August 15, 2005
Remember Japan? Back in the early 1980s the Land of the Rising Sun was, once again, the world’s most feared invader. But instead of military might, the new Japan was rallying behind industrial muscle and corporate audacity. Icons such as the Rockefeller Center and MGM Studios were being scooped up like so many billion-dollar baubles. As Japanese cars and televisions flooded the market, Westerners marvelled at the country’s technological wizardry and its phalanx of tireless workers whose labour was only stopped short by karoshi — Japanese for death by overwork. Who could compete with that? At the time, it seemed, a new world was dawning and Japan would be its champion. It all seemed inevitable, right up until it fell apart.
Fast-forward 20 years and the world is facing a new Asian deluge. If Japan was a surging tide, then China is a tsunami. The globe’s most populous country turned manufacturing juggernaut has a one-two punch of low-cost labour and homegrown national champions taking the world by storm. Its economy, which has been growing above nine per cent for a decade, has already surpassed Japan’s in size, and is expected to overtake the U.S. by 2040. Its voracious appetite for energy and resources has sent commodity prices skyrocketing and its cheap manufactured goods power consumer spending around the globe. With its sheer drive for material success, after centuries of deprivation, China seems unstoppable. But is it? Or is it just history repeating itself?
At its apex, Japan’s economy crumbled like a house of cards. The yen, which had been kept weak to promote exports, was engineered upward to rein in fast growth, igniting a speculative real estate bubble. When it burst, the banks, which had lent money to companies based on their real estate equity, were left virtually bankrupt. Trillions in personal and corporate wealth disappeared overnight. The implosion revealed structural rot beneath the economy’s seemingly ironclad exterior. The upshot was 15 years of stagnation that Japan is only just now emerging from.
China is, in many ways, following in the footsteps of Japan’s early success. Nobel prize-winning economist Robert Mundell recently compared China’s ramp-up to Japan’s beginnings as a low cost manufacturer in the 1950s and ’60s. And now, like Japan was in the 1980s, China is focused on expanding into international markets and on developing its own technology for sale to the world.
But other similarities are more disturbing. Andy Xie, chief Asia economist with U.S. investment bank Morgan Stanley, points to the US$350 billion in speculative “hot money” that has poured into China in recent years on the expectation that its currency, the renminbi (or yuan), would appreciate. Much of that money has been parked in real estate as the recently privatized housing market goes through an unprecedented boom. In Shanghai, prices skyrocketed by 28 per cent last year, with sleek condo towers, office high-rises, hotels and malls being thrown up at a breakneck pace. The vacancy rate officially stands at 2.7 per cent, but anecdotal evidence suggests up to 40 per cent of the new space sits empty.
Speculators just got their first whiff of the potential payoff after the Chinese government bowed last month to mounting international pressure to revalue the renminbi, abandoning its decade-old peg to the U.S. dollar. China’s central bank has pledged to keep a tight rein on the currency, which was tweaked a mere 2.1 per cent and will now trade within a narrow band against a basket of international currencies. But Bridgewater Associates, a U.S. asset manager, estimates that with the renminbi now unleashed, a 25- to 30-per-cent gain is “inevitable” over the next three years.
If currency traders are right, the revaluation heightens the risk of a massive exodus from real estate, as speculators look to cash in. Observers fear that could, in turn, push the country’s already shaky banking sector into a tailspin. “The revaluation of the renminbi enhances the possibility for a tremendous amount of property to hit the market, and prices will go into a free fall,” says Ken DeWoskin, a well-known sinologist, and a partner at U.S. accounting firm PricewaterhouseCoopers in Beijing. “It’s the most significant crisis on the horizon.”
Still, many don’t believe China is headed for a Japanese-style collapse. “We talk about it behind closed doors,” says one Beijing-based adviser to the government, who preferred not to be identified. “But the consensus is, it won’t happen here.” There are plenty of differences between the two economies. Unlike Japan’s insular economy, China has become the leading destination for foreign investment, sucking in US$260 billion in the past five years. Foreign multinationals account for nearly 60 per cent of its exports. China also has a cheap and flexible workforce. And, unlike many other developing countries, it has virtually no external debt and a high savings rate.
Even with all those advantages, however, China is still vulnerable, in part because its phenomenal success has blinded many in the government and the ruling Communist party to rising economic and political risks. “Many of the new generation of leaders are overly confident,” the government adviser says. “They’ve gone from a planned economy to a market economy and they have never gone through a recession or severe economic downturn. It’s hard for them to imagine China could ever go through an economic curve like every other country in the world. They don’t appear to be bracing themselves for the real potential problems.”
And the problems, like everything in China, are mind-bogglingly huge. At their heart is a dysfunctional, corrupt and virtually bankrupt financial system. PricewaterhouseCoopers estimates the country’s banks have racked up as much as US$800 billion in bad loans, mostly doled out to weak state-owned enterprises that churn out cheap, inferior products in a thinly veiled effort to keep millions employed in the absence of a social safety net.
The government in Beijing has tried to clean up the banks’ books and present a semblance of financial order by offloading US$325 billion in bad debt to state-run asset management companies. But, like the banks, these groups are headed by Communist party officials, and they’ve shown little interest in disposing of the loans. Instead, they prefer to swap the bad assets among themselves at inflated prices financed by central bank loans. Reminiscent of Japan’s failure to settle ailing accounts in the 1990s, the Chinese asset managers have dumped less than a third of their bad debts since 1999, collecting just 20 cents on the dollar.
While all that debt languishes in murky obscurity, a new crop is being groomed. The government, anxious to lure more foreign investment and bulk up production capacity, has been on a frenetic building spree — investing in high-speed railways, power generation and state-of the-art airports. New steel mills, concrete plants and aluminum smelters have sprouted up like weeds, while five-star hotels gather dust in provincial backwaters alongside deserted golf courses.
The level of capital investment, equivalent to half of China’s gross domestic product, is not only highly inefficient, but unprecedented, says DeWoskin. “No other economy in the world has reinvested in the economy to such a degree. It’s a situation that is fundamentally not sustainable.” In addition to some US$500 billion in bad loans generated as of 2003, as much as another US$300 billion is in the pipeline, says Mike Harris, a partner at PwC in Beijing. “It’s pretty frightening if you think about it.”
So far, Beijing has solved its problems by throwing more money at them. Flush with a whopping US$711 billion in foreign currency reserves, the government recently spent US$60 billion bailing out three of the country’s biggest banks, and is expected to put up another US$15 billion to revive the moribund stock market, among the world’s worst performing exchanges and currently limping along at an eight-year low. More money is expected to flow to dozens of brokerages teetering on the edge of insolvency after dabbling in shady financing schemes.
But the bills keep mounting. Standard & Poor’s, the U.S. rating agency, estimates it would cost as much as US$190 billion just to clean up two of the country’s largest banks. Then there is some US$314 billion in provincial and local government debt, and mounting military budgets. Add another US$250 billion in rising petroleum and energy costs needed to feed China’s unbridled growth, and the stash of foreign currency starts to look “inadequate,” as DeWoskin says. “Pressure is building for some kind of adjustment,” he adds. “What we don’t know is if it’s imminent or if things can keep going for another 10 years.”
Nicholas Lardy, a senior fellow at the Institute for International Economics in Washington, has been predicting China’s financial downfall for years. Given the country’s already heavy fiscal burden, a slew of new non-performing loans coupled with a downturn in the economy could be the last straw. “The question is, when the economy goes through a downturn, how many loans are going to go bad?” says Lardy. “Will it be manageable, or a massive tsunami that the banks can’t handle?”
And there is little doubt that there will be a downturn eventually. The government is trying to hold things together until after the 2008 Olympics in Beijing. But there are indications that the delicate balancing act of government-subsidized production is beginning to teeter under the strain of overcapacity and ballooning inventories. Foreign investment is down, costs are rising, and profits are being squeezed as consumer prices on everything from cellphones to air conditioners continue to drop.
Market watchers believe real growth going forward should be in the six- to seven-per-cent range. While that is still more than double what Canada can expect to see, it’s a sudden deceleration for China and a definite cause for concern to the government, observers say. (Although the official growth rate was 9.5 per cent in 2004, economists estimate the real number was somewhere between 11 and 15 per cent.) Such a slowdown opens up a whole new set of concerns for the ruling Communist party, whose grip on power is a result of two central precepts: creating wealth and keeping a lid on the always latent threat of social unrest. With 12 to 15 million people entering the workforce each year, the party needs to keep the economy humming at a minimum seven-per- cent growth. “China works on a bicycle theory,” explains Yuen Pau Woo, chief economist at the Vancouver-based Asia Pacific Foundation. “You have to keep going forward. If you don’t, you fall off the bicycle and you may not be able to get back on again.”
To keep the economic wheels spinning and attract more foreign capital into its wobbly financial sector, Beijing has been working hard to clean up its four largest banks — adopting Western-style management and accounting practices in preparation for their debut on international stock markets. Foreign banks like HSBC and Bank of America, anxious to get in on China’s US$1.5 trillion in banked savings, have been buying in at every opportunity. But again, some see more pitfalls than potential.
Many of the banks’ balance sheets are inflated by dubious bonds that are not guaranteed by the government. So, if the economy does hit a soft spot and the banks are forced into bankruptcy, foreign investors would be left holding the bag for billions in losses. In the words of Elliot Wilson, a financial journalist with the Hong Kong-based Standard newspaper, investing in Chinese banks is “like a man betting his kid’s college fund on a three-legged horse.”
The real wild card, though, is corruption. The financial system is rife with tales of skulduggery involving billions of dollars and top bank officials. The former chairman of the China Construction Bank is serving a 12-year jail sentence for graft, and his successor stepped down in March, under investigation by the party for “violation of discipline.” Some of the more startling stories include a bank manager who disappeared with US$100 million in cash, and another scheme involving 69 people charged with stealing US$894 million in bank funds.
Many are hopeful the threat of an economic slowdown will force the party to speed up much-needed reforms, but others remain skeptical. The government is relatively untested when it comes to stick-handling delicate fiscal matters, and its ability to make quick, informed decisions is bogged down by a glacial adherence to consensus-building and a generation of leaders born of the immensely destructive Cultural Revolution.
That raises many frightening possibilities, not just for China but for all those investors who’ve pumped billions into its rickety institutions. “If the Chinese banks collapse, the whole world economy collapses,” Wilson warns. “The world economy is very dependent on China in ways we still don’t completely fathom, and we won’t for another five or 10 years.” We do, however, know this: when Japan arrived at its day of reckoning, the rest of the world escaped relatively unscathed, and the lessons learned faded quickly. Should the same fate befall China, the pain will be spread far and wide. It’s not something we’re likely to forget.