Riding on China's coat-tails
Beijing-based Arthur Kroeber, managing director of Chinese economic research firm Dragonomics, tells Business Spectator's Isabelle Oderberg:
Isabelle Oderberg: You have spoken about the need for China to rebalance its economy. Could you please run through the key points of that and how that might actually happen? It’s all very well to say it needs to happen, but actually doing it in an economy that big is a different story.
Arthur Kroeber: The key point I would make is that outside of China people usually talk of this as a process of shifting from investment in export-led goals to consumption-led goals and that’s true in the long run, but you can’t go directly from one to the other. The challenge for China right now is to increase the efficiency of investments and if you increase the efficiency of investments and raise the cost of capital, which means that over time rates for investment rise and less resources in the economy are directed towards investment, gradually that enables resources to shift into the household sector where they’ll be consumed.
But that’s a long process and the first stage is investment deficiency. You can’t go straight to consumption friendly policies. So, just to conclude, the key challenge over the next five or ten years in China is to restructure the financial sector, so that capital allocation becomes more efficient and if they get that right, that will improve investment efficiency first and then lay the groundwork for consumption led growth in the future.
IO: So, when you talk about investment efficiency, are you talking about how a lot of China's stimulus has been funnelled into equity markets and the property markets? Is that the kind of investment efficiency you're talking about?
AK: No. This is a much more long term issue. And the stimulus is one example of low efficiency investment in China. They’ve thrown a whole lot of money into infrastructure projects and the point about that is that this is low efficiency in a financial sense. The financial return on these infrastructure projects is not going to be high. The social return tends to be very high over a long time, so if you’ve got a lot of roads, railways, power generation or telecoms networks, these enable a lot of economic growth over time, so they’re good things to do, but the financial return on them is low and the problem is that if you do so much of them, you create a lot of demand for steel and cement and these basic industries, so you have over investment in those sectors which is very easy to do because the cost of capital is low.
So the basic problem, and this is a long-term problem, is that the cost of capital is too low and that makes it too easy to invest and particularly too easy to invest in capital intensive industries. They consume a lot of resources, but don’t actually employ that many people. So, gradually what you want to do is you want to raise the cost of capital, so that people have to think a bit harder about each new investment and you’ll create less excess capacity in the basic industries and you’ll encourage people to thinking about different kinds of investments and particularly in industries which are a bit more labour intensive over time.
IO: It sounds like the complete opposite of what’s going on in developed economies, with businesses struggling to get their hands on capital at a reasonable cost, because of liquidity tightening. It’s strange to look at it from the other point of view of how to increase the cost of capital, but I’m imagining you're talking about interest rate policies?
AK: Interest rate policy eventually becomes part of the equation, but it has much more to do with the structure of the financial system. Right now, China’s financial system is essentially the banks which are all owned by the state. Ninety per cent of corporate external finance comes from the banking system. The banks are very politically influenced and so they are not able to allocate capital very effectively. So, what you need to do is you need to increase the role of the capital markets, the bond market and the stock market, you need to make those markets work more effectively, so that they’re not just casinos. The Chinese stock market in particular is just like a gambling operation, because there are structural problems.
You need to improve the structure of the capital markets and you need to diversify the ways by which people can get finance by promoting private equity and venture capital in all of these things and if you diversify that, then that will create markets for capital which will set a price on capital and regulate its allocation more efficiently and then once you’ve got that infrastructure in place, then you can liberalise your interest rate regime and give the market more of a say in setting interest rates in the price of capital, but that happens later. You first need the structures in place that enable you to run a more flexible interest rate.
IO: When I spoke to Andy Xie a few weeks ago, we talked extensively about bubbles that are appearing both in the stock market and the property market as a result of stimulus money flowing through to those two particular areas. Are you a bubble believer and do you think that the government’s listening to these warnings?
AK: I don’t have quite as dire a view of this as Andy. Remember mainly what we’re talking about here is the increase in loan volumes; it’s not the fiscal money, because you’re right, the fiscal part of the stimulus was kind of a repackaging of commitments that were already there. Most of the stimulus has been this vast increase in bank lending that we saw in the first half of this year and there’s no question that a slice of that money went into investments in the property and stock markets and this is pushing up asset prices. I do agree that this is the big problem that the government is going to have to face next year is the speed at which asset prices are rising and how they respond. I think that the way they’re going to respond is over the next month or two, I’m quite confident that there will be some targeted measures aimed at the property sector to constrain speculative behaviour.
And then probably by the second or third quarter of next year we may see a tighter monetary policy in a broad sense, so you know a bit of a restriction on the lending quotas and maybe potentially a hike in interest rates. So, are we in a bubble right now? Not quite, but I think we’re clearly heading in that direction in the property market and the government has already signalled that they’re concerned and I think they will intervene and I think the question then is will the intervention be effective and we can’t be certain about that.
IO: Do you think there’s going to be any form of intervention to avoid the stock market getting to over-inflated levels?
AK: Yeah. The stock market so far has not been anywhere near the problem and the reality is that the number of people who participate in the stock market in China is very small. There’s a myth that there are all of these retail investors out there and it just is not true. There’s a very small number of people involved in the stock market, so if it goes up and it goes down, the social impact of that is limited and plus the stock market is just not going up anywhere near as much as the property market. The property market everyone is involved because everyone needs to buy a house and in fact the price movements this year have been much more severe in the property market, so I think that is really the key question. The stock market is secondary.
IO: You say that there’s a complex relationship between China and its state-owned enterprises. 'State-owned enterprise' is a bit of a dirty word in Australia, because we’re very protective of our commodity sector. What Australia should be concerned about or be aware of in that complex relationship? What’s the most relevant to us in terms of that dichotomy?
AK: The first thing I would say is actually, if you can compare with other resource economies, Australia’s by far the most open to foreign investment in this sector; it's just by huge orders of magnitude and there’s this perception that even in Australia, that somehow Australia has wanted to try and close the doors to Chinese investment and it’s simply not true.
In the past two years I think there have been 110 investment proposals by Chinese companies, of which 105 have been approved without conditions with a total investment value of almost $40 billion. There are five that had been approved with conditions and a couple of very high profile ones that were withdrawn, right. The first thing to recognise is the fact that Australia has been extremely open to investment from Chinese state-owned enterprises and it’s only in a very small number of cases that conditionality has been imposed.
China is different from other past investors like the Japanese or whoever because there’s this very close relationship between the state owned companies and the government, which is very non-transparent, is a function of the extreme complexity of the Chinese political system and is not going away anytime soon. Basically, this is just a problem that everyone who accepts Chinese investment is going to have to deal with. It’s not comfortable. I think the Chinese can do a lot more to make it clear exactly what that relationship is, but I think realistically they’re only going to go so far, so people just have to figure out a way to decide how they deal with this.
IO: At the height of the crisis China’s GDP outlook was being scaled back and back. It's now come back a bit and people are expecting figures around the 8 per cent mark. Could you give us a little bit of insight into GDP growth, because for Australia that’s the most important thing, because the GDP growth will be linked directly to commodity consumption which is what my readers are most fretful about.
AK: Right. Basically we’re looking at about eight per cent this year and I think eight to eight and a half per cent next year. I think it’s very hard for the Chinese economy now to run at a growth rate of much more than eight per cent without generating more inflation on the government bonds. Yeah, you’re right. A year ago all the private forecasters were saying China will be lucky to get five per cent this year.
IO: It went to three at some stage!
AK: Right, which I always thought was ridiculous, because people didn’t understand the ability of the government to mobilise money.
IO: And domestic consumption not just export-related production?
AK: It’s not consumption. It’s just the ability of the government to mobilise money to plug a hole. But then once that became clear everyone said 'well the government is omnipotent and they’re just going to spend money and we’re back to ten or eleven per cent growth rates'. I don’t think that’s reasonable, because I think the structure of the economy now means that growth much above eight per cent is seriously inflationary. There is an inflation problem in property prices, as we mentioned.
This will probably require some kind of response by the government to scale back things, so I think there’s a natural equilibrium around eight per cent. However, from the standpoint of Australian resource producers, that eight per cent is going to feel more like 12 or 13 per cent because so much of that growth, about 95 per cent of that growth, is coming from fixed asset investment which is very resource intensive, so the level of investment is similar to what it was when China was growing much faster a few years ago, so I think Chinese growth in total stays around eight per cent, but it’s so investment intensive that the next two or three years it’s still broadly positive for resource producers.
IO: Thank you so much.
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