Moving China Up To The Next Level

By ANDY XIE

When China's GDP surpassed Japan's in the second quarter of 2010, the international media gave this milestone considerable coverage. But with natural disasters, environmental problems and the property bubble to cover, the domestic media hasn't given it as much attention.

Perhaps it is because China has over ten times as many people as Japan which puts China's per capita income at less than one tenth of Japan's - hardly something to celebrate. Nevertheless, it is useful to look back at how far China has come, study the risks it faces in the future, and, if the country can overcome the existing challenges, explore how much further it can go in the next decade.

China's economy took off in 2002 and since then nominal GDP has grown at 18.5%, and exports in dollars at 21.7% (I have extrapolated the economic performance for the remaining months of 2010). The nominal GDP has increased 2.9 times, and exports 3.8 times in USD and 2.9 times in RMB. Japan had a similar performance in the 1960's, Korea and Taiwan in the 1980's, but they are much smaller. In terms of scale, what China has done is unprecedented.
When growth is sustained over many years, with the miracle of compounding there is a huge long-term impact. Twenty years ago China and India had about the same value in GDP, yet this year China's GDP is roughly four times that of India.

Reform and opening up, China's policy center over the past three decades, has undoubtedly been the most important factor. China is now the largest exporter in the world. Having virtually no exports three decades ago and almost none even two decades ago, the country's exports have risen 5.2 times over the last decade. 'Being the workshop of the world' is the most important part of China's economy today. Without China's export success China's economy wouldn't be nearly where it is today.

Joining the WTO made a critical difference to the country's export success, giving multinational companies (MNCs) the confidence to base significant production in China. As China's domestic market grows, it gives MNCs another strong reason to keep production in China. No other country can offer economies of scale that combine selling locally and exporting abroad with low production costs.

However China no longer offers the lowest production cost. The labor cost in Bangladesh is merely one-fourth of China's. Indonesia's labor cost was twice as high as China's before 1997 and is now comparable to China's and rising at a much slower rate. Industries that do not require the supply chain to be nearby may exit China - for example the shoe and garment industries - but most others will stay since relocation is not an easy solution. Many manufacturers will simply pass their higher costs on to consumers and MNCs may just have to accept lower profit margins.

Infrastructure development has been a competitive advantage for China, and is the result of the government's ability to mobilize resources. Land and credit are usually constraints on infrastructure development in most other countries, but state ownership of land and banks has allowed China to develop large infrastructure projects while also benefiting from economies of scale.

The national expressway system is a good example of this. Only an interconnected system of such a large size can deliver economic benefits due to the so-called 'network effect'. In a dozen years China has completed over 60,000 km of expressways and another 30,000 km are under construction. The expressway system has made the national population more mobile, integrated villages and small cities into the national economy, and sharply decreased logistics costs.

The development of ports and industrial parks has encouraged OEM industries (original equipment manufacturers) to locate in China. Together with the highway system, this made it possible for China to become the largest export country in the world.

China was also early to embrace the Internet - and this laid the foundation for China to be part of and benefit from the global economy. In addition, China's large and productive labor force has contributed more than any other factor to China's growth. Until five years ago the nominal wage had been stagnant in nominal dollar terms for over a decade, even though labor productivity had been increasing at nearly 10% per annum and total factor productivity at over 4%. The increase in productivity of Chinese labor meant declining prices for western consumers, rising profits for MNCs, and rising tax revenues for the Chinese government. This saw more MNCs coming to China for production, and Chinese local governments in China continue to invest in infrastructure to attract them.

China's rapid growth has also coincided with a weak dollar. The dollar index peaked in 2002 and has declined by one third since. The dollar's weakness is due to globalization and technology, a result of driving liquidity into emerging economies, particularly China's. Though the tendency is to blame a crisis on slow growth, actually crises always seem to follow periods of high growth in emerging economies. It is the problems that are allowed to accumulate during the high growth period that cause both the crisis and subsequent slow growth. Nothing hides problems like high growth so policymakers tend to try and sustain it for as long as possible in the hopes they can outgrow the problems. But history teaches us that this is usually not possible. The longer the growth lasts, the more intractable the problems become.

China's money supply has quadrupled in the last eight years, growing at 19% per annum, and if the off-balance sheet expansion of the financial institutions and underground financial activities are included, the money supply may have grown at 11% per annum. During the same period the nominal GDP has grown at 18.5% so if one compares the official GDP data and monetary data, it does not seem cause for concern, as the two are about the same. But there are two potential problems to consider: nominal GDP has been inflated by the property bubble, thus the rapid monetary growth is also probably a bubble; and real monetary growth is much higher.

China's electricity consumption grew at about 13% per annum between 2002-10. Historically China's real GDP has grown faster than electricity consumption - the ratio of electricity consumption increase to GDP increase is called elasticity and it was around 0.8 during the 1990s. Heavy industry has been leading the current growth boom, thus the economy has become more dependent on electricity for growth, so the elasticity should have increased and I suspect it wouldn't be more than one. Hence, it is reasonable to guess that China's real GDP has grown at 13% over the past eight years, which would put the GDP deflator - the broadest inflation gauge - at 4.5%

So far, inflation has mostly occurred in land and commodities. Land prices have increased on average by more than ten times since 2003, 30 times in some hot coastal cities, and more than 100 times in the most speculative areas. It is reasonable to believe that China's land price is highest among all the major economies today, even though China's average wage is one tenth that of developed countries.

Land price inflation has shown up in the nominal GDP through rising property sales of over 14% of GDP last year. Much of the investment has been due to the collateral value of land, with local governments borrowing enormous amounts of money (probably around 17% of the total bank lending) to fund or subsidize investment to create GDP. The loans are secured with land, so without high land prices such financing would be impossible. With fixed investment being driven by the government and close to half of GDP, it is easy to see how the land bubble has accounted for a large portion of the growth during the current cycle.

Recent manufacturing investment, for example, is due partly to high land prices. Local governments have been competing fiercely for manufacturing investment and many companies have learned how to extract enough benefits from local governments that they do not need to put up any equity capital for investment. They often ask for free land and use that as collateral for a bank loan. They then lease equipment from the manufacturers who have used the leasing contracts to obtain bank loans. This explains why so many companies have been able to continue expanding with a negative cash flow: expansion is critical to their survival as new investment brings in the cash they need to sustain themselves.

Profit drives investment, which in turn powers employment, and that then grows consumption. When profit is due to asset appreciation and not sustainable, it may lead to crisis. Large bubbles often occur during prolonged prosperity, when people stop paying attention to risk and there is excessive demand for risky assets, leading to an asset bubble that prolongs prosperity beyond the normal cycle.

Possibly half of China's bank lending is going into property-related businesses or local governments that are pledging land as collateral. While the current boom has catapulted China ahead of Japan to become the world's second-largest economy, we must remember the excesses in this cycle and the need for an adjustment as soon as possible. Nothing reveals the vulnerabilities more than the banking system's exposure to unsustainable economic activities that are dependent on land appreciation. China should proactively bring about the needed economic adjustment.