(Part 2 of 3) Conversation with Andy Xie, former Chief Asia Economist of Morgan Stanley — China will export excess capital through foreign listings on its stock markets — Hong Kong will lose dominance as China’s offshore financial centre — multinationals are still bullish on China, despite market fluctuations.
Here is the transcript of the video.
1. The dynamics of a slowdown of economic growth in China
Emmanuel Daniel (ED): What does a China slowdown mean to the global economy and how will that slowdown take place? And what will the mechanics and implications of a China slowdown mean?
Andy Xie (AX): China’s property market is deflating now. The market itself is very large with a 4.6 billion square metres under construction, the investment level about over 10% of the GDP in the last few years, so it’s a very large industry. There’s a knock-on effect on the local government finance. Local governments are very dependent on the property market for funding, so as the public market deflates the local governments will have less money to spend. So put these two together, plus the exports to China that are slowing down. The slowdown is good for the economy and its need to adjust. The bubble is not good for the future. China has labour shortage and an energy shortage so the slowdown will give China time to rebalance its economy.
From the external side, I do believe that it will mainly affect natural resource suppliers, especially for base metals for example. We will see a downturn that’s going to be with us for some time, possibly through the first half of next year or even beyond.
ED: What are some of the important policy objectives that China has always wanted to deal with which today it has a chance to deal with because the economy is not running off at 10-12% year-on-year growth. What are the objectives at the national policy level that you think can be achieved?
AX: Sustainability is much more important than speed now. Speed was important before, because China had a labour surplus, and employment was a big deal. Now with the one-child policy in place for three decades, the labour supply is not growing like before, in particular manual, the blue-collar labour force is barely growing, while industry is growing at a double digit rate, so inevitably there will be inflation. The priority is changing, it is much more about quality now than quantity. So China needs to boost productivity and increase the value-add of the industry rather than just expending quantity.
ED: Right. Now when I asked you about China, the first thing you pointed out was the fall back on property prices and the impact that it has on local governments’ ability to generate income. But at the same time, it’s the state-owned enterprises that are most exposed to the property sector as well as to the shadow banking industry, for example, where they become lenders to parts of the economy that the banking system has not been lending to. Now if there is a slowdown, how much should we be concerned outside of China in terms of the impact of the state-owned enterprises and that fall back into the banking system, because the banking system lends to the state-owned enterprises?
AX: Among the state-owned enterprises, there are some big property developers, but there are very few of them. Out of the over 20,000 property developers, the overwhelming majority are private companies. The banking system might run into trouble, mainly because of the loans to private property developers. A lot of those guys are highly levered. And unlike in the United States, the household sector mortgage part is okay. It’s not going to run into huge trouble. It’s really the loans to the developers, as well as upstream industries like maybe steel and cement and so forth, some of these businesses might have trouble.
ED: A number of countries need to spur investments and keep the economy running. At the same time, not all of them have been very successful in dealing with inflation. So when I say inflation, what does that conjure up in your mind relative to China, relative to India, relative to the Southeast Asian countries?
AX: China inherently should not have high inflation rate because this is a country that can put up capacity very quickly so you’re not going to have inflation due to production bottlenecks, but the problem is that China has a labour shortage now. Wages for manual labour are rising faster than productivity, so it’s a source of inflation, and China has energy shortages so energy prices could continue to rise in the future. The two are about 50% of China’s total cost, so obviously China will have inflation for many years to come. That’s part of the adjustment, Chinese wages need to go higher so Chinese consumption can go higher to bring the economy to balance. That’s part of the process. Inflation is inevitable, but it doesn’t have to be very high inflation. That’s different from some of the economies that have infrastructure bottlenecks, or factories having trouble producing. In China’s situation, inflation is much more like what Korea and Taiwan had in the late 1908s and early 1990s, or Japan in the 1970s.
ED: Are there any more efficiencies to be built on China’s infrastructure?
AX: China now has the best infrastructure in the world, bar none. Coastal highways, for example, are very congested, but in a lot of places you cannot build enough highways to alleviate traffic. It’s just not possible. But in some areas, the highways are in surplus, for example. What I see is that China has one big bottleneck, and this is in its subways. In China we’re building subways rapidly but not fast enough. That’s leading to a lot of congestion in cities with heavy traffic congestion. So China needs to speed up subway development. That doesn’t cost a lot of money. Shanghai already has the largest subway system in the world and lots of cities in China will catch up. Within ten years all the subways will be built, so the road congestion will ease.
ED: And at the same time, the airports that are being built at the moment, is there any more upside for airports as well as for high speed trains, for example, and given the fact that because of safety issues the government has actually pulled back on some of these high speed train constructions that had been started.
AX: In terms of the number of airports, China is still small relative to the number of people compared to the West. The problem is that the congestion in the air is really causing delays everywhere. Flying is not the way forward for China. That’s why I don’t think China will build a lot more airports anymore. If you build airports and you cannot fly, what’s the point? High speed rail is the way to go. Chinese people will travel mostly on high speed rail in the future. There’s a safety concern – you have an accident, then you deal with it, and after a few times then the system is developed and it will run smoothly. That’s how it works in China. China is not like the Germany and Japan where they invest huge amounts of money to make sure the system is perfect and doesn’t have an accident for 30 years. That’s not China, they try to make it happen very quickly, they have an accident, then the whole system responds. After a few rounds, then the system is okay. That’s how it works in China.
ED: Now, you’ve been very positive generally about where China is today and the fact that its role as a global economic pillar will continue. What do you worry about or what are you concerned about in terms of China’s ability to sustain its growth going forward?
AX: There are two interrelated risks. One is to focus people’s attention on the bubble. Instead of focusing on real productive work, Chinese people get diverted by all these get-rich-quick schemes, so the economy becomes less and less productive. There you have financial markets or a stock property markets becoming bigger and bigger, that’s what’s been going on in the last few years.
The other is corruption, which distorts the economy and its debilitating for social stability. Corruption has risen because of the property market giving local governments easy money. That has led to a lot of corruption. Chinese people are hard-working and well-educated. The country has the best infrastructure in the world and the per capita income is only five thousand dollars.
There’s a lot of upside for China. Regardless of how weak the global economy is, if you have productivity, you will grow. So, maybe it’s not 12% anymore, maybe it’s 7% but that’s good enough. You go down because the system breaks down. So it’s really corruption and a bubble: this is the two headed monster that could bring down China.
2. The evolution of China’s economy in context of other markets
ED: In fact, now that the Chinese leaders are talking about increasing productivity and themes like that, it’s beginning to sound like a middle-income country rather than the world’s low-cost manufacturer. That, in turn, has had an impact on other low-income countries. You see production coming up again in countries like Vietnam, Indonesia, and so on. So what is the knock on effect for other emerging market countries as a result of this middle-income thinking?
AX: Three industries are leading in China: garments, shoes and furniture, these three are very large industries. At one point, the furniture industry alone accounted for one tenth of China’s trade surplus. These are very large industries, but they are all very labour intensive industries. The wages in Southeast Asia now are much lower than China. Before 1997, the wages in Southeast Asia were twice as high as in China. Now China’s wages are twice as high as Southeast Asia. So obviously, a lot of the industries are moving to Southeast Asia. Bangladesh, by the way, is coming up too.
But these countries are facing infrastructure bottlenecks; China succeeded because it was able to increase infrastructure very rapidly to accommodate all of the industries moving to China. Southeast Asia needs to do that otherwise they will miss another opportunity. For the remaining industries, like electronics, the whole chain is in China, and for heavy industries, say like ship-building and chemicals and so forth, they will remain in China because China still has a great advantage in terms of the cost of capital. And the wage level is still much lower than the rich economies like in Europe or the United States, total labour cost is one eighth or one ninth as much. So China is not losing competitiveness in most industries.
ED: Right, and do you think that the thinking at the policy-makers level, are they nervous at all that China might be losing competitiveness and that some of the manufacturing has actually reversed back to, especially in garments for example, to Indonesia, to Bangladesh, and so on?
AX: So far the central government is taking it easy. This trend is hitting some provinces like Guangdong very hard. In a lot of areas, you see that migrant workers have gone back. So a lot of those people in Guangdong today than before, and Guangdong’s economy is very slow. But the impact on the rest of China is more limited and if you go up north, where there is more concentration in electronic and heavy industries rather than in light manufacturing industries. There is a serious regional impact, so far the central government is still okay taking it as part of the adjustment. You cannot hang on to everything and at some point some industries will lead.
ED: The political leadership keeps looking at Japan and what happened to Japan in the 1990s, and then where Japan is today in terms of very moribund growth. Is there any chance at all of China becoming like Japan where you see considerable growth, and then a loss of a formula and a loss of direction?
AX: Well, China is not quite there. China’s per capita income is only $5,000, so the cost advantage is still there. When Japan lost it, Japan did not have the cost advantage. In the last 20 years, Japan has been losing competitiveness to China. They are holding on to upstream industries where they still have competitiveness, but the industrial base is shrinking, so Japan’s problem is not just a leadership problem. That’s what the financial market talk about, and Western economists think it’s a stimulus issue, you should stimulate, but actually Japan’s problem is a competitiveness problem. It’s not something you can solve through internal policy adjustment. One day China may lose competitiveness, but not in the next 10 years. And also China has an economy of scale, so the Chinese market can go on its own. Japan doesn’t have these advantages. China’s population may start to decline ten years later, but still, because of the size, there’s still room for productivity and gains. So beyond 2020, China may still be able to grow at the relative speed of like 5% for another ten years.
3. the challenges of China’s banks
ED: Now, given the fact that China has many different types of banks, which types are the most exposed to these property developers as you mentioned?
AX: There are five national banks and fourteen regional banks and lots of city commercial banks. Municipal banks are facing a lot more trouble, but they are much more linked to local governments so their loans are heavily influenced by local governments. We are already seeing some of those banks facing liquidity problems, they are not competitive in terms of attracting deposits because they don’t have good networks to service deposits, so they are dependent on interbank borrowing. And that market may not be sustainable. So a lot of the local banks will first face trouble.
ED: Right. What would a policy objective be on these banks that, because of their funding sources, potentially in trouble, and that sort of thing?
AX: A consolidation in China is inevitable and it’s not just in the city bank market, or in the property sector for example or in the steel sector or cement sector. We’re going to see a lot of consolidation over the next few years. The city banks need to consolidate into regional banks so that they can rise above the municipal governments so that their lending decisions in the future will be less influenced by local governments. That could be the way out.
ED: For national level policymakers, there’s the China that’s projecting itself on the global economy, and only recently the CICC chairman said that China would not get involved in the Eurozone problems or the US problems unless it’s able to achieve greater influence on the global marketplace. To what extent is this desire for global influence shape China’s ability or desire to pick up undervalued assets in the Euro’s own, for example?
AX: China has a capital surplus, so where to deploy this capital surplus is an important issue. And so far, the government has been able to buy government bonds basically, US treasuries or German bunds. Every time Chinese companies wanted to buy some important assets, usually they failed. The international environment is hostile to Chinese capital. So when the West needs money, they should not be so picky. “I point there, you should put your money there,” no, that is sort of condescending and China will not cave in to that. China needs to buy better quality assets rather than government bonds. The corporate sector is in better financial condition than governments. It makes more sense for Chinese money to buy bigger, global companies.
ED: So how do you think that conversation is evolving? Do you think that there is greater appreciation that the Chinese will be much more strategic in where they want to be involved?
AX: In the short run China has not been successful. In the future, it would be cautious. What I see is that China should, and they will turn to a Shanghai international board. China wants to set up an international board so that global companies can list in Shanghai and so Chinese surplus capital can buy the stocks of the global companies in Shanghai and the capitals in exported that way. And from the Chinese government’s perspective, it diversifies the risk bearing and lets Chinese people making the decisions rather than the government. So the government does not take all the risk on exporting capital. At the same time, the corporate sector is in better financial condition. The valuation is not that high so if Chinese people are getting to listed stocks, the risk is relatively low.
ED: This point about Shanghai being a global capital market centre, the Chinese government has articulated a desire for that to happen, but for it to become a reality, the government is finding it difficult to downsize its ownership of equities in the Shanghai stock market. It’s finding it difficult to allow the vagaries of the marketplace affect private investments in China because of the fall-back on government if things go bad. So, as much as they want to make it international, the whole process is not as straightforward as we think it is.
AX: The demand side for stocks in China is problematic so far, because the market has been very speculative. The government has been sucking a lot of money out of the stock market to subsidize enterprises, so obviously the market is has struggled. A lot of things need to change. The regulator is thinking about requiring companies to distribute the dividends, for example, that would give the market more confidence. Also, China is trying to introduce a 401K-type savings mechanism so that the people can buy stocks and avoid paying income taxes. That could boost the demand quite a lot. So there are still quite a lot of chips that the government has. One thing China has is surplus capital, so how to mobilize this surplus capital is the issue. So far, the Chinese government has not been successful at mobilizing that because the stock market has not been rewarding to investors. So they need both to make the stock market a better place to invest and also to introduce new channels for people to put money into the stock market.
ED: And also the liberalization of the renminbi, because if you go to make it an international stock market, the capital account has to be opened at some point. What do you think are the steps involved in making the capital account open in the future, in the near future?
AX: The capital account really requires the exchange rate to be free floating. China is not yet ready for that. A much safer bet is to have a local stock market exporting capital to global companies.
ED: So if there’s a global company that’s interested in listing in China, the real motivation is really access to Chinese capital?
AX: That’s correct. It’s a cheaper source of capital, so it benefits global companies.
ED: But the formula doesn’t hold, because then they become very domestic to China because the use of the capital is also domestic.
AX: That’s the stock market so far, in the future the global top 500 companies will all get listed in Shanghai. Over the next ten years, you’re gradually going to see that happening. The Chinese surplus capital will become shares in the global companies and the global companies will have more and more shares. Even majority shares will be owned by Chinese.
ED: And how would you juxtapose that to Hong Kong’s role as a capital-raising destination for China?
AX: Hong Kong so far has been an off-shore financial centre for China. It’s been a place for Western capital to get into China by buying Chinese stocks. That role is unlikely to change, and obviously the West doesn’t have the money like before so Hong Kong’s role may diminish. But Hong Kong, because it sits outside of China’s system, is not the best place for Chinese capital to go abroad because it’s not under the Chinese government’s control. So my bet is that Hong Kong will not become China’s global financial centre.
ED: Given the global economy as it is right now, what are you seeing in terms of the FDI flows into China: how much of that is hot money, how much of that is being invested in productive assets, is there a shift in the kind of FDI that’s been flowing into China?
AX: Multi-national companies still invest quite a lot. Just look at the announcements. For multi-national companies in China, their business in China is rivalling what they have in Europe and the United States. So this is serious business, this is no longer an emerging economy. For multi-national companies, China is becoming the most important source of profits, actually. You look at German car companies, they probably make half of their money in China. A lot of US companies make half of their money overseas, and quite a lot of that is from China. So China is a big source of profits for multi-national companies. There is a lot of hot money getting to the property market, but most of the FDI is genuine capital expenditure by global companies.
ED: And that hasn’t shifted? That hasn’t changed? Is there a softening of FDIs into China?
AX: A little bit, but multi-national companies are very bullish about China. The financial market goes up and down, up and down. Most multi-national companies are very bullish about China. Investment in China will continue at the very high level
