Thursday, February 6, 2014

Chinese inequality and the growth imperative

My recent posts about inequality generated an enormous amount of feedback (see Inequality: Does it matter? and Inequality and the genetic lottery: Two views). While those posts addressed the issue of inequality from what was mainly the perspective of the developed world, I got to thinking about the issues of inequality in China, which is one of the key global engines of economic growth.

The economic costs of inequality
From an economic viewpoint, income and wealth inequality can retard growth. Andrew Berg and Jonathan Ostry of the IMF wrote a paper entitled Inequality and unsustainable growth: Two sides of the same coin? Here are their primary findings [emphasis added]:
We found that high "growth spells" were much more likely to end in countries with less equal income distributions. The effect is large. For example, we estimate that closing, say, half the inequality gap between Latin America and emerging Asia would more than double the expected duration of a "growth spell". Inequality seemed to make a big difference almost no matter what other variables were in the model or exactly how we defined a "growth spell". Inequality is of course not the only thing that matters but, from our analysis, it clearly belongs in the "pantheon" of well-established growth factors such as the quality of political institutions or trade openness.
As well, Akio Egawa, a visiting fellow at Bruegel, wrote a paper entitled Will income inequality cause a middle-income trap in Asia? He concluded:
A sensitivity analysis for three Asian upper-middle-income countries(China, Malaysia and Thailand) also shows that the situation related to a middle-income trap is worse than average in China and Malaysia. These two countries, according to the result of the sensitivity analysis, should urgently improve access to secondary education and should implement income redistribution measures to develop high-tech industries, before their demographic dividends expire. Income redistribution includes the narrowing of rural urban income disparities, benefits to low-income individuals, direct income transfers, vouchers or free provision of education and health-care, and so on, but none of these are simple to implement.
For those who don't understand what a "middle-income trap" is. It is also known a a Lewis turning point when it runs out of cheap labor and growth becomes constrained because it can't move up the value-added ladder. The World Bank warned about China's middle-income trap in early 2012, as explained by Ambrose Evans-Prichard:
A joint report by the World Bank and China’s Development Research Centre has warned that the low-hanging fruit of state-driven industrialization is largely exhausted.

"As China’s leaders know, the country’s current growth model is unsustainable," said Robert Zoellick, the World Bank’s president. "This is not the time just for muddling through. It’s time to get ahead of events."

Countries across Latin America and the Middle East saw catch-up growth in the 1960s and 1970s but then they hit an invisible ceiling and have mostly languished in the "middle income trap" ever since, with per capita incomes far behind the rare "break-out" states such as Japan and Korea. "If countries cannot increase productivity through innovation, they find themselves trapped. China does not have to endure this fate," it said.

There is no doubt that the existing model has hit the buffers on every front and risks "unbearable friction" with trading partners unless the trade surplus is brought under control.

China is running out of cheap labour from the countryside and faces a "wrenching demographic change" as the old-aged dependency ratio doubles to North European levels within 20 years, and is fast depleting aquifers in the North China plains.

China rebalances growth
The Chinese leadership is well aware of these risks. The latest Five Year Plan addressed these issues by re-focusing the source of growth from export and infrastructure to consumer spending. Raising consumer spending involves increasing household income, which lessens the degree of inequality.

Beijing must have read, or been aware of the principles, behind the IMF and other studies relating inequality to growth. The objectives of their plan is laudable.

The corruption roadblock
Most of the academic studies relating to inequality and growth refer mainly to inequality caused by rapid urbanization and how inequality is heightened by the rural-urban divide. Branko Milanovic outlined the two causes of inequality in China:
[T]he increase in inequality is primarily due to a transition of labor from low-productivity agriculture to a higher productivity industry, not dissimilar from the evolution in the United Kingdom between the mid-1800s and early 20th century or for that matter in the United States between the late 1800s and 1927. China, like the United Kingdom and the United States, is following an intense inequality upswing of the Kuznets curve (named after Russian-American statistician and economist Simon Kuznets), characteristic for all, or most, fast industrializers. But after a certain points, or so Kuznets’s theory suggests, equalizing elements kick in: urban-rural gap declines as agriculture becomes more productive, more people get educated (and the skill premium declines), and greater wealth as well as the aging of the population lead to increased demand for social welfare and thus redistribution. This is basically the path that the US and the UK both took after they passed the (previous) peak of their inequality some 100 years ago. On that reading of Chinese inequality, one can be optimistic: there are strong forces that may curb it in the future. We already see some first signs of it: from rising wages to the demand to extend the social safety net beyond urban state-sector workers.

But there are reasons not to be so sanguine. Chinese inequality is truly spectacular in the sense that it has exacerbated all cleavages: the urban-rural gap in China is greater than in any country in the world; the gap between the rich maritime provinces and the poor Western regions is growing; the gap between capital-owners (in a nominally socialist state!) and farmers is enormous. Reversing inequality means reducing some of these gaps, and this is a very arduous task: who is going to stop a Shanghai-based highly educated technician from earning more or compel him to share it with a Hunan farmer? How will far-away poor provinces become more developed? Will rich provinces be willing to fund the needed transfers?
What is less discussed are the effects of corruption, which is prevalent in China [emphasis added]:
More importantly, the single-party political system has led to massive corruption at all levels of government, but particularly at the top. The recent scandal that revealed secret bank accounts in the Caribbean belonging to the families of the top politicians underlines the massive extent of corruption throughout the system. As with the top 1% in the United States, it is hard to see that those in China who have profited the most from inequality will vote for lower benefits, lower premiums, and fewer opportunities for corruption for themselves.
A recent FT editorial tackled this subject head-on [emphasis added]:
The Gini is out of the bottle. China’s leaders accept that income inequality, measured imperfectly (and in Beijing’s case dishonestly) by the Gini coefficient, is one of their biggest challenges. The State Council, or cabinet, has issued a 35-point income distribution plan aimed at narrowing a gap worse than Russia’s. At least in theory, Beijing is making a welcome shift of emphasis from crude top-line growth to more meaningful economic development. Everything, though, will depend on execution.

Inequality lies at the heart of social unrest in China. Ordinary Chinese distrust the process by which some in government or with close connections to power have accumulated vast wealth. Nice cars and fancy watches have quickly gone from signs of prestige worthy of flaunting to evidence of corruption to be hidden away. Last week, the government continued its supposed war on graft by banning advertisements that tout luxury items as “gifts for leaders”.
Social unrest - these are words that no Chinese leader, starting from the early emperors,  likes to hear. Yet, decades of growth oriented policies have encouraged corruption, just because of the nature of infrastructure-led growth.

Infrastructure spending a formula for corruption?
Rather than just focus on China, consider the case of the Sochi Olympics as an example of how corruption works. Bloomberg reported that the Sochi Winter Olympics cost is $51 billion, which is more than the $40 billion China spent on the Beijing games, a summer Olympics that was vastly bigger in scale. Now read these early reports from reporters about what Russia got for its money - shoddy athletes' quarters, incomplete hotels with no rooms, no lobbies and questionable water quality.

...and there are the facilities for athletes:

As this New Yorker article points out, corruption is an enormous problem at Sochi [emphasis added]:
Whatever happens on the ice and snow of Sochi in the next couple of weeks, one thing is certain: this Winter Olympics is the greatest financial boondoggle in the history of the Games. Back in 2007, Vladimir Putin said that Russia would spend twelve billion dollars on the Games. The actual amount is more than fifty billion. (By comparison, Vancouver’s Games, in 2010, cost seven billion dollars.) Exhaustive investigations by the opposition figures Boris Nemtsov, Leonid Martynyuk, and Alexei Navalny reveal dubious cost overruns and outright embezzlement. And all this lavish spending (largely paid for by Russian taxpayers) has been, as Nemtsov and Martynyuk write, “controlled largely by businesspeople and companies close to Putin.”
That's because it's easy for government officials to siphon off funds in construction and infrastructure projects [emphasis added]:
What makes construction so prone to shady dealings? One reason is simply that governments are such huge players in the industry. Not only are they the biggest spenders on infrastructure; even private projects require government approvals, permits, worksite inspections, and the like. The more rules you have, and the more people enforcing them, the more opportunities there are for corruption. And, in many countries, the process of awarding contracts and permits is opaque. As Erik Lioy, a forensic accountant and fraud expert at Grant Thornton, told me, “When it’s not clear how projects get approved, people assume the worst, and that provides incentives to do a bribe or kickback.”
$51 billion may sound like a lot of money, but that's a drop in the bucket compared to what China spent in infrastructure projects in the post-Lehman Crisis era. Given how easy it is for Party officials to line their own pockets, what's the effect of corruption on inequality and social stability in China? A commentary by Yanzhong Huang of the Council on Foreign Relations discusses the challenges facing China, among which is inequality and corruption [emphasis added]:
The economic boom in the past decades has also been associated with a widening wealth gap. According to a report from China’s Southwestern University of Finance and Economics, the Gini coefficient – measured on a scale of 0 to 1 with higher figures associated with greater inequality – was 0.61 in 2010. While it’s not atypical for a fast developing economy to experience increasing inequality, China’s level of inequality is comparable to that of the Philippines and Russia and much worse than that of Japan, the United States and many countries in newly liberalized Eastern Europe. Based on the study of Wang Xiaolu, an economist at the independent National Economic Research Institute in Beijing, analysts have estimated that the wealthiest 10 percent of Chinese earned 65 times that of poorest 10 percent. High inequality has increased the danger for China to tumble into the “middle-income trap” – getting stuck at a level of development that falls short of that of more advanced economies. Worse, the government’s failure to address this social crisis may pit the underprivileged against an entitled minority.

The existing sociopolitical crises in China are exacerbated by entrenched corruption. The market-oriented economic transition has created new opportunities and made corruption more pervasive than in previous decades. More than 10 years ago, two eminent Chinese scholars suggested that some 80 percent of the Chinese government officials were corrupt, and the situation has not improved. A conservative estimate by the Carnegie Endowment for International Peace put the cost of corruption in China at about 3 percent of GDP annually, or about $200 billion. Similar to a Greshamite system, which rewards bad behavior, making it rampant and driving out good behavior, China’s corruption has reached a level that touches almost every sector and every member of the society. According to a nationwide survey conducted in October 2011, about 82 percent of responders agreed that China has experienced a significant moral decline over the past decade, and more than half of respondents did not think that complying with ethical standards was a necessary condition for success.
Just imagine the scale. The corruption cost estimate of $200 billion a year dwarves the Sochi bill of $51 billion.

Moral hazard + Slowing growth + MIA rebalancing = ?
Here's the problem. One of the necessary ingredient in rebalancing China's growth path is a resurgence in consumer spending and a reduction in inequality. How will China do that with roughly 80% of government officials at the trough? This may be a case of where leadership commands, but the bureaucracy resists.

Already, the stresses are building. This FT Alphaville post rhetorically asks "Moral hazard + Slowing growth + MIA rebalancing = ?". First of all, Fitch warned about the moral hazard created by the recent backdoor bailout of the failed “2010 China Credit / Credit Equals Gold #1 Collective Trust Product”:
However, by bailing out investors in this particular instance, the authorities are perpetuating moral hazard within the Chinese financial system – and this risk may in fact have become a whole lot bigger. There was an important difference with this product: it appears to have been sold through bank branches of ICBC, but it was not a bank managed product. So in this case it was one step further removed – issued by a trust company, ChinaCredit Trust, which is independent of any bank, has historical links with the authorities, and counts The People’s Insurance Company of China (PICC) and other SOEs as its largest shareholders.

As a result, we think the authorities have missed a chance of putting a clear marker in the sand that non-bank products would certainly not be supported. But what they may have also created here is the impression that investments in bank-managed products would most certainly be made whole – at least for the time being. Moreover, this event will increase systemic risks down the road – given the very high (and still rapidly growing) levels of credit in the system. As a result, we believe these repayment difficulties are likely to become more frequent.

BNP Paribas pointed out that Chinese growth has been slowing:
As Rudi Dornbusch used to remark, it takes two nominal variables to make a real variable so China’s debt dynamics in the coming years and the speed at which ‘real debt’ continues to rise will necessarily also be conditioned by prospects for nominal GDP growth. A second misleading and persistent canard is that the Chinese economy will effortlessly be able to sustain relatively rapid top-line growth despite accumulating evidence to the contrary. Nominal GDP growth has slowed sharply in recent years as diminishing returns to China’s investment-led growth model have increasingly set in.

Accelerating malinvestment in frequently unfinished real estate developments and white elephant infrastructure projects has seen the credit efficiency of growth plunge while serial overcapacity in basic industries has led to engrained industrial deflation. PPI inflation has now been negative for 22 months with the latest survey evidence suggesting that deflationary pressure is again re-intensifying (Chart 3). The net result is that China’s nominal GDP growth has struggled to reach 10% in each of the past two years; the worst performance outside the global financial crisis since the late 1990s. The bottom line is that debt service capacity is diminishing even as debt service obligations continue to rise unsustainably fast.
What's more, the much trumpeted "rebalancing" is MIA:
A third widespread canard that bedevils the macro-debate over China is the view that slower economic growth implies rebalancing. Given an investment share of close to 50% of GDP and a household consumption share of around 35%, slower growth is a necessary but far from sufficient condition for rebalancing away from investment towards consumption. Despite a barrage of media headlines, there is little, if any, evidence of rebalancing towards more consumption-driven growth taking place. Rather, the Chinese economy over the last year or so appears to be getting the worst of both worlds; slower growth but investment-dependence becoming ever more extreme…

Crash landing or long landing?
Unless Bejing can successfully navigate the hazards of the need to rebalance growth while maintaining social stability, it either risks a crash landing, where the economy craters into negative growth, or a long landing, where China lapses into the middle-income trap.

The first scenario, while painful, would present a generational buying opportunity for investors as it allows China to clean up the excesses created by the previous growth phase. The second could be enormously bullish for America, as the combination of falling commodity prices from lower Chinese demand, which lowers input prices, and a resurgence of onshoring, which would boost consumer incomes, creates a New Renaissance for the US economy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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