developing nations. Analysts are also fully aware of historical crises within developed nations. How exactly are analysts using a ‘developed’ country model thats materially different than a ‘developing’ country model?

    GDP is GDP whether its developed or developing. If too much of it comes from one bucket that is essentially at the cost of future GDP (malinvestment), then eventually a rebalancing will occur.

    Furthermore, if too much of it comes from one bucket at the expense of another bucket (exports v consumption), then eventually a rebalancing will occur.

    The questions is more ‘how will the politics of China allow the rebalancing to occur?’ In a rebalancing, someone always loses.

    For the record, overinvestment in high-speed rail is probably a good thing long term. Certainly the banks will lose their shirts, but the externalities from those railways are going to be enormous for the country – like the Britain circa 1830 – 1850 or the US 1875 – 1900.

    The Chinese housing (unproductive asset) bubble just sucks and essentially boosts GDP today at the expense of GDP tomorrow.

  15. Sell on News, you write excellent stuff on stocks, but you should stick to your knitting. A cursory glance at China’s history show multiple attempts, at various times, to centrally-plan the way to prosperity. Each time, so far, has fails. To borrow a cliche from Niall Ferguson, China lacks the “killer apps” that made Britain and America global empires and military-industrial superpowers in the 19th and 20th centuries. China has a lot of people who desire a better life, but it has always had a lot of people who desire a better life.

  16. Ive spoken with a mainland chinese girl in australia, she says prices are cheaper here than over there LOL. The railroads they built they used cheaper incredaint in the metal, those tracks will last 50% or less than the western standard, same as there empty building i guess thats a good way to create jobs for the future.
    China is a kleptocracy, absolute power absolute corruption, they have trillions in so called reserves yet they have 1 billion nearly starving while the rest are middle and rich class.