Stimulus Assisted Financial Suicide

Consider these excerpts from a recent Financial Times article:

I've been an optimist on China. But I'm starting to worry

By Stephen Roach

Published: July 29 2009 03:00 Last updated: July 29 2009 03:00

On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009.

A back-of-the envelope calculation suggests China may have accounted for as much as 2 percentage points of annualised growth in inflation-adjusted world output in the second quarter of 2009. With contractions moderating elsewhere, China's rebound may have been enough in and of itself to allow global gross domestic product to eke out a small positive gain for the first time since last summer.

That's the good news. The bad news is that China's recent growth spurt comes at a steep price. Fearful that its recent economic short- fall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending.

Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China's recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009, bank loans totalled Rmb7,400bn - three times the pace in the first half of 2008 and the strongest six-month lending surge on record.

This outsized bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

Yet there can be no avoiding the destabilising consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 - double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year - a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week, Chinese regulators told banks that new loans must be used to bolster the real economy and not for speculation in equities and real estate.

A little over two years ago, premier Wen Jiabao warned of a Chinese economy that was becoming increasingly "unstable, unbalanced, uncoordinated and ultimately unsustainable". Prescient words. Yet rather than act on those concerns by implementing a pro-consumption rebalancing, growth-hungry China was seduced by the boom in global trade and upped the ante on its most unbalanced sectors. By 2007, investment and exports accounted for about 80 per cent of Chinese GDP. And now, in the face of a severe global recession, China has compounded the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector.

This is not a sustainable outcome for any economy - or sustainable support for the world economy. China must redirect economic growth towards internal private consumption. This may require a compromise on the quantity dimension of its growth outcome. But to the extent that leads to improved quality in the Chinese economy, a short-term growth sacrifice is well worth the effort.

Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure. In many respects, that's what the global crisis and recession of 2008-09 are all about. China will not get special dispensation from the most critical lesson of this post-crisis era.

And an August 5th article from Barrons quoting economist Andy Xie:

China's property market has been bid up to levels that rental yields on commercial real estate are negligible, leaving price appreciation the only source of return, Xie explains. Moreover, local governments depend on taxes from property sales, so they keep prices aloft by carefully controlling land sales. State-owned companies borrow from state-owned banks to buy land from local governments. "The money circulates in the big government pocket." But the bubble results in overbuilding that leads to the bust and a surge in bad loans.

The stock market, he continues, is in the final frenzy. "The most ignorant retail investors are being sucked in by the rising momentum. They again dream of getting rich overnight."

That's especially true of the young, who can see their holdings gain more in value in a day than their monthly salaries, Xie continues. They usually lose, but the idea that government won't let the market drop is rooted in Chinese market psychology, especially before Oct. 1, the 60th anniversary of the Peoples Republic. "This sort of belief is self-fulfilling in the short term. The market tends to roll over around the time. If the past is of meaningful guidance, this wave will taper off before October," says Xie.

As always, bubbles are inflated by excess liquidity.

"How far the bubble would go depends on the government's liquidity policy. The current bubble wave is very much driven by the government encouraging banks to lend and the super low interbank interest rate. As the Fed's interest rate is zero, the dollar is weak, China's foreign exchange reserves are high, and the loan-deposit ratio is low, China could increase liquidity, which would expand the bubble further. However, other considerations may motivate the government to cool it off."

If so, China may engineer a soft landing for the economy -- if the global economy recovers -- but it would still mean a hard landing for asset markets. "However, if the global economy remains weak then, which is my view, both asset markets and the economy would have a hard landing," Xie concludes.

There is an inherent problem with government stimulus. The money tends to go places that do not generate long term benefits because decisions are made for political reasons rather than economic ones. Some economists would argue about this (Keynesians in particular) but as a thought experiment, consider spending on highways.

Action – Governments spend money building new roads.

Result – Long term highway maintenance costs increase.

Problem – a structural deficit is created unless taxes or other revenue sources increase to off-set the new higher costs for highway maintenance.

Unintended Consequence – taxes are increased to generate revenue to offset costs, business and individuals have less to spend and economic activity declines.

So what sounded like a good idea and had good intentions ends up having the opposite effect in the longer term. Are we as nations all committing stimulus assisted financial suicide?