4 reasons why China's capital waste is about to hit the fan.
“Soon after awarding the contract in December, the city subway operator indefinitely delayed the equipment purchase and shelved plans to expand the underground's rolling stock by seven trains in 2012.
"’The subway project has been completely postponed,’ the executive told Caixin, clutching the contract that won't be fulfilled. ‘For now, we have no new orders, and old orders are being deferred. This has affected us greatly.’
“It was not an isolated letdown. A golden but brief era for urban railway suppliers, builders and related companies across China appears to have ended in recent months.
“Local governments nationwide have slashed infrastructure spending since last summer, and the urban rail business has slowed to a crawl after several years of rapid growth. Spending for subways was cut as central government economic planners put the brakes on rail projects and indirectly reduced local government spending power by maintaining real estate market controls designed to prevent housing price inflation.
“The property market controls, which began in 2010, diminished demand for the valuable land that local governments typically sell to raise fiscal revenue. As a result, cities have less money to spend on railways and other infrastructure.”
-Caixin online
I have a lot of questions when it comes to China. There is much I don’t know and maybe will never understand about the Chinese economy. But I do understand the silly notion espoused by China bulls that the Chinese leadership has fashioned together some new and improved quasi-commie-capitalistic economic model is total claptrap! It is ironic that what is perceived as a great achievement (and to a large degree much of it is and no denying that), the massive infrastructure build across China, could be the very thing that comes back to haunt them and drive GDP growth deeply into the proverbial toilet.
The Austrian School types would call it malinvestment. Force-fed infrastructure as state initiatives, laced with corruption along the way (like New York City mob-led union payoffs but think of it on a massively larger scale) that, lacking market incentives, have to be paid for sooner or later and one way or the other. It all comes out in the wash no matter the economic model.
Our vicious treadmill representation, which we created a couple years ago, and shared with you many times before, nailed it again as a framework to follow China’s terminally ill economic model. I have added one new component today – hot money now flowing out of China. The idea of a big appreciation in the yuan has faded.
Stay with me ...
CAPITAL MISALLOCATION ==> PAID FOR BY HOUSEHOLD SECTOR ==> HITS GDP HARD
Aka Wasteful Projects Aka consumption tanks
Most of us now understand China’s exports are being hit thanks to current slow demand from the industrialized world now ... and expected muted demand for years to come because of under capacity growth across the US, Europe, UK, and Japan. So what is the saving grace for Chinese growth? — a transition to consumption.
However, those China bulls that are optimistic on this front are missing a major problem with this view—the household sector in all countries pays for the mistakes of the state’s misallocation of capital; this is not just a China thing. But here is the danger for China – there is no other growth engine left if the consumer doesn’t start contributing.
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Export demand muted and may fall more if the Eurozone heads into deeper recession.
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Overcapacity in many industries and massive capital waste – not only real estate but many other state infrastructure projects – is starting to hit the fan.
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China’s consumer [household sector] will take the hit for the misallocations and wasted capital. In other words: Consumption in China represents an incredibly low 35% contribution to GDP; how can this ever grow when they are about to pay for all the wasted capital for infrastructure build across China? The infrastructure build enriches the ruling party elites, their relatives, and others connected to the system—it is part of a model that has worked well for them. They are not about to rock this boat with rapid transition to some new model. Chinese power elites are no different than elsewhere. Many policymakers inside Chine see this slow-motion train wreck in the making, but they can do nothing about it.
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Therefore, there is no other area that can pick up the slack of GDP growth. Time to pay the piper!
It sets the stage this year for a massive growth disappointment.
Here are the payoff paragraphs from Prof. Michael Pettis in his recent piece on the topic of wasted capital inside China:
The debt will be serviced. One way or the other it will be assumed by the central government through the banking system.
But this is not the important issue. The important issue is that it is clearly proving impossible to keep GDP growth levels high without explosive debt growth, and there are serious debt capacity limits to this kind of debt growth. I have no idea where the debt will next show up, or what the next debt panic will be (I suspect this year it will be SOE debt), but I have no doubt that there will be more of these debt panics. This is not an accident. It is intrinsic to the way the development model works.
The problem, then, is not that there will be defaults. The problem is that the only alternative to default is to service the debt, and this is what will cause the real damage to the economy. If the economic benefits generated by the investment are less than the correctly-valued debt-servicing costs, as they almost certainly are, the difference has to be made up in the form of a transfer of resources from some sector of the economy.
...The problem with this solution is in what it implies about future growth in demand. If investment is being wasted, it must be reduced or it will create a debt crisis eventually. If the external environment is tough, the demand impact of a sharp drop in investment cannot be made up for by a surge in the trade surplus – in fact the trade surplus may actually contribute negative demand. So where will the demand come from needed to pull the Chinese economy? The only possibility is a surge in domestic consumption.
Can consumption possibly surge? No, not if the household sector is going to be forced to clean up the banking mess again. This is the same problem that caused household consumption to drop after the last banking crisis from a very low 46% of GDP in 2000 to an astonishing 34% in 2010.
...The only way to boost household consumption is either to redistribute income from the low-consuming rich to the high consuming poor, or, better yet, to redistribute wealth from the state to households. Both of these have serious political implications that have to be resolved and are unlikely even to be addressed with consumption subsidies. After five years of this argument, during which time consumption has plummeted relative to total savings, you would think they would start to abandon the idea that all we need to do to get consumption to surge is to reduce household savings a little.
The 1% inside China controls a staggering estimated $2-$5trillion dollars in wealth; they are starting to move money out of China, seeking a safe haven. That should be a good enough signal as they know a lot more about their economy than I do.