China's Train to Nowhere
04/15/2011 8:00 am EST
The graft and corruption plaguing China’s railway system are not what worry me—it’s the misallocation of capital. China may not unseat the US as the world’s largest economy as soon as expected.
China’s economy will catch and then surge ahead of the US economy by…2015, 2020, 2025, or 2050.
The date is subject to debate, but the assumption is that in relatively short order the Chinese economy will be bigger than that of the United States, currently the world’s largest.
The argument makes basic sense to anyone familiar with compounding. China is growing its economy at 10% a year; the US growth rate is closer to 3%. With that 10% growth rate compounding every year, at some point China catches the larger but slower-growing US economy.
How long it takes really depends on how you calculate the size of the Chinese economy. The CIA World Factbook notes that, since 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 Factbook puts the size of China’s economy at $9.9 trillion. The size of the US economy is $14.7 trillion.
Next year, the gap will be $550 billion smaller, given current relative growth rates. It seems inevitable that China will match the size of the US 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 think it will happen—is massive misallocation of capital in China.
If instead of investing its growing wealth in projects that will increase the country’s wealth in the future, China pours its annual “profits” into projects that will never pay off and should never have 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.
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, as well as how much capital China might be pouring down rat holes rather than into investments with positive returns.
And it gives us a way to guess how much longer it may take for China’s economy to overtake that of the United States.
High-Speed Train Wreck?
No doubt about it, the Chinese high-speed rail system is one of the wonders of the world. China began this year with 5,014 miles of high-speed rail already in operation.
As 2011 progresses, 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 line between Beijing and Wuhan will complete the north-south route between the Hong Kong border and Beijing.
By the end of the year, the final links will be in place to connect Shanghai with Chengdu. Imagine a 1,250-mile trip across some of China’s highest mountains and deepest river valleys at speeds of up to 180 mph.
By the end of 2020, China plans to have built a high-speed rail system of 9,600 miles.
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 naive about the way government spending works in Beijing or Washington to believe that so 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, who was the minister of railways until February and is a friend of Ding's. Zhang Shugang, the 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.
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A Recipe for Corruption
But what’s interesting to me about the investigation aren’t the kickbacks and other forms of payoffs—or even the amounts involved. $120 million is surely a lot of cash, but it’s not enough to make the difference between a high-speed rail system that is economically viable and one that’s a white elephant.
What the investigation also shows is 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 involved, 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, over and over again, officials demanded that trains be able to achieve top speeds, even if it meant spending more on rail beds, employing viaducts to speed construction (since elevating the track meant avoiding protests about appropriating land), and extending the network to as many towns as possible.
This has 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 for what are in effect provincial or city projects—by selling ten-year bonds.
All of this is a sure formula for not worrying about whether an investment is going to turn a profit.
Until recently, all the delays on interest and principal payments built into this system meant that the ministry ran close to break-even after collecting passenger and freight revenue. In 2009, the ministry even ran a small ($400 million) profit.
But the bills for past construction borrowing and for the big ramp-up in spending on the high-speed system are about to kick in. In 2011, as the Chinese media company and Web site Caixin calculates, the ministry will have to pay $26 billion in interest and principal.
NEXT: But It's Not the Debt That Worries Me|pagebreak|
But It’s Not the Debt That Worries Me
Nobody who knows how the Chinese financial system works will get very worried about these debts or the pluses and minuses of cash flow. Beijing will shift debt from one pocket to another, create new financial entities to buy bonds where needed, and kick 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 whether it was a good investment of the nation’s capital. The waste—however much there is—won’t make or break any bank or ministry.
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 the railway ministry itself, to wonder about these investments.
For example, on April 14, the ministry announced that it would reduce the top speed on the country's network from 210 mph to 180 mph out of 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 mph, and other lines will see speeds drop to less than 120 mph. Tickets for high-speed trains running at less than 180 mph will sell at lower prices.
This effort to lower some prices seems intended to address one criticism of the high-speed network. Because the high-speed rail 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 airplanes to high-speed trains or from the rail network to buses.
Yep, 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—was projected to rise 12% this year.
One reason for that is the cancellation of many slow but cheap long-haul trains, in an effort to increase traffic on high-speed lines and to decrease congestion on the rail system. A 12% increase, the ministry estimates, would put 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 those 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.
More Airports and Empty Cities
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 from 175 to 230 over the next five years.
High-speed trains cut into air travel on competitive routes—and now, 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 whole new cities without residents—it does make me wonder about how much return China will get on most of its current investments.
The US (and British, and Irish, and Spanish) real estate boom and bust demonstrated exactly how devastating misallocation of capital can be to future economic growth.
I doubt that China’s misallocation of capital rises to the level of the US debacle—we’re No. 1, after all—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 years down the road.
Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.