Why Beijing’s Troubles Could Get a Lot Worse

Few foreigners know China as intimately as Anne Stevenson-Yang does. She has spent the bulk of her professional life there since first arriving in 1985, working as a journalist, magazine publisher, and software executive, with stints in between heading up the U.S. Information Technology office and the China operations of the U.S.-China Business Council. She’s now research director of J Capital, an outfit that works for foreign investors in China doing fundamental research on local companies and tracking macroeconomic developments.

Among other things, J Capital conducts trips for hedge fund managers, U.S. corporate executives, and bankers all over the Middle Kingdom, relying on Stevenson-Yang’s roster of government officials, Communist Party leaders, financiers, small-business operators, and ordinary citizens to take the pulse of economic and political developments.



Here Is Xi’s China: Get Used To It

Arthur R. Kroeber from China Economic Quarterly
The prevailing mood among China-watchers in 2014 was one of anxiety and skepticism. The year began in the shadow of Chinese assertiveness in the East and South China Seas. Economic concerns quickly took over: by February the property market seemed...

An American, Stevenson-Yang, 56, is fluent in Mandarin, although her husband, a former People’s Liberation Army intelligence officer, and their two adult children sometimes mock her accent. For Stevenson-Yang, who toted Chairman Mao Zedong’s Little Red Book in high school, her years in China have given her a skeptical view of the nation’s miraculous growth. Her disenchantment arises from the stark inequality of wealth and opportunity, the thuggishness of the Communist elite, and the amount of chicanery and accounting fraud engaged in by Chinese companies and government organs. Read on to find out why she thinks that China has entered the early stages of slowing expansion, severe credit problems, and potential instability.

Barron’s: Investors seem far more concerned about Europe’s sinking into economic despond than slowing growth in China. Are they whistling past the graveyard?

Stevenson-Yang: I think so. China, for all its talk about economic reform, is in big trouble. The old model of relying on export growth and heavy investment to power the economy isn’t working anymore.

Sure, the nation has been hugely successful over recent decades in providing its people with literacy, a decent life, basic health care, shelter, and safe cities. But starting in 2008, China sought to counter global recession with huge amounts of ill-advised investment in redundant industrial capacity and vanity infrastructure projects—you know, airports with no commercial flights, highways to nowhere, and stadiums with no teams. The country is now submerged by the tsunami of bad debt that begets further unhealthy credit growth to service this debt. The recent lowering of benchmark deposit rates by the People’s Bank of China won’t accomplish much because it won’t offer more income to households. It also gave China’s biggest banks the discretion to raise their deposit rates back up to old levels, which would give them a competitive advantage

How bad can the situation be when the Chinese economy grew by 7.3% in the latest quarter?

People are crazy if they believe any government statistics, which, of course, are largely fabricated. In China, the Heisenberg uncertainty principle of physics holds sway, whereby the mere observation of economic numbers changes their behavior. For a time we started to look at numbers like electric-power production and freight traffic to get a line on actual economic growth because no one believed the gross domestic product (GDP) figures. It didn’t take long for Beijing to figure this out and start doctoring those numbers, too.

I put much stock in estimates by various economists, including some at the Conference Board, that actual Chinese GDP is probably a third lower than is officially reported. And as for the recent International Monetary Fund report calling China the world’s biggest economy on a purchasing-power-parity basis, how silly was that? China is a cheap place to live if one is willing to eat rice, cabbage, and pork, but it’s expensive as all get out once you factor in the cost of decent housing, a car, and health care.

I’d be shocked if China is currently growing at a rate above, say, 4%, and any growth at all is coming from financial services, which ultimately depend on sustained growth in the rest of the economy. Think about it: Property sales are in decline, steel production is falling, commercial long- and short-haul vehicle sales are continuing to implode, and much of the growth in GDP is coming from huge rises in inventories across the economy. We track the 400 Chinese consumer companies listed on the Shanghai and Shenzhen stock markets, and in the third quarter, their gross revenues fell 4 percent from a year ago. This is hardly a vibrant economy.

How bad do you see things getting?

I hate to wear sackcloth, since in late 2011 I became quite bearish and yet a sharp dose of government stimulus managed to steady the economy. By our calculations, since June the central government directly and indirectly has added more than $400 billion of stimulus and relaxed lending terms for housing purchases. Yet, every spasm of new stimulus seems less and less effective in boosting the economy.

So most likely, China is sinking into a deflationary recession that’s increasing in speed and may take some time to run its course. Investors have lost faith in the property market, which alone comprises about 20 percent of GDP, when taking into account the entire supply chain, from iron-ore production to construction to related financial services and appliance sales. Employment and wage compensation will suffer. Consumption will continue to suffer. There’s even an outside possibility that China’s economic miracle could end up in a fiery crash landing, if a surge in banking-system loan defaults outruns government regulators’ attempt to contain such a credit crisis and restore financial confidence.

What are some of the other signs of economic malaise?

A big one is increasing capital flight from China on the part of wealthy Chinese, and corporations using phony trade invoicing and other ploys to get around the country’s capital controls. This trend so far has been masked by the influx of hot money into China to take advantage of its higher money-market rates, strong foreign direct investment, and, of course, China’s positive trade balance.

But something curious is happening. In the third quarter, China’s vaunted foreign-currency reserve balance actually declined by $100 billion, to $3.89 trillion. Sales of luxury foreign brands are faltering. Clearly, a lot of wealthy Chinese are rushing to cut back on in-country assets and get money offshore. If one has the ability to own a house in Sydney over an apartment in suburban Shenzhen, the choice is obvious.

Rampant capital flight could turn into a rout given the ridiculous concentration of wealth in China, cutting the seemingly impregnable foreign reserves dramatically.

Any other worries?

The giant government economic-stimulus programs since 2008 are rapidly losing their effectiveness. The reason is simple. Much of the money has been squandered in money-losing industrial projects and vanity infrastructure spending that make no economic sense beyond supplying temporary bump-ups in GDP growth. China is riding an involuntary credit treadmill where much new money has to be hosed into the economy just to sustain ever-mounting bad-debt totals. Capital efficiency, or the amount of capital it takes to generate a unit of GDP growth, has soared as a result.

And what about the much-predicted popping of the Chinese real estate bubble?

It is already under way, though in seeming slow motion. Government price data, such as its 70-city report, aren’t all that helpful since the numbers are cherry-picked and manipulated. But we do know that sales volume has been dropping this year.

The Chinese home real estate market, mostly units in high-rise buildings, is truly bizarre. Many Chinese regard apartments as capital-gains machines rather than sources of shelter. In fact, there are 50 million units in China that are owned but vacant. The owners won’t rent them because used apartments suffer an immediate haircut in value.

It’s as if the government created a new asset class that no one lives in. This fact gives lie to the commonly held myth that the buildout of all these empty towers and ghost cities is a Chinese urbanization play. The only city folk who don’t own housing are the millions of migrant laborers continuously flocking to Chinese cities. Yet, they can’t afford the new housing.

What would be the impact of a significant drop in Chinese housing prices?

We’ve talked about housing’s immense weight in national GDP. Likewise, a huge proportion of financial assets in China both in the banking and shadow-banking system are exposed to the real-estate market. All of China’s major corporations are speculating on residential real estate with either cash reserves or borrowed money. Who wants to build, say, a shipbuilding plant when a company thinks it can make a lot more speculating in the housing market?

Families have more than half of their wealth in housing, including the less affluent in recent years who have taken to buying fractional shares in luxury apartments and town houses. Local governments, which rely on land sales to developers and real estate transfer taxes for something like 35 percent of their revenue, would be in a bad way in a housing-price bust. The psychology bolstering the housing market is changing despite all the efforts of the government to control prices. People are starting to realize that housing isn’t a one-way street to future wealth, and selling pressures are starting to build.

Conventional wisdom holds that China has plenty of levers it can pull to stave off severe economic contraction and any debt crisis. Do you agree?

Not really. Take, for example, the $3.9 trillion foreign-currency reserves that we discussed. Many people regard it as a giant piggy bank that can be tapped at will to rectify any financial problem. But the reserve is only good for defending the yuan and is a lot less liquid than many people realize. And as we pointed out, capital flight could dramatically diminish the size of the reserve.

Interestingly, liquidity seems to be a growing problem in China. Chinese corporations have taken on $1.5 trillion in foreign debt in the past year or so, where previously they had none. A lot of it is short term. If defaults start to cascade through the economy, it will be more difficult for China to hide its debt problems now that foreign investors are involved. It’s here that a credit crisis could start.

Bad debt in China never seems to get written down. The huge pile of nonperforming bank loans that Beijing assumed earlier in the millennium in order to be able to take its major banks public still sits on the balance sheets of various asset-management companies.

All that the government can do is hose down economic problems with more and more cash. Certainly, such investment has proved a powerful tool, but you shouldn’t mistake wanton money creation with omnipotence.

You don’t put much stock in the rhetoric of President Xi Jinping’s administration about economic reform, giving wider sway to free-market principles, and bolstering Chinese consumer spending.

I see such moves as unlikely to occur anytime soon. [Beijing] will be hampered in carrying out such policies by special-interest groups and the Xi patronage network’s desire to maximize their slice of what may well be a diminishing pie. China has to invest more and more at falling rates of return just to keep growth going. Thus, by necessity, consumption has to decline as a proportion of GDP.

Can you expand on your feelings on Xi Jinping and his first two years in power? He has captivated the foreign press with his seemingly unassuming manner, glamorous entertainer wife, and the wide diplomatic swath he cut at the Asia-Pacific Economic Cooperation summit in Beijing.

In my opinion, the press is somewhat guilty of willing suspension of disbelief on developments in China. Xi’s agenda of Confucian [moral] purification has nothing to do with opening up the economy or social reform. He wants to bolster the power of the Communist Party and tamp down the cynicism about the system that is increasing in China. This explains in large part his bellicosity in the South China Sea, quashing of dissent on the Internet and elsewhere, and heavy-handed attacks on non-Han populations like the Uighurs. He openly disdains Western democratic values.

Of the same piece is China’s attacks on foreign companies and brands on the grounds of claimed antimonopoly practices, discriminatory pricing, corruption, and inadequate product quality. Chinese state-owned companies and firms in which party members are invested, however, are largely exempt from such scrutiny. In a state economy like China’s, the playing field is increasingly tilted so ultimate gains go to Chinese companies.

As for Xi’s much-ballyhooed anti-corruption campaign inside China, it offends me that international media depict it as a good-governance effort. What’s really going on is an old-style Party purge reminiscent of the 1950s and 1960s with quota-driven arrests, summary trials, mysterious disappearances, and suicides, which has already entrapped, by our calculations, 100,000 Party operatives and others. The intent is not moral purification by the Xi administration but instead the elimination of political enemies and other claimants to the economy’s spoils.

OK, Anne, on that happy note, let’s conclude.