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China's high-speed rail scandal opens a window into when China's economy will catch that of the U.S.
04/15/2011 8:30 am EST
The date is subject to debate but the assumption seems to be that it’s inevitable that the Chinese economy will be bigger than that of the United States, current the world’s largest, in relatively short order.
The argument makes basic sense too to anyone familiar with compounding. China is growing its economy at 10% a year; the U.S. growth rate is closer to 3%. With that 10% growth rate compounding every year, at some point China catches the larger but more slowly growing U.S. economy. How long it take really depends most only how you calculate the size of the Chinese economy. The CIA World Factbook notes that since the China’s currency is undervalued, the official exchange rate, which puts the size of the Chinese economy at $5.7 trillion at the end of 2010 isn’t very accurate. Using purchasing power parity, which looks at how much a yuan actually buys in China, the CAI World Factbook puts the size of China’s economy at $9.9 trillion. The size of the U.S. economy is $14.7 trillion.
Next year the gap will be $550 billion smaller at current relative growth rates. It seems inevitable that China will match the size of the U.S. economy and then pass it by.
Unless—compounding really isn’t at work in China’s economy. The only thing that can derail these projections—whatever year you buy into—is massive misallocation of capital in China. If, instead of investing its growing wealth in projects that will increase the country’s wealth more in the future, China is pouring its annual “profits” into projects that will never pay off and should have never garnered a yuan of investment, then, maybe, China won’t catch the United States. Or at least it will take much longer for the country to close the gap with the world’s largest economy.
This is why the current scandal that shows massive graft in the construction of China’s vaunted high-speed railway system is so fascinating and important. It gives investors a window—albeit a window with a narrow view—into how China allocates capital and how much capital China might be pouring down rat holes rather than into investments with positive returns.
And a way to guess how much longer it may take for China’s economy to overtake that of the United States.
No doubt about it, the Chinese high-speed rail system is one of the wonders of the world. China began 2011 with 5014 miles or 8,358 kilometers of high-speed rail already in operation. In 2011 China will build out major connecting lines that will turn this into a true high-speed network. For example, by the end of December a 664-mile (1107 kilometer) line between Beijing and Wuhan will complete the north-south route between the Hong Kong border and Beijing. By the end of the year too the final links will be in place to connect Shanghai with Chengdu. Imagine at 1250-mile trip through some of China’s highest mountains and across some of its deepest river valleys at speeds of up to 210 miles per hour (350 kilometers per hour.)
By the end of 2020 China plans to have built a high-speed rail system of 9,600 miles or 16,000 kilometers.
A system like this doesn’t come cheap. Over the next four years China will spend an estimated $500 billion on high-speed rail.
You’d have to be completely naïve about the way that government spending works in Beijing or Washington to believe that this much government cash wouldn’t draw a trainload of officials looking to grease their own pockets. Investigations into that graft started with Ding Shumiao, a well-known businesswoman in the railway equipment industry, who in January 2011 was accused of taking $120 million in “fees” to arrange railway projects. From Ding the investigation grew to include Liu Zhijun, minister of railways until February and a friend of Ding. Zhang Shugang, deputy chief engineer and director of the transportation bureau of the Ministry of Railways, is also under investigation. He was suspended from his post in February.
But what’s interesting to me about what the investigation has revealed isn’t the fact of kickbacks and other forms of payoffs—or even the amounts involved. $120 million is sure a lot of cash but it’s not enough to make a difference between a high-speed railway system that is economically viable and one that’s a white elephant.
What the investigation also shows is the way that the decisions about the design of the system were driven at every step of the way by the desire to produce extra revenue for everyone ranging from the state-owned companies that built the system to the real estate developer who would make a killing if the high-speed line extended to his or her city.
So, for example, over and over again officials demanded that trains be able to achieve those top speeds of 210 miles per hour even if it meant spending more on rail beds, that viaducts be employed to speed construction (since elevating the track meant protests about appropriating land), and on extending the network to as many towns as possible.
Actually it wasn't "even if." It was "because" since anything that added to the cost of the system meant more money for contractors and subcontractors and consultants.
This has all resulted in a very big network with relatively high costs that includes some routes that will never pay off.
The financing for this system flows through the Ministry of Railways where the Financial Center is the borrower in chief. The center borrows from China’s banks—long-term 20-year loans at a significant discount—and doesn’t have to pay principal until five years or more after a project goes into construction. (For up to two years after the line starts operating, the center doesn’t have to pay interest.)
The ministry finances these projects—and it is the chief borrower even on what are in effect provincial or city projects—by selling 10-year bonds.
Until recently all the delays on interest and principal payments built into this system meant that the ministry ran close to breakeven after collecting passenger and freight revenue. In 2009 the ministry even ran a small $400 million profit.
But the bill for past construction borrowing and for the big ramp up in spending on the high-speed system is about to kick in. In 2011, Caixin calculates, the ministry will have to pay $26 billion in interest and principal.
Nobody who knows how the Chinese financial system works will get very worried about these debts and the pluses or minuses of cash flow. Beijing will shift debt from one pocket to another, create new financial entities to buy bonds where needed, and kick all the problem ten years down the road if that’s what’s required.
From this point of view, it doesn’t matter whether China’s high-speed rail system makes a profit or if it was a good investment of the nation’s capital.
But if you’re looking at the ability of an economy to compound its wealth—to invest its capital this year to get more capital next year that it can invest again—then it does matter. And the investigation has caused institutions in China, including the Chinese Academy of Sciences, and even the railway ministry itself to wonder about these investments.
For example, on April 14, the ministry announced that it would reduce the top speeds on the country’s network to a top speed of 180 miles per hour from 210 out of a concern for safety and in order to introduce more variation in ticket prices. Speeds on regional high-speed lines will be limited to 120 to 150 miles per hour and other lines will see speeds drop to less than 120 miles per hour. Tickets on high-speed trains operating at less than 180 miles per hour will sell at lower prices.
This effort to lower some prices seems intended to address one criticism of the high-speed network. Because a high-speed rail system has been so expensive to build ticket prices may—and I think the jury is still out on this—be too high for many Chinese. There’s some evidence that while the goal of the high-speed system was to pull passengers from slower trains thus freeing up rail capacity for freight trains, the biggest effect has been to move passengers either from the rail network to buses or from airplanes to high-speed trains.
Yep, to buses. The Ministry of Transportation noted that long-distance bus traffic over the Chinese New Year—when many lower paid migrant workers make the long-trek home—is projected to be up 12% this year. One reason for that is the cancellation of many slow, long haul trains in an effort to increase traffic on high-speed lines and to decrease congestion on the rail system. A 12% increase would put, the ministry estimates, an extra 70,000 buses on the roads.
Earlier this month Wang Changshun, the deputy head of the Civil Aviation Administration of China, told a conference that high-speed trains are leading to the cancellation of shorter flights along the routes of high-speed trains.
So what? Think of capital allocation again. China is investing a lot of money to build high-speed lines—and if the return for part of that investment is more bus traffic and more congested roads, then the return on some part of that investment is negative.
And if you need more evidence that capital allocation is not exactly the strong point in China’s economic system, consider this: As part of the country’s new Five-Year Plan China will build 55 new airports—increasing the number of airports in the country to 230 from 175—over the next five years.
High-speed trains cut into air travel on competitive routes and after building out a 9,600-mile high-speed rail network, the country will build another 55 airports?
Along with persistent anecdotes about new developments and indeed whole new cities without residents, it does make me wonder about how much return China will get on much of its current investment.
The U.S. (and U.K. and Irish, and Spanish) real estate boom and bust demonstrated exactly how devastating to future economic growth the misallocation of capital can be.
I doubt that China’s misallocation of capital rises to the level of the U.S. debacle, but I have to admit that I don’t know its exact dimensions. And that gives me pause whenever I read a projection about the size of the Chinese economy five or ten or more years down the road.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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