Note: This is not my original work. It is a thorough rewrite of an existing article supplied by a client. It was an unpaid gig, and hence I have posted it up here.
Philippe Petit became world-famous for his death-defying high wire walk between the World Trade centre’s twin towers in New York. Young Petit’s jaw-dropping performance is a perfect metaphor to explain how Chinese leaders are gently untangling their debt-fueled economy.
Petit said a complex mission like high wire walking could not be accomplished all at once. The beast must be tamed, slowly and cautiously. We often wonder if the Chinese policymakers paid heed to the maestro’s advice on how to handle such a delicate yet mammoth task.
Since last few years, credit growth, specifically M2, was considered as one of the primary indicators of the overall Chinese economy. However, the correlation between the two broke in 2017 when M2 recorded the slowest growth of the decade, while PMIs, Industrial Production and overall growth continued strong performance.
We believe this variation was caused due to several factors.
- A Majority of the credit growth stayed within the country,
- Improved efficiency in credit allocation,
- Credit weakness offset by a boost in fiscal spending, and
- Success in reform measures to increase consumption in tier two and tier three cities.
The primary reason for the divergence is that credit deceleration happened at the same time when the capital account got further tightened. In the past, when the capital account was flexible, a part of the earnings was moved to offshore holdings by households and businesses. However, once the capital controls got tightened, money movement has slowed down. We believe this led to a bigger portion of credit getting reinvested within the country, resulting in a boost to growth.
Another significant factor that promoted the correlation breakdown had to do with improved credit. China saw a decline in credit efficiency since the beginning of 2010. The Incremental Debt to Output Ratio kept increasing regularly. But recently, the trend reversed. We think credit efficiency improved because spending moved away from state-owned businesses to the private sector in the commodity market. Private sector’s focus on productivity-enhancing technology and other services resulted in better allocation of capital, which helped improve growth numbers.
The third factor that impacted the divergence was the slowing of credit growth while the state’s spending increased. According to the IMF’s “adjusted” fiscal deficit numbers, China’s deficit has been the largest since the 2008 financial crisis. While budgetary planning is done at the central level, most of the expenditure is approved by local officials.
A surge in land sales, along with above 50 percent growth in size and value of land transactions in smaller cities, has played a crucial role in supporting growth. City governments earn more than 42 percent of their revenue from Land sales. There is a direct connection between land sale and the city’s revenue.
Within six months of land auctions, the receipts of the sale become a part of the local government’s fiscal revenues and are soon utilized as budgetary spending.
In the past, Tier 3 city governments used Local Government Financing Vehicles (LGFVs) to finance projects or to fulfil funding shortages. But the revenue generated from land sales in smaller cities has limited the need for LGFV issuance.
As a result, fiscal stimulus has gotten more explicit targets. Local fiscal spending is under stricter watch than the expenditures under the LGFV route. Our research suggests the regional economic stimulus may increase to over 1 percent of the GDP for the last six months of 2017 and the first six months of 2018. Local economies generating money from land sales and a reduction in LGFV-based borrowings has had a force multiplier effect on the states’ revenue.
China initiated two significant programs to increase expenditure in smaller towns and cities. Firstly, they aimed at improving social benefits. Due to a lack of a “social safety net,” savings rate has always been very high (about 47% as per IMF 2017 report) in China. Lower-income groups save money to meet their healthcare, education, housing, and emergency needs. The government focused the transfer payments to households, specifically targeting housing, education, and healthcare. These payments are increasing by more than 10 percent every year and are aimed at encouraging broad-based consumption.
Wage growth is the second driver behind the increase in low-income consumption. According to available data, unskilled wage growth (now at above 12 percent) is higher than the growth seen in skilled workers’ wage.
The likely reason behind this change is a massive number of workers moving from capacity reform-induced commodity sector to higher-paying jobs in the service sector in e-commerce and transportation. For example, Didi, the Chinese ride-hailing application has hired over 200,000 people who were laid off from the commodity industry.
We believe these four factors played a crucial role in disconnecting credit growth from economic performance (M2). The Chinese government has succeeded in its first steps towards an ambitious goal. Petit said one must not look down or change focus while on the high wire because the results of such an action could be fatal. We hope the Chinese consider these words of wisdom as they continue to untangle the economy.