China has tool-box to help
head-off high-speed crash
By Peter Lee
China's Ministry of Railways recently announced its high-speed trains will run
slower in order to cope with problems of high operating costs and low passenger
figures. This was promptly seized upon as a matter of important symbolism ...
for the United States.
Charles Lane, an irregular contributor to the Washington Post's famously
right-wing op-ed page, echoed the view of many conservative pundits when he
wrote that the Chinese move
vindicated Republican opposition to President Barack Obama's plans for
high-speed rail in the United States.
Meanwhile, in the United States, Obama's high-speed rail
plan, originally set at $53 billion over six years, has gotten a thorough
democratic vetting. Three freshly elected Republican governors spurned federal
dollars for high-speed rail, fearing a long-term burden on their budgets;
homeowners in liberal Northern California are fighting construction through
their neighborhoods; and the president agreed with Congress to trim
current-year spending as part of a budget deal.
On the whole, I'd say China should envy us. 
In Lane's view,
partisan gridlock will allow the United States to avoid the perils of socialist
big-government planning and enjoy the enviable economic trifecta of decaying
infrastructure, sluggish growth, and high employment.
By way of instructive contrast, the financial year 2011 cost of US military
operations in Iraq and Afghanistan is expected to exceed US$171 billion (for a
cumulative total of over $1.2 trillion to date). Fortunately this exercise in
financially irresponsible big-government paternalism is discretely piling up
corpses and blasting holes overseas, instead of affronting the eyes of
value-conscious American taxpayers with the infuriating spectacle of shiny new
high speed trains in their backyards. 
Nouriel Roubini observed the same Chinese trains and was able to extract some
useful lessons for the Chinese economy.
China has grown for the last
few decades on the back of export-led industrialization and a weak currency,
which have resulted in high corporate and household savings rates and reliance
on net exports and fixed investment (infrastructure, real estate, and
industrial capacity for import-competing and export sectors). When net exports
collapsed in 2008-2009 from 11% of GDP [gross domestic product] to 5%, China's
leader reacted by further increasing the fixed-investment share of GDP from 42%
Thus, China did not suffer a severe recession - as occurred in Japan, Germany,
and elsewhere in emerging Asia in 2009 - only because fixed investment
exploded. And the fixed-investment share of GDP has increased further in
2010-2011, to almost 50%.
The problem, of course, is that no country can be productive enough to reinvest
50% of GDP in new capital stock without eventually facing immense overcapacity
and a staggering non-performing loan problem. China is rife with overinvestment
in physical capital, infrastructure, and property. To a visitor, this is
evident in sleek but empty airports and bullet trains (which will reduce the
need for the 45 planned airports), highways to nowhere, thousands of colossal
new central and provincial government buildings, ghost towns, and brand-new
aluminum smelters kept closed to prevent global prices from plunging further.
In the short run, the investment boom will fuel inflation, owing to the highly
resource-intensive character of growth. But overcapacity will lead inevitably
to serious deflationary pressures, starting with the manufacturing and
Eventually, most likely after 2013, China will suffer a hard landing. All
historical episodes of excessive investment - including East Asia in the 1990s
- have ended with a financial crisis and/or a long period of slow growth. 
The views of Dr Roubini, a professor at New York University and lord of an
extensive econometrics and punditry empire, carry significant weight in China
because of his reputation as "Dr Doom" - the economist who, as early as 2005-6
and virtually alone among his peers, predicted the catastrophic popping of the
US real estate bubble and the subsequent unraveling of the world financial
Dr Doom's diagnosis of the problem is widely accepted. China engaged in an orgy
of infrastructure building to stimulate industrial - as opposed to consumer -
demand in order to dodge the 2008 recessionary bullet.
China's extravagances, most notably in the area of high-speed rail, do need
some paring back.
As for the prognosis - that China will finally, in 2013, experience the hard
landing that economists have continually predicted since the economy of the
People's Republic kicked into high gear - views are considerably more mixed.
Morgan Stanley's analysts weighed in with an optimistic prediction that the
Chinese consumer will, at long last, step up and drive the restructuring of the
Chinese economy away from export-oriented industries and immense infrastructure
projects that generate much more prestige than cash flow:
controversially perhaps, the analysts predict what they call "a golden age of
consumption". China's consumption as percentage of GDP is currently among the
lowest in the world, which many analysts attribute to cautious Chinese families
saving money for their retirements or to pay for healthcare bills. But Mr Wang
says Chinese consumers aren't waiting for the government to build a new social
safety net before they spend more. They're waiting to make more money, which
they'll do as labor demand boosts wages over the coming decade. Consumer
spending zoomed in [South] Korea and Japan after those countries reached the
$7,000 mark. 
Shaun Rein of the China Marketing Group put
some factual - or at least statistical - meat on the rhetorical bones in an an
op-ed for CNBC:
My firm interviewed 5,000 Chinese in 15 cities last
year. It is true consumers over the age of 60 reported savings rates near 60%
because they feared soaring medical and housing costs. After living through
decades of upheaval and missing out on the recent economic boom, they remain
thrifty. Little can be done to change decades of ingrained habits.
Our research suggests the key metric Roubini misses is shifts in how younger
Chinese spend. Respondents under 32 years old had effective savings rates of
zero. They remain confident about their money-making potential. Secretaries
earning $600 a month commonly save two month's salary to buy the latest Apple
iPhone or Estee Lauder cosmetics.
Consumer finance reforms are also spurring more consumption for younger
Chinese. Total credit cards in circulation rose from 13.5 million in 2005 to
240 million in 2010 and will rise 22% annually for five years. More than 80% of
the 18 million auto sales there last year were paid 100% up front. Brands like
Toyota and General Motors are starting to push financing options, which will
further unlock consumption. The data dispels the myth that Chinese are
culturally high savers. 
Xinhua took note of Roubini's
arguments and the rebuttals in a Chinese-language article.
The basic theme was polite skepticism, pointing out that China's growing
economy had in the past defied predictions of overbuilding by catching up to
the infrastructure and productive capacity poured into the economy.
But as for the future...
However, Roubini is perhaps quite correct in
one respect. He believes that China's infatuation with excessive investment
will lead to enormous waste and a significant decrease in the growth rate in
the future. This view of his is very persuasive. 
article picked up on the "future" theme, pointing out that the 2008
infrastructure investment bulge was a temporary measure to counteract the
global economic slump.
An academic at Beijing Normal University, Li Shi, was interviewed by Caixin. He
also pinned his hopes on the Chinese consumer. According to Li:
past, increases in individual incomes have lagged behind GDP growth. However,
the 12th Five Year Plan intends to change this. It should be said it can be
changed, because in the coming years there will be a major change in China's
entire economic structure. If the economic structure can change, urbanization
will accelerate, excess labor capacity in the villages will be mopped. It is
possible that within three to five years, if the labor market experiences
conditions of demand exceeding supply, worker's wage growth will accelerate.
This would change the problem of excessively low personal incomes.
Also, China has been continually upgrading the social safety net ... which
will, to a certain extent, contribute to an increase in individual
Maintaining 7% growth and maintaining relatively full employment while at the
same time the government structurally adjusts its outlays and use a greater
proportion to meet the demands for improved people's well-being, all can
increase personal consumption.
Lot of conditionals, ifs, cans,
coulds, and shoulds in Mr Li's observations. 
Roubini identifies some deeply embedded structural issues for the Chinese
economy that he defines as critical and fears will take "two decades" to
reform, rendering moot hopes of a soft landing in the next couple years:
ease the constraints on household income, China needs more rapid exchange-rate
appreciation, liberalization of interest rates, and a much sharper increase in
wage growth. More importantly, China needs either to privatize its SOEs
[state-owned enterprises], so that their profits become income for households,
or to tax their profits at a far higher rate and transfer the fiscal gains to
households. Instead, on top of household savings, the savings - or retained
earnings - of the corporate sector, mostly SOEs, tie up another 25% of GDP.
But boosting the share of income that goes to the household sector could be
hugely disruptive, as it could bankrupt a large number of SOEs, export-oriented
firms, and provincial governments, all of which are politically powerful. As a
result, China will invest even more under the current Five-Year Plan.
Continuing down the investment-led growth path will exacerbate the visible glut
of capacity in manufacturing, real estate, and infrastructure, and thus will
intensify the coming economic slowdown once further fixed-investment growth
becomes impossible. Until the change of political leadership in 2012-2013,
China's policymakers may be able to maintain high growth rates, but at a very
high foreseeable cost.
Dr Roubini has a point. The 12th
Five-Year Plan is not a glorious political and economic document. Its apparent
priority is to kick the can down the road rather than risk the big reforms that
might upset the applecart prior to the leadership handover.
Instead of moving openly and aggressively on the issue of the real estate
bubble - thereby gutting the finances of the SOEs and local governments that
rely on the real estate boom for significant revenues - the Five-Year Plan puts
a political band-aid on the problem by mandating the construction of low-income
housing for citizens priced out of the private sector residential market.
The perpetual lure of the bubble, combined with access to virtually cost-free
money courtesy of China's inflation-beleaguered individual depositors,
continues to drive runaway bank lending, despite government efforts to cool
things down by raising interest rates, boosting reserve requirements, limiting
the leverage available to buyers of first and second homes - and trying to
reduce local government dependence on revenues from real estate boondoggles by
introducing a property tax.
As Reuters reported:
"Net interest margins for the quarter were higher,
and that's the most important factor for Chinese banks," said James Antos, a
banking analyst with Mizuho Securities. 
interest margins" translated into expected average profit margin gains of 29%
for the banking sector in just one quarter over last year.
The undervalued yuan is still one of the best bargains on the planet,
especially since the burgeoning Chinese economy offers plenty of places to
invest it. China's exchange rate policy continues to suck in dollars - hot
money and investment dollars as well as export earnings - that contribute to
the real estate and stock market bubbles.
China's forex reserves are ballooning to ridiculous levels - ridiculous as in
$3 trillion. The immense reserves - and the exchange rate policy that enabled
them - are no longer a source of reflexive national pride. They are a source of
anxiety, as Zhou Xiaochuan, the head of the People's Bank of China, conceded:
reserves have exceeded the reasonable levels that we actually need," Zhou said.
"The rapid increase in reserves may have led to excessive liquidity and has
exerted significant sterilization pressure. If the government doesn't strike
the right balance with its policies, the build-up could cause big risks," he
said, without elaborating. 
In the current environment, an
ever-growing mountain of foreign exchange represents a double headache. Forex
inflows have to be purchased using yuan, and then yuan bonds issued to sop up
the excessive liquidity - the sterilization pressure Zhou is talking about, and
a most unwelcome contributor to China's worrisome inflation rate. Meanwhile,
the forex has to generate some kind of return, but there's no good place to put
$3 trillion - thanks in part to the inrush of Chinese dollars, the rate on
short term US Treasury paper is near zero.
Raising interest rates in a global environment of rock-bottom interest rates is
not a recipe for success, as Brazil is learning. Rapid appreciation of the yuan
is emerging as a possible measure to curb inflation and cool the economy.
Even so, allowing rapid yuan appreciation in order to put China's financial and
forex policy on an even keel is an unnerving leap into an unknown of
diminishing exports and growing unemployment that the Chinese government is
still hesitant to make.
In sum, China's response to its overheating and structurally unbalanced economy
is not a profile in courage. Maybe it's a disaster waiting to happen. Over at
the quant-hive Seeking Alpha, Craig Pirrong pontificated:
Chinese economic management can avoid the kind of catastrophe that Roubini and
I consider to be likely depends on your view of the efficacy of centralized
economic management of the type that China practices. The Thomas Friedmans of
the world, and arguably Obama, believe that such dirigisme is superior to the
messy, decentralized, unplanned and non-centrally coordinated actions of greedy
individuals in markets. People like me, conversely, believe that the visible
hands of greedy, largely ignorant, and short-sighted politicians and
bureaucrats is likely to lead to inferior outcomes.
smug celebration of free-market omniscience is a little harder to digest when
one remembers that, in 2006-2008, the invisible hand was not efficiently
allocating capital. Instead it was engaged in busy, sticky self-gratification
as hedge funds and investment banks pumped subprime debt into the financial
markets to give them an excuse to sell more derivatives and borrow more money
until leverage was over 35:1... so they could buy and sell more derivatives.
The credit default swap (CDS) market grew to $60 trillion - or $38 trillion,
depending on how you keep score (for comparison purposes, total US GDP is $14
A delicious vagueness was part of the whole CDS magic. The swaps were almost
entirely synthetic, written and purchased by financial institutions that had no
exposure to the underlying security or commodity. The market was unregulated,
open only to the so-called "experienced", ie deep-pocketed investors, and
characterized by fearsome information asymmetries.
Despite declarations of its defenders that the existence of this global casino
promoted efficiency and liquidity, the global market's fundamental lack of
transparency came back to bite it. As the real estate market finally soured, a
spasm of panic and mistrust in 2008 caused the entire financial system to seize
up; the market lost the ability to price the complex and opaque swaps, capital
flowed out of the financial companies, and credit was unobtainable. Titanic
leveraging converted into titanic deleveraging and the financial markets were
The financial companies thereupon slunk back to the public trough like whipped
hounds to convert to bank holding companies to avail themselves of
government-insured deposits, or to obtain government assumption of toxic waste
debt in order to enable mergers between stronger firms and their crippled
The public - the "little guys" who were disqualified from participating in the
derivatives financial orgy in the first place - were not allowed to simply play
the role of fascinated and eventually horrified bystanders. When the mess
unraveled, they paid the toll in lost retirement savings, lost homes, lost
jobs, and the cutbacks in public services that came with collapse of tax
revenues in the recession.
The only force to survive intact was the industry's invincible self-regard,
made possible only by its convenient and conveniently short memory, the tender
mercy of bespoke politicians and regulators worldwide, and the co-dependent
driveling of the fanboy financial press.
In contrast to the United States, China's financial system is biased toward
regulation, government management, keeping a lid on international capital
flows, and ignoring calls for financial innovation that serve primarily to
enlarge and fatten the profits of the financial sector.
China's wishlist for reform of the international financial system is
incorporated in the April 14 declaration at Sanya, Hainan, after a summit of
the leaders of Brazil, Russia, China, India and South Africa - the BRICS group
The declaration makes it clear that the PRC believes that the current default
attitude - ignoring the role of the sizable Chinese government stimulus in
averting a global recession and finger-wagging China for its exchange-rate
peccadilloes while disregarding the Western world's colossal financial fail -
should be abandoned.
Instead, the PRC is yearning for an endorsement of China's
government-knows-best financial policy on a global scale: a coordinated
international effort to make the international flow of capital and trade in
derivatives more transparent and susceptible to multilateral intervention.
The conclusion that the United States, by reason of its serial regulatory and
fiscal transgressions, is no longer fit to lead the international financial
system (or impose fealty to its free-market nostrums) is also made clear by the
call for a new reserve currency protected from the machinations of the US
16. Recognizing that the international financial
crisis has exposed the inadequacies and deficiencies of the existing
international monetary and financial system, we support the reform and
improvement of the international monetary system, with a broad-based
international reserve currency system providing stability and certainty. We
welcome the current discussion about the role of the SDR [the special drawing
rights of the International Monetary Fund] in the existing international
monetary system including the composition of SDR's basket of currencies. We
call for more attention to the risks of massive cross-border capital flows now
faced by the emerging economies. We call for further international financial
regulatory oversight and reform, strengthening policy coordination and
financial regulation and supervision cooperation, and promoting the sound
development of global financial markets and banking systems.
17. Excessive volatility in commodity prices, particularly those for food and
energy, poses new risks for the ongoing recovery of the world economy. We
support the international community in strengthening cooperation to ensure
stability and strong development of physical market by reducing distortion and
further regulate financial market. The international community should work
together to increase production capacity, strengthen producer-consumer dialogue
to balance supply and demand, and increase support to the developing countries
in terms of funding and technologies. The regulation of the derivatives market
for commodities should be accordingly strengthened to prevent activities
capable of destabilizing markets. We also should address the problem of
shortage of reliable and timely information on demand and supply at
international, regional and national levels. The BRICS will carry out closer
cooperation on food security. 
Good luck with that.
The counterintuitive lesson that the US and Europe seem to have derived from
the financial meltdown is that debt, stimulus, reform, and regulation are only
going to make matters worse. With an unwillingness to regulate capital and
derivative markets domestically, the will to regulate them internationally is
The most interesting social experiment in the world today is communist China's
attempt to manage economic stresses through classic national Keynsianism, while
the United States gyrates in an apparent death spiral of deregulation,
austerity, and defunding of its national and local government services.
To be sure, China has to date displayed a distinct aversion to the hard choices
that would reform its economy and put it on a firm footing for sustainable
growth - such as pricking the real estate bubble and undertaking a major and
risky appreciation of the yuan.
The difference is that Chinese Keynesianism retains the fiscal, regulatory, and
political means for intervention, adjustment, redirection, and if desirable,
deregulation and privatization.
In the United States, once the revenue and regulatory apparatus is gutted as a
result of political calculation and national disillusionment, will there be any