Move over Shinzo Abe.
Move over Shinzo Abe. There’s a new eponynomics craze in town: Likonomics. This is not the economics of Facebook “likes”; it’s what Barclays Capital has christenedthe policies of China’s premier, Li Keqiang. (We think it really should be Liconomics or maybe LiKenomics, but it’s probably not worth quibbling about.)
Like Abenomics, Likonomics is based on three pillars:
1) Ending fiscal stimulus by diminishing state-led investment.
2) De-leveraging in order to slash debt.
3) Structural reform, including relaxing controls on utility prices and liberalizing interest rates.
Barclays says that implementing these will put the country on track to hit 6-8% GDP growth for the next decade(link in Chinese). Li himself says the country’s on track to hit its 7.5% targetfor 2013. Here are some thoughts on why both expectations are bonkers:
Slashing stimulus means killing GDP growth
Since the Chinese government seldom issues bonds, “fiscal stimulus” actually just means “lending.” And in China, lending is one of the only sources of growth for most of the economy—it now depends on the gush of lending to grow.
Or, at least, to look like it’s growing.
GDP measures economic activity. But it doesn’t capture the economic value—meaning, the future money-making potential—of that activity. Say someone borrows $30 million to invest in opening a steel factory. That $30 million is counted toward GDP — since it purchases labor and materials to make the factory — even if no one buys the steel produced and the factory earns no money. Investors still have to pay off their initial debt. But with no revenue, they have to take out more loans to cover that.
That’s clearly happening in China’s economy now. More and more money is needed to generate slower and slower growth. Here’s a look at how the broadest measure of money supply, M2, tracks with GDP growth (looking at money supply should capture some degree of the liquidity pumped into the economy from shadow lending—loans issued that aren’t recorded on bank balance sheets—which isn’t captured in official loan data):
Ending the stimulus—i.e. lending—will make that appearance of GDP growth impossible to sustain, especially at the 7.5% that Premier Li promises. And probably not even at the 6% lower bound Barclays projects.
As Michael Pettis, economist and expert on the Chinese economy, recently wrote, consumption can power GDP growth of 3-4% each year— but there’s a caveat. “[I]t is not clear that consumption can be sustained if investment growth levels are sharply reduced,” he writes. That’s because people need jobs—ultimately supported by Chinese lending—to be able to keep spending. And as we explore more below, Likonomics as Barclays has framed it poses big risks to job providers.
Killing growth means bellies go up
China as a whole needs to deleverage—meaning, to slash the proportion of borrowing in relation to output—in order to start making productive investments again. In that general sense, Likonomics is on the money.
But in order to pay off debts, companies have to be making money. If they don’t, they default.
That’s a big problem in China right now. Growth is already slipping fast, leaving businesses generating less and less cashflow to cover their debts. Cutting lending will start to expose this insolvency even more. Untold numbers of local government investment platforms, real estate developers, and factories, to name a few, will go under.
True, postponing writing down bad debt will only make things worse. But a chain-reaction of defaults will cause growth to implode. And waiting for unproductive assets to start making money again could take years—even decades. That’s what Charlene Chu, an expert on Chinese debt at the ratings agency Fitch, was referring to when she recently warned of “ Japanese-style deflation.” In other words, with far more factory capacity than it needs, consumption will fail to keep up with production, driving prices down. Meanwhile, companies left standing will use profits to pay off their debts, which will suppress wages, restraining consumption even more.
China’s banks aren’t ready for Likonomics
Ending stimulus and deleveraging would both deprive banks of the interest income that they need for revenue and, worse, leave them empty-handed as their debtors go bust. What’s more, just as that’s happening, Likonomics would loosen the government’s hand in setting interest rates.
China’s banks are perilously unprepared for that.
Currently, the interest rates on bank deposits are set by the government, and are kept artificially low, which gives banks a nice cushion of money to lend with. Letting the banks set rates themselves would mean they’d have to compete for depositors, reducing that cushion.
This would be great for household consumption. Shifting wealth from the state and its patron companies would allow households finally to start feeling wealthy and secure enough to consume. As we’ve discussed many times, that’s critical in the long run.
But it would also crush bank profit margins and drive up the borrowing rates for businesses. Higher rates will also make it harder for businesses to pay off old loans with new ones. The spike in inter-bank rates last monthhinted at how easily higher borrowing costs could cause a rash of failures among small and mid-tier banks. Here’s a look at the interbank rate trends over the last four years:
Those peaks: the new normal? That may be a prerequisite for reform, but it will come at a big cost to growth.
SOEs and structural reform
None of this will sit well with state-owned enterprises (SOEs), the companies owned and operated by the Chinese government in order to direct economic development.
Reforms in the 1990s wiped out the worst ones, but they ones left standing are now bigger and more powerful than ever before, thanks in large part to the 2008 stimulus. They now contribute more than 40% of China’s GDP.
They may be big, but SOEs aren’t necessarily competitive. In fact, these behemoths are still inefficient compared to private firms. Their profitability has been declining, as you can see from this World Bank chart(pdf, p.133):
That’s probably because much of SOE profits depends not on their performance, but on government patronage. As cogs in the state-planned economy, they benefit from monopolies as well as from extraordinarily cheap lending rates.
Likonomics will see those rates go up. On top of that, introducing market pricing for things like utilities means removing another state subsidy. This would also deal a short-term blow to growth, even as these reforms start spurring growth among non-state companies.
Reasons for skepticism
These factors suggest that Likonomics would pretty much collapse China’s current model for economic growth. That’s an excellent thing in the long term, but it’s not consistent with Li’s projection of 7.5% annual GDP growth for 2013. That makes one wonder how serious the premier actually is about sacrificing growth for Likonomics.
And that’s not the only reason for doubt. There’s also his championing of a trillion-dollar urbanization plan, which will require colossal investment in housing and infrastructure. Stimulus, leverage, repressed interest rates—Li will be needing to call on all those tools to fund more steel-and-concrete structures that China can’t afford.