Andy Xie on China

Andy Xie, an independent economist based in Shanghai and the former Morgan Stanley chief Asia-Pacific economist, yesterday published an excellent article in Caixin warning that an inefficient public sector and negative real interest rates are pushing China towards stagflation, instability and a possible financial crisis (h/t

Xie’s article more or less supports earlier warnings from Michael Pettis and prominent China bears: Jim Chanos, Vitaliy Katenelson, Gary Shilling and Puru Saxeena. Below are some key extracts:

The central government has embarked on a monetary tightening program to slow the nation’s growth rate and fight inflation, using credit rationing as its main tool.

It’s a policy that’s compounding the nation’s inefficient allocation of capital. It’s also contributing to slower growth potential in China at a time when the nation’s inflation rate is surging…

China’s monetary policymakers are too far behind the curve. Inflation is entering crisis territory, as consumer prices for many products and services rise at double-digit rates. Signs of panic have appeared along with hoarding which, when it spreads, could trigger a social crisis.

Yet something else is happening. By shifting capital to inefficient users against the backdrop of negative real interest rates, China’s economy is being pushed toward stagflation. Meanwhile, the public is afraid that the government wants to inflate away the value of their money.

What’s prevented a full-blown crisis so far is a belief that the yuan will appreciate. If not for this assumption, capital flight from China would be rampant.

To change course, policy tightening must shift away from credit rationing and toward market mechanisms. Moreover, the interest rate must be lifted out of the negative column: It should be raised at least three percentage points to allay public fears. These changes are needed as soon as possible.

Xie goes on to explain how the Chinese Government’s attempts to control inflation through credit rationing and suasion, rather than through appropriate (higher) interest rate settings, are creating perverse outcomes and inefficiencies:

Forcing businesses to hold down prices is only a temporary fix. Input costs are rising 20 percent per annum for some businesses, and these companies will not survive unless they raise prices. Businesses pressured by the government to hold down prices might have to halt production or find other ways to increase revenues. For example, they might shrink portions or repackage old products, selling them as new.

State-owned enterprises can use subsidies and borrowing to slow price increases. For example, bank loans have been covering losses posted by thermal power plant companies, which have been forced to depress prices. Virtually every power company in China is losing money but survives on loans, basically shifting the inflation burden to banks.

This tactic has many side effects, including human health damage. Power companies limit costs by burning low-quality coal or switching off smokestack scrubbers, forcing people to breathe harmful coal smoke…

Few private companies can get any credit from banks these days, forcing them to turn to the gray market for financing at interest rates often above 20 percent. Many, if not most, will not survive if these high financing costs continue.

Xie then warns that private enterprise in China is being crowded out by Government bias towards state-owned enterprises (SOEs), which is reducing capital efficiency and risks creating stagflation – a situation whereby the inflation rate is high and the economic growth rate is low.

China’s capital allocation mechanism is likewise working against the private sector, with increasing bias toward state-owned enterprises. Banks have been lending to underperforming SOEs simply because they’re owned by the government. Most funds raised on the Hong Kong and Shanghai stock markets are for SOEs. Local governments have been raising massive amounts of money by auctioning land and taxing property purchases.

As a result, government expenditures have risen as a share of GDP. Indeed, government and SOE expenditures may have reached half of GDP…

History shows that government and SOE spending tends toward inefficiency. There’s plenty of evidence of this in China, where image projects have been sprouting across the country like bamboo shoots in spring.

Inflation is a byproduct of inefficiency. Money spent on activities with low productivity levels lack products or services to absorb the money, leading to inflation.

Credit rationing is making the situation worse. While the public sector wastes money and fuels inflation, efficient small- and medium-sized enterprises are being starved of cash.

As capital efficiency declines in a climate of persistent negative real interest rates, stagflation emerges. Stagflation eventually leads to currency devaluation, and devaluations in emerging economies in the past led to financial crises.

However, Xie sees little prospect of the Chinese Government taking the actions necessary to rebalance the economy and stave off stagflation. Too many sectors of the Chinese economy are reliant on artificially cheap money and would likely collapse if interest rates were raised above the level of inflation.

The forces that favor low interest rates are powerful. For example, China’s local governments are so indebted – with debts now averaging three times revenues, and some extended by 10 times revenues – that they could not possibly survive positive real interest rates. Their survival hopes rest with sales of land at high prices, and higher interest rates would burst the real estate price bubble.

State-owned enterprises are in similar shape and thus favor low interest rates. They reported 2 trillion yuan in combined profits last year but were still cash-flow negative. The SOE sector has never been cash-positive, and last year’s negative cash flow was the worst in years…

Government companies are so cash-flow negative and so leveraged that one cannot help worrying about financial health issues. Big problems could be impossible to hide if interest rates turn positive.

The force is with credit rationing and negative real interest rates, even though this combination of policy tools makes stagflation inevitable… Stagflation benefits debtors. At the same time, however, savers pay a high price. No one expects savers to sit idly by while their savings are wiped away. Thus, stagflation never creates a stable equilibrium but instead breeds social instability…

In an emerging economy, serious stagflation always leads to currency devaluation, which always triggers a financial crisis.

Like Michael Pettis, Xie believes that China’s growth model will continue to suppress the middle-class in order to continue subsidising inefficient SOEs. Such actions will make it near impossible for China to make the shift to a consumption-based economy, and raises the risk of it experiencing a devaluation-triggered financial crisis at some point in the future.

At the root of China’s problems is the rising level of inefficient public sector spending. The system is biased toward supporting public sector income growth. And as public sector demand for funding exceeds what the economy can bear, money-printing is inevitable.

Tools for shifting money to the public sector are taxes and land sales. Unless these fall, all the talk about economic rebalancing will be no more than talk. So China should cut taxes, as soon as possible, to signal a new approach to economic growth. The top personal income tax rate should be slashed to 25 percent and the value-added tax reduced to 12 percent.

Until that happens, China’s growth model will be suppressing the middle class. A successful white collar who has worked 10 years in a first-tier city cannot afford to buy an average piece of property in China. Suppressing middle class growth is not in the country’s interest, since social stability in modern society is linked to a large, content middle class…

A turnaround for real interest rates is not only necessary for containing inflation but vital if China is going to shift its growth model to household spending from government spending and speculation. Savers who lose wealth to inflation are unlikely to be strong consumers but, instead, may speculate to recoup losses, trapping the economy in an inflation, speculation cycle.

China’s economic difficulties are interlinked and cannot be addressed separately. The root cause is the political economy that gives public spending the leading role in driving economic growth. A fundamental solution must involve limiting the government’s means for raising funds.

Containing inflation and controlling bubbles must be viewed in this context, as the current growth model is pushing the economy toward stagflation and currency devaluation risks loom large. China could see a devaluation-triggered financial crisis similar to what the United States has already experienced. The difference, however, is that China’s system is not robust enough to maintain stability during such a crisis. It’s easy to see why fundamental economic reforms are urgently needed.

As I have said many times before, a hard landing in China is the biggest risk facing the Australian economy. Even a slowdown of Chinese growth to 5% could see overall commodity prices fall by 30-40% according to a recent report by Canada’s TD Economics. And Australia’s two largest exports – iron ore and coal – would be hit particularly hard, adversely affecting Australian growth, jobs and government revenues. The flow on impacts to the rest of the Australian economy – from the housing market, to the banks and retail – could be devastating, potentially culminating in a deep recession and falling asset values.

The future trajectory of the Chinese economy is the big unknown. Hence, it might pay to operate with an increased margin of safety, just in case Australia’s largest and most important trading partner hits a speed bump.

Cheers Leith

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Unconventional Economist
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  1. Xie is arguing for lower taxes because higher taxes are causing asset price distortions? What if the government simply invested in, say, hospitals and medical personnel training instead of building expensive apartment flats?

  2. Andy Xie has been consistently pushing these themes for a few years now. He was instrumental in publicising the now famous 64.5-million-empty-apartments statistic (which incidentally came from an essay in the overseas edition of People’s Daily, the official Communist Party newspaper, by Yi Xianrong a researcher Chinese Academy of Social Sciences. The estimate was made using electricity meter readings)

    For background read:


    I understand there are no official stats on residential vacancy rates in China, so that’s why you see these “unofficial estimates” which are swiftly denied by the authorities. Here’s another unofficial estimate based on some kind of internet poll of people counting lights on at night in apartment buildings:

    “There are no official and reliable figures to reflect the vacancy rate in the current housing market, but for those who care about the healthy operation of the market, we feel responsible to do the research,”’s online survey editor, Liao Lanxin told People’s Daily:

    Using the most direct and grassroots methodology by counting the rooms with lights on, netizens get a look at the current housing market, she added.

    The results?

    Volunteers reported to Sina that 51.23% of bought flats in about 100 Shanghai property projects were empty. This was lower than the rate in Beijing (65.6%) and Hainan (over 70%), but some warned that the method was unreliable. Media outlets reported a week ago that developers would sometimes leave vacant houses lit up at night to give the illusion that people live there.

    Besides leading to calls for more accurate information about housing stock, the issue of vacant apartments has also dredged up worries about China’s real estate bubble. As Andy Xie, an analyst in Shanghai, argues:

    Property bubbles can be divided into two kinds—quantity bubbles (too much supply) and price bubbles (too expensive). China, however, is facing a combination of the two.

  3. I feel that the much talked about housing crash could be tempered by the stock market. If the market corrects with a China slowdown, then i can see, rightly or wrongly, money flowing back into property.

  4. The article is mindless China bashing by a high priest of free market . The problem facing China is structural and political. It’s not something a free market can solve.

    A new apartment in Shanghai cost at least 2 million RMB. The average annual wages for a worker is 30,000 RMB. The ratio is 67 times!! For it to become affordable, either wages have to rise 10x, or the price of apartment have to fall 90%. Either action will be major economic disaster. It’s like the joke about a tourist asking a local for direction : “I would not start from here”.

    The fundamental problem is wealth distribution. The only solution is to tax the rich, and then find a way to redistribution the wealth to the rest of the population. Calling for ‘Lower Taxes’ is insanity. China needs higher taxes and government funded semi-pblic housing.

    • Really? I agree with Xie, the answer is higher interest rates in China. China should stop propping up the SOEs and local govts, and start paying ordinary Chinese a decent return on their savings.

      China needs to start rewarding its citizens and stop funneling money into big (state-owned) corporations and property developers.

      • I see it this way; China has to keep propping up the SOE’s; they’re broke. The only way to do this is to “print” money – keep the fire stoked to keep the winter chills away. The advantage China has over the US is it’s fixed currency. The US prints, the value falls. China prints 1 or 1 billion the value stays the same to the rest of the world. Can China keep printing? Who knows.

  5. When will the China economy hit the wall and crash? I am saying late 2011 or early 2012. I cant wait till everyone, especially Australians, really get to see that all of their policies were all crap.

  6. Chinese property developers feel pinch of tightened belt

    BEIJING – Chinese property developers are suffering from a slump in cash flow amid government tightening measures meant to battle rising inflation and rein in speculation in the housing market, according to a report by a financial information provider.

    The free cash flow of the 84 property developers that had filed their annual reports for 2010 to the Shanghai Stock Exchange by Monday stood at negative 70.59 billion yuan ($10.79 billion), according to Wind Information, a Shanghai-based financial data provider, in a report on its website Tuesday.

    The developers’ free cash flow, referring to their operating cash flow after capital expenditure spendings, came in sharp contrast to the 115 billion yuan of 2009, according to the report.

  7. I think China might do just fine. The U.S. and some other countries have debt problems – private and public – and the budget deficit is like a black hole sucking up everything in its way.

  8. “Suppressing middle class growth is not in the country’s interest, since social stability in modern society is linked to a large, content middle class…”

    Citation needed.

  9. That’s it? 8 Replies to an article that basically says the second biggest economy in the world could implode? No wonder fools like me can’t work ‘it’ out.

    If this is all the interest this story makes (and it seems plausible to me), where is all the money going?

    • Yes, well, everyone is being somewhat sanguine about it. How else should one greet the arrival of a tidal wave?

      Truth be told, the underlying facts remain uncertain, despite the best efforts of independent researchers. Let’s face it, even with rigorous and open data collection the outcome would be uncertain.

      We are speculating and nothing more.

      The money itself? I imagine as much is being squirreled away as the elite can manage.

  10. “Their survival hopes rest with sales of land at high prices, and higher interest rates would burst the real estate price bubble.” Sounds familiar.