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China’s Dr. Dolittle Problem
01/10/2012 8:00 am EST
Like the doctor’s fictional creature, China is being pulled 2 ways, toward a soft economic landing and something much worse. It’s hard to know which way it will go.
I’d compare China right now to Dr. Dolittle’s pushmi-pullyu —except that then you might think I believe the battle between the forces pushing that country’s economy toward contraction and those pushing it toward expansion is comic.
And there’s nothing funny about the perilous balance in China that will determine whether its economy will bottom near an 8% growth rate in the second quarter or shrink much more drastically to a hard landing.
There’s nothing—not the fate of the euro, a possible Greek default or an economic slowdown in the United States—that has more power to determine the returns investors will see in 2012.
I know I’ve written about this battle recently, in "China’s Bear Threat Isn’t Over." I also gave you my view that by the middle of 2012 we’ll see hard evidence of the 8% (or so) soft landing that will lead to a rally in China and other emerging markets (in "The 10 Best Stocks for 2012").
But besides the tiny little issue of whether China can actually achieve a soft landing, there’s the question of how scary the flight path becomes. The scarier that flight path, the more uncertainty investors will see—and the bigger the drop that Chinese (and other emerging market) stocks will suffer before any bottom this summer.
The more uncertainty and the bigger the drop, the stronger the argument to move more of your portfolio to the sidelines in the first half of the year.
And I’d have to say right now that although I’m still looking for a bottom in China (and other emerging markets) in mid-2012, the going looks increasingly rough, and the damage that the bear will inflict, even worse with every news story from China.
The Subway Freeze
The war isn’t over, and I think ultimately the forces of expansion will pull out the victory, but the news from the front is certainly negative right now.
How negative? Well, let’s take a story that Caixin online reported Friday about the collapse of subway construction in China
The story reported that the cities of Chengdu, one of the fastest-growing cities in China; Xian; and Shenyang will open a second subway line in 2012. And then stop any further expansion of their systems.
The pattern is being repeated throughout China. Shanghai, for example, has indefinitely postponed the scheduled addition of seven trains’ worth of rolling stock to expand its subway system.
Zhang Jiangyu, vice director of the transit technology planning office at the National Development and Reform Commission, told Caixin that 70% to 80% of projects are being postponed nationwide.
Part of this is a result of an explicit decision by the government in Beijing to cut spending on rail projects as part of the efforts to slow the economy in order to fight inflation. (The National Development and Reform Commission didn’t approve a single subway project in 2011.)
This part of the story doesn’t worry me too much—explicit central government decisions to cut spending can be quickly reversed by explicit central government decisions to increase spending.
But actions by the central government explain only part of the collapse in subway spending. Most of it is a systemic effect of the central government’s decision to slow the real-estate market and to hold down or reduce real-estate prices. I’d call it an unintended systemic effect, and as such it will be much more difficult to reverse.
And that’s what worries me—and other China investors—about this piece of news.
The Real-Estate Slowdown
That effort to slow the real-estate market cuts deeply into the largest source of revenue for infrastructure projects for local governments.
The process works like this: Local governments sell developable land to raise revenue, and they can drive up the price that developers are willing to pay by promising infrastructure improvements such as subway lines.
As the real-estate market softened in response to Beijing’s policy, the price of land and the amount of revenue that local governments would have been able to raise would have fallen in any case. But the decline in revenue has picked up speed as local governments have cut back on infrastructure improvements that might have enticed developers to increase their bids for land.
Land sales in 25 major cities generated 950 billion yuan ($145 billion) for local governments in the first 11 months of 2011, according to the China Index Academy. That’s down 11% from the same period in 2010.
The fear is that the downturn in revenue and the decrease in infrastructure projects at the local level could build up enough momentum to slow the national economy by more than Beijing plans. To counter that possibility, the central government already has reversed the monetary tightening that it imposed in 2010 to fight inflation.
Data released on January 7 showed that the money supply in December, as measured by M2, rose by 13.6%—well above the 12.9% expected by economists surveyed by Bloomberg. The 13.6% rate is the fastest growth since July and a big increase from the 12.7% growth rate in November 2011.
New bank loans came to 649 billion yuan ($101 billion) for the month, well above the consensus call by economists of 575 billion yuan. For the year, new bank lending totaled 7.47 trillion yuan, and expectations now are for a big hike in the lending quota for this year, back to the 9 trillion (or even higher) levels of the post-2008 financial crisis stimulus effort from Beijing.
Also, the People’s Bank of China is expected to ease bank-reserve requirements, in advance of the January 23 beginning of the Lunar New Year festival, by 0.5 percentage points. This would add $55 billion to $65 billion in bank lending power to the economy.
Stimulus on the Local Level
Mention of the 2008 stimulus package, though, raises the fear that this time Beijing won’t have the fuel needed to jumpstart the economy—because of the effect of lower real-estate prices on local government revenue.
In the aftermath of the Lehman Brothers bankruptcy, as the global economy teetered on the edge of recession, China’s central government announced a package of stimulus spending totaling $586 billion over two years. Local governments, however, topped that figure with an announced package of $1.4 trillion.
Granted that both figures included a lot of double-counting of projects that were already in national and local government budgets, and that the actual new money was much lower than announced, local governments in 2008 still targeted twice as much as Beijing to the national economic stimulus plan.
No one thinks that kind of response by local governments is likely now. In fact, as in the United States, local governments will be cutting spending just when the national government needs them to help stimulate the economy.
In the US, the failure of national economic policy to provide more countercyclical cash to state and local governments has slowed the recovery. (For example, in December, when private-sector employers added 212,000 jobs, the government sector continued to shed jobs, losing 12,000.)
In China, where the local contribution to the 2008 stimulus was so large and where the local role in infrastructure spending is so critical, the result of budget cuts at the local level could spell the difference between a hard and soft landing for the Chinese economy.
So far, Beijing seems to intend to work around this problem rather than tackle it head-on. For example, the measures flagged by a recent front-page article in the official China Daily to spur growth emphasized direct central government action to spur consumption with subsidies and rebates to encourage the purchase of cars and appliances, for instance. More than ten government departments, the paper reported, are now at work on concrete measures to boost consumption.
The Local Debt Problem
All well and good, but measures like those won’t help local governments with huge—and unsupportable—debt levels.
The official figure from the National Audit Office shows local governments with debt of 10.7 trillion yuan ($1.65 trillion). Moody’s Investors Service says that’s low by 3.5 trillion yuan. That would bring the total to 14.2 trillion ($2.18 trillion). That’s a lot of debt to carry when your key revenue stream is falling.
Of this local debt, 4.97 trillion yuan, by the official count, is owed by financial entities affiliated with local governments. Much of this debt can’t be supported by the revenue that the projects it financed will generate.
The Line 4 subway in Beijing, for example, was financed through a private-public partnership. About two-thirds of the 15.3 billion yuan construction cost was paid by a city government entity called Beijing Infrastructure Investment. Some of the 4.6 billion yuan cost of trains and signal equipment was paid by Beijing MTR, a joint venture between two companies backed by the Beijing city government and the subway operator, also a government company.
How do the entities involved turn a profit? They don’t. Ticket sales are indeed one source of cash, but the system’s debt financing also relies on government subsidies and revenue from real-estate sales.
If you want to track fear among investors, I’d watch this local government debt market. Same if you’re trying to figure out when to buy into the bear market in Chinese stocks.
Stories about debt defaults by local governments will ramp up fear in the markets. The Chinese debt market isn’t especially transparent, but because some of this debt was sold in the form of bonds, there is more news on defaults than you might expect.
For example, on January 5, bond markets in China were briefly rattled by news of two corporate debt defaults. The defaults lasted just a few hours, but they were reported.
Stories about even transparently cynical attempts to bury local government debt, as China did in 1998 in the aftermath of the Asian currency crisis, have the power to decrease fear. The solutions to the local government debt problem all involve assumption of local debt by Beijing or the transfer of the debt to a financial entity backed by Beijing.
Stories that indicate that the central government is moving to assume or bury local government debt will reassure investors that the debt problems of local government won’t ripple out through the entire economy.
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 September, see the fund’s portfolio here.
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