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Is the Chinese boom sustainable,
or is China headed for a slowdown or even a financial crisis? A debate is
taking place in the Far Eastern Economic
Review over how the Chinese boom is being funded: bank credit expansion
or retained earnings. Hofman and Kujis of the World Bank credit retained
earnings by highly profitable Chinese businesses in Profits Drive
China’s Boom ($).
Investment banker Wei Jian Shan
responds with The
World Bank’s China Delusion. (See also Stephen Roach's comment
on the two articles).
Shan points out serious problems
with the World Bank economists' paper. One, that the enormous bad loan
problem is inconsistent with the picture of well-capitilized Chinese firms.
Here Shan's article parallels the work of Brad Setser (which I commented on here). Setser discussed
the bad loan problem in the Chinese banking system resulting from massive
credit expansion, non-market interest rates, and politically-driven lending.
Shan presents the results of his
research on the Chinese government's database of Chinese firms' financials.
For the details see his article. In short, he finds several discrepancies in
the data that result in an exaggerated value for return on equity, a
dimensionless measure of how efficiently firms use their capital.
Shan finds that
industrial firms are indeed suffering from falling
profit margins caused by biflation. As seen in the accompanying graph, gross
profit margin has been declining steadily between 2000 and 2005. The margins
for Chinese industrial firms have been squeezed because relentless capacity
expansion has created, on the one hand, high demand for raw materials and
increased prices in the global market and, on the other, overcapacity that
has depressed prices of finished products.
Shan continues:
The profitability of Chinese industrial firms, or their
retained earnings, cannot be the main drivers of China’s
capacity-expansion and fixed-asset investment. There is no question that China’s growth continues to be financed by banks. In fact, total investment by
industrial firms likely accounts for no more than 20% of the country’s
annual fixed-asset investment. Bank loans, on the other hand, are greater
than China’s GDP. Furthermore, off-balance sheet credit can be as much
as 80% of loans. Combined, bank’s total credit likely equals two times
GDP. The financial means of industrial firms, whose total net asset value is
no more than 50% of GDP, or approximately one year’s worth of
China’s investments, pale in comparison.
Shan is describing a
disproportionality between different parts of the productive structure. The
rising costs at the for inputs at the high end of the structure in the face
of falling prices for output due to overcapacity in the next stage is exactly
what an Austrian economist would expect to occur toward the end of the cycle
of a credit-driven boom. This further supports the view that it is bank credit
expansion driving the Chinese economy.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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