Fraser Howie Interview Part 1: China’s Obsolete Growth Model
In 2011, most people still thought China, as a nation, had less debt than Europe or the United States because of its relatively low government debt levels. Then came Fraser Howie’s seminal book “Red Capitalism,” one of the first books to expose the debt machine within the Chinese banking system and the risks of the debt-filled growth model.
After a six-year stay in China, Fraser now lives in Singapore and still has one or two things to tell us about China and its economy. This is Part 1 in a 3-part series.
Let’s Recap the Chinese Economic Story of 2014
In 2014 there was fear of defaults and people were talking about 2014 being a year of defaults. There would be growing defaults and the government would try and pick winners so therefore small private companies in the solar field would be allowed to default but obviously large state banks would not be allowed to default.
There was an expectation that some of the bad debt would come home to roost. And of course it did not. Fundamentally the analysis has not changed. But I think that any economic system and any economic system as big as China is far more complex and hard to model than you would guess. There is an ability to be flexible, to postpone things, to roll things over in a way that people often underestimate.
What Are China’s Main Problems?
The problems of China are chronic problems, they are not acute problems. This isn’t a Greece or a Dubai where they need to refinance in a currency they cannot print. The problems China has are long-term structural issues of a model that has fundamentally run its course.
It’s not to say that things will stop or that they will collapse. And when I say collapse I am talking about a government default, a bank default, a 30 percent devaluation of their currency. These types of things you see in other collapsing economies, I don’t see that happening.
The Chinese government still has a lot of control over capital flows. It clearly has all the levers of power when it comes to the domestic financial sector. It also has tremendous control over information.
But There Is a Price to Pay
What they cannot do, they fundamentally cannot make bad projects good projects. If you built an apartment block in the middle of the desert and no one wanted to live there, you are going to lose money on your project. Even if you move people there you are going to attract them by either subsidies or cheap rents so therefore your financial return is going to be lower.
So all of a sudden, instead of your company making a 10 percent return, it is making a 1 percent return. That cannot be avoided and this is where we are at in China.
So we are seeing demand across the board weaker. Electricity growth: very low single digits. You see consumption growth notionally relatively high at 10 or 11 percent. But then you look at the actual measures, it’s not what people are buying in shops. It’s what is being sold to shops from factories.
So what you are seeing is inventories building up across a lot of sectors. So you see gross overcapacity in a whole list of sectors and a whole list of commodities and you think: This looks like a horrible picture.
What Can the Regime Do?
The regime is petrified to accept the situation they are in, largely of their own making. This is not some nasty foreigner who has done this. This is ultimately the results of a planned economy and the limitations or trying to plan too many things, so you are going to have misallocation of resources.
And when you have incentive structures based purely on growing GDP at any cost, it’s hardly surprising you see GDP going up and also your debt levels going up.
China is in a very difficult position to deal with this model which has run its course. How do they accept lower growth? You look around the micro in China, whether it is inventories or corporate performance or electricity consumption or corporate profits, and everything is under pressure. And yes somehow many analysts continue along with this macro fiction that the economy is OK: It’s still growing at 6.8 percent [IMF estimate for 2015], which would be the envy of Western countries.
What About the Growth?
I don’t think the Chinese are just artificially making up a number. No one is just saying “Oh, what will it be today?” They are clearly measuring or inferring something. But the connection between what the GDP growth is and what conditions are like for businesses on the ground are very divergent and that is the problem.
If you are in the United States and your growth is 5 percent, there are clearly a lot of things at the micro level—jobs are being created, companies are making money, there is expansion.
In China, you allegedly have 7 percent and yet none of those things are happening in any meaningful way in China so there is a great disconnect. This is a problem that will remain with us for years to come this is not going away.
What About Demographics?
It’s also not going to be helped by the fact the demographic dividend in China has changed as well. Instead of bringing more and more workers into the workforce, now you have fewer and fewer workers in the workforce. You have this problem of an aging society. You have tremendous inequality; you have tremendous issues of pollution.
One of the things that saves the regime—and it’s a bit of luck, something they can exploit—the Chinese people foolishly are prepared to accept an awful lot of rubbish from their government.
This is what they called “eating bitterness in China.” They see that as a great virtue, to go through great hardship and suffering. Chinese can be very stoic in that sense and accept a lot of trouble. That’s why you get a lot of trouble. If you refuse to stand up and push back against some of this nonsense, it’s hardly surprising that the regime continues to force this on you.
Will the People Revolt?
This does not require a revolution from the bottom, but it certainly leads to a lot of discontent and the discontent is partly addressed by rising wages. Whenever possible the regime is trying to drive up wages or limit prices, which means it’s difficult for businesses to make profits.
The theme of China of being the cheap export capital of the world is also falling apart. Nothing uniquely Chinese in any of that. These are problems that any country would face. But what China has failed to do in its years of boom and growth is put in place structures which can mitigate some of the worst excesses of that.
So you have this iron first, which is clamping down on any level of plurality. If there was a bit more freedom in the civic space then they would be in a far better position to respond to some of the stress. And be able to cope with the slowing growth.
Since the early ’90s, the Chinese Communist Party’s legitimacy comes purely by GDP growth and improving the lives of its citizens. That can be a dubious measure if your food, water, and soil is contaminated, the air can’t be breathed.
Then you have other nonsensical economic scenarios where in Beijing the capital of the world’s next superpower [sic] you are encouraged to buy a car but you can only drive on half the days of the week. What kind of economic miracle have we created here? This is some sort of dystopian nightmare, rather than a shining example of economic success.
Read about China’s political problems in Part 2.
Fraser Howie is the author of three books on the Chinese financial system, including “Red Capitalism,” named a Book of the Year 2011 by The Economist magazine. For 20 years, he has been trading, analyzing, and writing about Asian markets. During that time he has worked in Hong Kong, Beijing, and Singapore for companies like Bankers Trust, Morgan Stanley, CICC, and CLSA.
The interview has been edited for brevity and clarity.