Why China’s Economic Troubles Run Deep

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Wharton's Marshall Meyer and Stanford's Richard Dasher discuss the causes of China's slowing GDP growth.

China’s GDP growth slowing to 6.5% in this year’s third quarter has raised questions over the role of excessive debt within the country, the impact of its trade war with the U.S., and the general trajectory of the Xi Jinping regime that is seen to be moving away from reforms toward stronger state control of the economy. Chinese leaders have sought to reassure investors that the country’s underlying fundamentals continue to be strong. However, experts at Wharton and Stanford University stress that problems such as China’s debt load run deep and pose a significant threat to the country’s economy.

Marshall Meyer, Wharton emeritus professor of management, said that more than China’s GDP growth statistic of 6.5%, or the trade war with the U.S., his concern is about “the underlying currents in the Chinese economy.” Senior Chinese government officials are correct in describing the impact of the trade war as mainly psychological, he noted. As it happens, China’s vice premier Liu He told the state news agency Xinhua last week: “The Sino-U.S. economic and trade frictions have also impacted the stock market, but frankly speaking, the psychological effect is bigger than the actual impact.”

“The underlying issues are profound,” said Meyer. He pointed to rating agency Standard & Poor’s discovery last week that China has “huge hidden debt” of between $5.5 trillion and $6 trillion. Another area of concern is the sharp jump in the so-called “collateralization” of shares by individuals to borrow money. The value of such shares pledged as collateral has quadrupled over two years to more than 6 trillion yuan ($898 billion), or a tenth of the total value of China’s stock market, according to a Reuters report.

China’s economic growth in the latest quarter by itself does not represent a “major slowdown,” but “it is part of a big, natural process that has started,” said Richard Dasher, director of the U.S. Asia Technology Management Center at Stanford University. “The structure of the Chinese economy has been shifting.” He noted that the slowdown is occurring against the backdrop of “increasing tension between China and the U.S. that is bigger even than the economy.”

Meyer and Dasher discussed the key takeaways from China’s latest growth figures on the Knowledge@Wharton radio show on SiriusXM.

Some bright spots exist in the data, too. China’s exports to the U.S. grew at an average monthly pace of 11.7% in the last quarter, but much of that could be because of “frontloading” by U.S. buyers in anticipation of the higher tariffs, and in preparing for the coming holiday season, according to a Wall Street Journal report. The U.S. is poised to raise import tariffs next year on some $200 billion worth of Chinese goods from the current 10% to 25%. That is on top of existing trade penalties of $250 billion worth of Chinese goods and $110 billion worth of U.S. products.

“Not only are we a little disappointed by the consequences of Chinese economic development for civil society but the directionality of their development seems to have reversed a bit.” –Marshall Meyer

Underlying Stresses

However, Meyer called attention to the underlying stresses in China, and explained why the problem of collateralized debt in China is more worrisome than may be immediately apparent. “The number and percentage of collateralized shares has gone up, but the value has plummeted as the Chinese stock market has gone down,” he said. “There will be a lot of margin calls this quarter (requiring investors to cough up more capital against borrowings), so we could expect all kinds of reverberations not necessarily due to the trade war.” The Shanghai Stock Exchange Composite Index has shed some 25% since the beginning of this year.

According to Dasher, the debt at the local government level is “not very good debt…. [Historically,] the Chinese government has had to write down debts like this a lot in the past.” China’s local governments have established so-called “local government financing vehicles” that fund projects with debt raised from the China Development Bank against mostly land as collateral, according to a Columbia Law School research paper. Added Meyer: “The question is how deeply involved are the local government financing vehicles in this type of borrowing, and with what risks.”

Dasher traced the borrowing binge in China to the November 2008 stimulus package of 4 trillion yuan ($570 billion at the then-prevailing exchange rate) that the Chinese government launched in the wake of the last financial crisis. “People in China did not really feel the crisis like we did here in the U.S. and in other Western countries,” he said. “That has given them kind of a sense of arrogance,” because they saw their economy and growth rate looking better than in the U.S.

The Chinese government has launched a policy drive to reduce debt and de-risk the economy. Although it may present some “transition risks” for some of China’s regions and some political challenges, the deleveraging and de-risking campaign “will ultimately lower financial system risks and lead to more sustainable economic growth,” a Moody’s analyst said. But that would not restore China’s growth levels of earlier years: Moody’s also said it expects real GDP growth in China to be “around 6-6.5% in the coming years.” Standard & Poor’s said the compression in corporate earnings could slow down the deleveraging process in China even as the central government is committed to lower debt at state-owned companies. “The most vulnerable borrowers, in particular private enterprises, will continue to face higher refinancing and default risk,” it said in a recent report.

China has also faced resistance over debt associated with its investments in infrastructure projects in other countries that are part of its One Belt, One Road (OBOR) project. Those investments in port infrastructure and related assets are financed by debt advanced by China to local country governments. Eight countries including Djibouti, Kyrgyzstan and the Maldives that are part of the OBOR project will find themselves vulnerable to above-average debt, according an analysis by the Center for Global Development, a nonprofit research organization.

In some cases, notably in Sri Lanka, the inability of the local government to repay the debt has resulted in China taking over the assets. “You’re seeing in Sri Lanka a lot of pushback against this debt, which when defaulted on results in a Chinese takeover — a lot of resentment,” said Meyer. “In that respect the infrastructure investment has not worked quite as planned.”

“People are much more concerned [than earlier] about the general ability of China and the U.S. to cooperate.” –Richard Dasher

Stock Market Declines

Meyer noted that the Chinese stock market has also been volatile, and pointed to how it “imploded” when the Shanghai Stock Exchange Composite Index crashed from levels of 5,800 to 1,750 between November 2007 and November 2008. “No causality implied here, but [the U.S. stock market crash] followed not very long after.” (The Dow Jones Industrial Average lost more than 50% in the 18 months leading up to March 2009.) “We’ve seen a long-term, very sharp decline in the Chinese stock market again,” he said, referring to current trends. “One wonders whether that reflects, on the one hand, a lack of confidence in the economy, and on the other hand the overextension of firms or their controlling shareholders and their inability to pay off their debts.”

The volatility in the Chinese stock markets may have been caused by expectations of continued government investments in the economy that turned out to be misplaced. “One of the big structural changes” is that the Chinese government has moved away from investment in fixed assets and infrastructure and into relatively softer innovation assets, said Dasher. “You’re seeing the government invest in becoming a world power in artificial intelligence. You’re seeing a lot of new ways in which the government is involved in things that have less tangible collateral.”

Rush to Move Money Overseas

Meyer pointed to another “fundamental change” that may be in the making in China – signals that reforms have come to an end. He said those fears have grown after China earlier this year removed the two-term limit for President Xi Jinping, enabling him to continue in office beyond 2023. That has prompted many wealthy Chinese individuals to move their assets overseas, he said. “This can’t have a positive impact on the Chinese economy.”

Meyer also pointed to the trend of the Chinese government taking over companies that are unable to repay their debts. “Not only are we a little disappointed by the consequences of Chinese economic development for civil society but the directionality of their development seems to have reversed a bit,” he said. “What can we do about that? Absolutely nothing. But it’s a surprise to all of us.”

Dasher said expectations that China’s economic growth would encourage it to become “more democratic and hold to the values that we have here in the U.S.” have not materialized. He pointed to China’s recent arrest of the head of Interpol as one example of strong-handed behavior. “I’m seeing more fear, and I’m seeing more concern and more negativity than I’ve seen over the years.”

Sino-U.S. Ties: Negative Sentiment

Meanwhile, perceptions that the Trump administration is putting obstacles on China’s growth path are not helping prospects for improved Sino-U.S. ties. “The U.S. is regarded as trying to prevent China’s natural growth,” said Dasher. “The attitude toward the U.S. is much more negative than it has been. People are much more concerned [than earlier] about the general ability of China and the U.S. to cooperate.”

Rising U.S. interest rates also impact China adversely, said Meyer. “When interest rates go up [in the U.S.], they either force Chinese interest rates up or force further devaluation of the RMB, which is very close to that tipping point of 7 to a dollar (6.95 RMB to $1 on October 22),” he said. “As a consequence, our interest rate increases make things a little tougher for China.”

“Historically China always fears encirclement, and therefore they see [U.S.] actions possibly as existential threats.”–Marshall Meyer

China feels cornered by the U.S. in many ways, Meyer said. “They see our actions as encirclement. Historically China always fears encirclement, and therefore they see [U.S.] actions possibly as existential threats.” He noted that China is already conducting joint military exercises with Russia, and that could imperil Sino-U.S. ties further. “If Russia and China are forced together out of mutuality of interest, we’re in a much weaker position globally.”

Combating Opioids

Meyer had an unlikely suggestion for thawing the ice between the U.S. and China. He noted that much of the opioids in the U.S. come from China, and that the Chinese central government has pledged to crack down on those exports. “The local governments [in China], however, [have not been] quite so active in helping us out,” he said. “That’s an arena where a real helping hand on the part of China could ease public opinion in the U.S. [regarding China] a little bit.” That could pave the way for the Trump administration to shift policies to favor China, but only “if President Trump finds that is a good deal.”

Dasher agreed that China’s help in combating the opioid addiction problem in the U.S. would be helpful. But he called cooperation on a wider front: “I would like to see the U.S. be able to work within multilateral frameworks,” he said. “This is an important time for us to go back to our core values and aim for a positive resolution in cooperation, not just with China bilaterally, but with lots of other countries.”

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