Wednesday, January 20, 2016

China gets it wrong

A write-in protest is unusual in an economic survey.

I am in the middle of compiling the annual BusinessDay survey, to be published at the end of the month.

This year, five of those surveyed complained about one of the questions.

They were asked to forecast China's economic growth.

Instead, they forecast what China would say the growth rate was, and said they wouldn't believe it. "I, as well as many others, suspect the official figures are significantly inflated," wrote one. "I have forecast 6.5 per cent, but the actual figure will be more like minus 1," wrote another.

That they are openly mocking the pronouncements of Australia's biggest customer says a lot about where China finds itself.

Its target growth rate is 7 per cent. Its official growth rate, released on Tuesday, is almost exactly the same, 6.9 per cent, suggesting either that China's leaders are incredibly good at meeting targets, or that their frightened underlings are good at leaning on the figures to make it look as if they are.

The first is unlikely, given the leadership's spectacular failure to get what it wants out of its own share market, the world's biggest. The Shanghai composite index plummeted 15 per cent at the start of the year, despite frantic efforts to prop it up.

What's happening to the share index isn't that important, except as an insight into a bigger game being played out on a larger canvas.

"Countries are like people," says Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York. "People do what works until it stops working, and then they keep doing it, because it used to work."

China latched on to something that worked. Appallingly underdeveloped with embarrassingly low local purchasing power, it turned that weakness into a strength. Like Japan, South Korea and Singapore before it, used its low wages to tap into the rest of the world's purchasing power. As as it sold more and more cheap goods it invested the proceeds in more and more factories and housing. It was bringing hundreds of millions of workers in from the country to cities.

As the number of its factories and housing units grew, its need for the rest of the world to buy even more of what it made grew; which it did, enabling China build even more factories and more accommodation, mostly with Australian iron ore.

Until China grew to the point where it dwarfed the economies it sold things to...

On one measure it is now the world's biggest economy, on another the world's second-biggest. With the rest of the world unable to keep buying increasing amounts of what it produced it needed to try something different. It needed to let the growth rate slow and allow the spending of ordinary Chinese drive the economy.

It paid lip-service to the idea, but mostly it kept doing what it used to do.

If building more factories and accommodation had boosted growth before, surely it would do it again, its logic went. And it worked during the global financial crisis, sort-of. Its economy kept growing while the rest of the world's stumbled.

But the rest of the world never really recovered, and China kept building increasingly useless factories and increasingly empty housing.

"Intellectually, China's leaders know what they have to do," Chovanec says. They need to shift resources away from construction towards households. It's been Communist Party policy since 2013.

"The problem is the moment they succeed they will knock the stuffing out of the investment boom. That's why they flinch. They pull back and try to shore up the existing model."

Chovanec was until recently a professor of economics at Tsinghua University in Beijing. No longer living in China, he is free to describe what he saw.

"Whether it's in the property market, in shadow banking, in the stockmarket, in bad debts or in uneconomic state-owned enterprises, they want a correction without having a correction," he says.

"And the longer that goes on, the deeper the hole they dig, the more traumatic and the scary the correction becomes, and the more they flinch away from it."

China's industrial production slowed last year. Yet borrowing jumped a further 5 per cent as banks pumped more and more money into less and less economic factories, housing schemes and loss-making businesses.

"The message it sends is: hey, if you invest in real estate it doesn't matter whether anybody occupies the building, we will ensure you will make a profit because we need it for GDP," says Chovanec.

"It's storing up problems for later, but it is also sucking the oxygen out of the parts of the economy that need to grow."

As Chinese cotton on and attempt to get their money out of the country, China's president, Xi Jinping, is becoming increasingly authoritarian.

Outside of the country he is being openly mocked. Australian economist Saul Eslake described the share market collapse as a "Wizard of Oz" moment. "Far from the Wizard being as omniscient as Dorothy and all the munchkins believed, he is just an old man behind a green screen," he said.

In the short-run doing what used to work is helping Australia. It's allowing us to sell a few more years of iron ore. In the long run it is making what's coming worse.

In The Age and Sydney Morning Herald