Feb 19, 2013 06:42 PM

Waiting for a Crisis


Bank loans and money supply rose sharply in January. The timing of the Spring Festival may have distorted the data. Still, there are signs that many local governments with new leaders want to try an old trick, pushing fixed-asset investment (FAI) to create GDP and fiscal revenue. This would turn bank loans into GDP and fiscal revenue.

Local governments are already heavily in debt. Pushing FAI would keep them liquid through new loans. It is essentially a pyramid scheme and can go on as long as the banks are willing and able to lend. But constraints have appeared.

Joining the World Trade Organization (WTO) and demographic dividends have sustained China's FAI push for so long. When an economy has underemployed factors of production like labor and natural resources, FAI, even though it is not profitable, can generate a positive return for the economy as a whole. The increased income leads to more bank deposits that can sustain loans to loss-making FAI. Over the past two decades, this has been the case for China.

After China joined the WTO, foreign direct investment rushed in to take advantage of its labor surplus. It has built up the country's export sector to the biggest in the world. The export success has supported bank loans through increasing bank deposits within and supporting the exchange rate value without. The loans could support more FAI that would help expand export capacity. It is a virtuous cycle as long as the factors of production are still underutilized and the export market healthy.

The virtuous cycle has come to a stop in the past few years.

The global financial crisis created a lasting barrier to China's export growth. The country's customers in developed countries literally went bust. Hence, there is no rising tide on the demand side for China's exports anymore. On the supply side, the labor shortage first appeared five years ago. Three decades of the one-child policy, the expansion of the college system and the beginning of the retirement of the baby boomer generation born between 1950 and 1975 have worked together to decrease the blue-collar labor force. The National Bureau of Statistics (NBS) announced that the labor age population shrank for the first time last year. This is why the blue-collar wages are not rising faster than labor productivity. Despite declining producer price index due to overcapacity in the past year, consumer price index has continued to rise and will likely continue to do so in 2013. The money supply continues to rise much faster than potential growth rate. The difference is working into inflation through labor and other costs.

Inflation Tax Is Maxed Out

In the past five years, the FAI boom lived off the inflation tax on two fronts. First, the negative real interest rate taxed savers to sustain the negative return on FAI. Second, the property bubble, now 25 percent of FAI, taxed buyers to boost government income that in turn supported a negative return of FAI. The inflation tax has serious side effects. It cuts into the country's competitiveness and threatens exchange rate stability.

Like other export-led economies in East Asia, China experienced a property bubble during the export and investment boom. The difference is that the government in China controls all the land and gets most sales proceeds as revenue. It has motivated the government to push the bubble as far as possible. This is why China has both a price and quantity bubble.

The quantity side is especially severe. NBS data showed that 10.6 billion square meters of properties were under construction at the end of last year, of which half were residential and the other half office and commercial. An average price close to the market price now would put the value of this inventory at around 1.5 times GDP. Such a high level of inventory value has never occurred anywhere else. It is hard to imagine where the money would come from to absorb it.

The economic fundamentals require China to slow monetary growth to about 10 percent. The inventory digestion would demand 20 to 30 percent. This is why so many vested interests complain that today's monetary condition is too tight. Last year's M2 growth rate of 13.8 percent is low relative to the average of 18.2 percent between 2000 and 2012. It is still too high for price stability. If the M2 growth rate rose to 20 percent, not only would inflation surge, the exchange rate would tumble. These constraints may force the government to control the rate of monetary growth despite the pressure from vested interests that need to liquidate inventory.

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