December 07, 2011

Two Explanations of China's Economic Growth

1. Forbes - How China's Economy Keeps Growing

Frank Newman is probably the only American to ever run a Chinese bank and a large American bank in his career. Newman ran the Shenzhen Development Bank for five years, ending in 2010. Prior to that, he worked as a CFO at Bank of America and was a former CEO at Bankers Trust. I spoke with him recently about Chinese banking, the real estate bubble and his new book “Six Myths That Hold Back America: What America Can Learn From The Chinese Economy.”

The banks in China are in far better shape than the people outside the country realize. Non-performing loans at Shenzhen Development Bank when I got there were around 20% of our loan portfolio and when I left they were just 0.5%. We didn’t take on a lot of commercial real estate risk, and I am sure that a lot of banks will see their non-performing loans (NPL) rise because of that risk. No one knows for sure the NPLs in China, but from my point of view, whenever problems arise in China, the government has been able to move quickly. That’s not a comment on the country’s politics. It’s just how the economy works. A lot of people don’t realize that fully.




NPLs (non performing loans) are coming down as a whole and are low by international standards. Working capital is solid. Regulations are very tough. I’m not making this up from an analysts desk in New York. I dealt with regulators for five years. They have pushed the banks to prepare for non-performing loans because of the possibility of mid-sized and small real estate developers going bankrupt. They’ve required banks to increase their provisions for bad loans. If your bank’s model for non-performers suggests you could lose a billion, you need to have two billion reserved in a special account to cover it.

Yes, some small and midsized developers could fail. You can’t save them all. China is slowly reforming its economy and when it comes to the private sector, business plans can go wrong. It happens.

I think most of the projects were not a waste of money. Shenzhen improved their subway system, now millions more people are using it. They’ve done this in other cities, too, and now have a better subway system than we have in the U.S. Let’s assume the government spends $1 trillion on infrastructure and 30% of it was wasted. What happened? You still saved yourself from a recession, you kept people employed during an economic slowdown and you made $700 billion in infrastructure improvements — a more efficient electric grid, improvements at ports to allow for greater U.S. shipments abroad when the global economy picks up. There are things the Chinese can learn from the U.S. about Democracy, but there is a lot we should learn from the Chinese instead of attacking them and blaming them all the time.

For all the press that’s given these vacant apartment buildings littering Chinese cities, I have to say that there is not many of them. Those properties were mostly bought as investments or for future retirement. Big developers bought the land to those buildings years ago, when land values were cheap so they are dealing with sizable profit margins and can revalue the properties lower if they had to without a loss.

Ten years ago, China’s biggest banks were all in trouble so the government created this asset management company that acquired all of these toxic assets, similar to what the U.S. would do years later. The balance sheets on the big four banks improved, and the debt was cleared. The government owned asset management company still holds the bad debt and slowly it is paying interest and principal, but it just keeps rolling that debt over. A loan that was due in 2012 gets pushed back to 2015 and so on. It could go on forever.

2. CFA Institute - What Explains China’s Economic Growth, And Is It Sustainable? by Professor Zhiwu Chen at Yale. Professor chen is an expert on finance theory, securities valuation, emerging markets, and China's economy and capital markets.
A popular explanation behind the recent growth in China’s per capita GDP is its “vast and cheap labor.” However, Chen suggested that he does not find this explanation adequate. He argued that in 1830 China had about 40% of world population whereas in 1913 it had a third; if a vast and cheap labor force were the reason behind growth in China’s per capita GDP, it should have grown in the past, whereas it remained stagnant.

According to Chen, the growth in China’s per capita GDP in the last 30 years is better explained by changes in the world that have enabled China to benefit from its labor resources — most notably lower transaction costs due to technological developments and, no less importantly, a different global order of trade.

Elaborating on this point, Chen said that the center of global textile manufacturing has moved from England to the United States to Japan to China within two centuries, reflecting how technological developments have enabled a sector in one country to quickly catch up with that of another.

Unlike many other economies, in China, it is the government that allocates resources and directly or indirectly commands a large proportion of national assets and income. Additionally, the Chinese government is not subject to the same democratic pressures in making unpopular decisions, such as raising taxes. This, according to Chen, has enabled China to industrialize and move at a much faster pace than other countries.

Having shared his explanation of China’s high per capita GDP growth rate, Chen turned his attention to its sustainability. He observed that the large size of government’s share in the economy means that growth in China has been driven mainly by investment by the government rather than consumption by the private sector. Since much of the benefits of growth in GDP go back to the state because of its large size, Chen thinks that the growth in GDP has much less impact on the growth in private consumption than in economies in which the private sector plays a more significant role.

Chen also disagrees with those who see an imminent banking crisis in China. He thinks that even if real estate prices fell sharply and banks ended up with large nonperforming loans, the government in China has enough resources to rescue the banking sector. This is why Chen sees “no banking or financial crisis in China until there is a fiscal crisis.”

While Chen does not see a crisis in the short term, he also considers it “unavoidable” in about five years. He thinks that such a crisis would perhaps be “healthy” as it could be an opportunity for restructuring China’s economy, with privatization and democratization being Chen’s preferred reforms.

Summarizing some of his views in numbers, Chen said that he expects China’s GDP to grow at 8.5% until 2016, decline by 12% in 2017, and then continue to grow at 5.5%, becoming equal to the US GDP in 2050.

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