China's economy hit by anti-corruption drive?

By He Qinglian on August 28, 2014
Source article in Chinese: 中国经济下滑并非缘于反腐

China's economy is in the process of going downward, the HSBC Flash PMI for August slipped to 50.3, lower than the final value of 51.7 in July. What is rather odd though, is the explanations for this that people came up with. The Wall Street Journal for instance, published a number of reports such as “China's Top Graft Buster, Wang Qishan, Probing Thousands—Anti-Corruption Drive Headed by a Heavy-Handed Communist Party Loyalist” citing analyses made by investment bank economists that heavy-handed anti-corruption campaign would cost 0.6% to 1.5% in China's GDP growth this year.

To think that the anti-corruption campaign cause the Chinese economy to go downward is indeed mistaking the superficial signs for the underlying causes. This view, however, points to the fact that the two major structural flaws of the Chinese economy are related to government behaviors.

The real link between anti-corruption campaign and the simultaneous drop in both government investment and spending:

It is true that the anti-corruption campaign leads to two major results, first being a decrease in local government investment and second being a drop in the final consumption rate in China. While this correlation is unlikely to appear in other countries, it unfortunately became a reality in China. And the reason for this is simple: in the past five years, the bulk of investment was from the government—the notable examples were the 4 trillion investment scheme from the central government and the 20 trillion local debts of the local governments.

Moreover, government spending has been abnormally high in the percentage accounted for the national final consumption in China—the very structural flaw of China's economy that is precisely the biggest hidden threat to it, what the anti-corruption campaign achieved was merely making this threat apparent before it manifests itself. If the anti-corruption campaign has not been started, this threat would just remain there and continue to be covered up by government spending and whatever investment projects the local governments see fit.

The real cause of China's economy going downward is as follows:

With respect to the drop in the growth rate of China's economy, the country's National Development and Reform Commission (NDRC) already predicted it in the beginning of this year and it cited two reasons. First, there is massive overcapacity, the economic structure has to be adjusted and the demand for investment growth would be suppressed; second, as the pressure of local governments repaying their debts mounts, the expansion in government investment would be constrained.

The prediction of the NDRC was that the launch of the “Comprehensive Deepening Reform Plan”, which aims to adjust the economic structure, would affect the stability of economic growth.

There are two ways the Chinese economy going downward can be attributed to this campaign to clamp down on graft-taking, though. To begin with, it keeps local governments from borrowing to build public constructions. According to a survey conducted by the People's Daily in July, a self-protection mode has been initiated among officials after the anti-corruption drive started. That survey revealed that 64.4% of the respondents believed that at the moment, what officials now fear the most is “something goes wrong with what they do”. An example is that, while in the past officials did not care about “mass incidents” caused by demolition and eviction so long as the local fiscal status looked good and the GDP grew, they now prefer not to do as many things as they did or they simply do nothing.

At Xi Jinping's instruction, the Central Organization Department announced at the end of 2013 that local debts would be included in the performance evaluation and those officials who leave behind bad debts should be held accountable. For this reasons, local officials can no longer borrow arbitarily to fund vanity projects as they did in the past and leave their successors to clear up the mess for them after they got promoted.

The other way that the anti-corruption campaign impacts on the Chinese economy is that Xi Jinping issued orders that officials stop misuse of public funds. As a result, government spending decreased and this in turn caused the final consumption rate to drop.

From the viewpoint of economic statistics, national final consumption consists two parts, citizen spending and government spending. There is one set of data few would have thought of: in this last several years, the employment in China hasn't been good, the increase in the income of the middle class and the grassroots have been extremely slow, thereby domestic demand has been weak all along and China's national consumption rate is significantly lower than the world's average.

The government spending however, accounts for a major part of this low consumption rate as studies showed. Starting from 1978, the ratio of government spending in the national final consumption has been rising. In the 1990s, this ratio stayed at around 24-25%; between 2000 and 2010 it rose to about 26-27%; and in 2011 it rose further to 28%. The government spending includes the much criticized transport, feasts and travels using public funds.

The anti-corruption campaign that launched last year would definitely curb these types of government spending.

The property market is another domain where consumption dropped due to the anti-corruption scheme. For years, there has been a huge bubble in China's property market, which has become way above the actual purchasing power of the populace and is shored up by officials and wealthy people who need to preserve the value of their assets. Although officials do not have to declare their personal assets yet, they realize that sooner or later they would have to do so.

In view of this, many are selling their flats and withdraw from the property market for good. Hence, the burst of the property bubble would take place sooner or later.

China has already missed the last window to actively initiate an economic restructuring. Back in 2008 when the Beijing Olympics was being held, the government of Guangdong province advocated already for a change so as to facilitate an upgrade and transformation in the industrial structure.

While this was what the government of Guangdong province planned to do, it didn't manage to create new incentives to attract foreign investment. Therefore, old foreign investment left the Pearl River Delta because of the surge in the costs of land, labor and logistics and no new investment came in.

At a time like this, when foreign trade—one of the three engines that propelled China's economic growth for more than 20 years—was about to lose its momentum, the central government should have promulgated new policies to guide the economic restructuring. Yet because of the impending transition, the outgoing administration was under tremendous political pressure. In order to be political correct, they had to maintain the prosperous look as the “golden decade for economic development” was drawing to an end.

For this reason, the central government announced instead the 4 trillion stimulus package. The bulk of this money, as well as those debts of Local Government Financing Vehicles (LGFV), eventually ended up in the property market and the stock market, thus created a huge and inflated bubble in the property market which in turn caused corruption, overcapacity and other problems China faced to worsen even further. China still faces these problems today.

The previous administration of China was able to prolong the prosperity for two to three years by printing money and passed the bucket to the next administration when all three of the engines propelling the Chinese economy lost their power. And so this current administration has to face a series of problems alongside zero growth in employment the pervasive smog and pollution and contamination of the earth, the sea and the sky. The first two or three years for this administration might be okay, but it won't be easy to hold on for ten years. This was why Li Keqiang intended to start a financial reform and end the old way of government stimulating the economy and find a new way instead.

However, in the face of the inertial forces of the Chinese economy, “Likonomics” has by and large been rendered empty talks and shortly afterward, the government announced the “micro-stimulus” measures, which means this administration uses the old ways of Wen Jiabao, albeit the money pumped into the market is of a smaller scale.

The real problem however, lies in the fact that there is little room left for this administration to maneuver. Even though it understood that the biggest threat of the Chinese economic slowdown is the burst of the property market bubble and that a debt crisis would lead to a financial one, the government has no option but to implement a loose monetary policy; and the real trouble lies in the fact that little would be achieved even if the government continues to inject huge amount of money into the economy to stimulate it.

A few days ago, Forbes ran an article The End Of China's Four-Decade Economic Cycle that quoted an observation of China Beige Book International that: “this slowdown may be the beginning of something much more important: weakness, perhaps of unprecedented degree, in both capital expenditure and loan demand.”

The authors of the Beige Book surveyed 2,200 companies and found that “in the second quarter of this year companies, because of a lack of promising opportunities, did not apply for much new credit, unlike the corresponding quarter in 2013”even though Chinese financial institutions were instructed to open the taps, issuing 1.08 trillion yuan in new renminbi loans in June and “social financing skyrocketed”; besides, “rates in the shadow banking sector, which caters to private and smaller businesses, were lower than in the state bank sector” which indicated falling demand.

The inconvenient truth that the Chinese government has to face is that the economic boom is over: China’s no longer the factory of world, the property market is losing steam, the emergence of a large number of ghost towns presages a grim future for the new urbanization project, and a new engine for economic growth is yet to be found. To keep the property market afloat is like quenching thirst with poison; to let it collapse would result immediately in an economic crisis and a massive amount of bad debts in the banking system alongside a host of social problems—the middle class would feel disgruntled because their assets shrink markedly.

Unlike the grassroots, which is much greater in number, the middle class want the government to maintain social stability so much that they would be willing to temporarily blush aside their frustration resulted from the political pressure and the fact that their social space has been severely compressed.

Given that the world’s economy is closely related to that of China and that a recession in the Chinese economy would be the biggest threat to the global economic recovery, some investment bank economists insist that anti-corruption would lead to a recession. The truth, however, is that even if the Chinese government stops fighting corruption now, the Chinese economy would still not flourish.