Posted : 2010-03-22 18:21
Updated : 2010-03-22 18:21

Lurking Costs of Growth in China

By Robert L. Eberenz III

As the ill-effects of a global financial crisis became evident to world leaders in late fall 2008, export driven economies used trade surplus coffers to stimulate their economies.

In the People's Republic of China (PRC), Premier Wen Jiabao's words fell like heavy boots on an ant hill, as decrees began to waterfall through the ranks of the quasi-communist CCP (China Communist Party).

First, the PRC spent a tangible magnitude of cash, $600 billion, equal to 13 percent of the country's 2008 GDP, which was split between direct infrastructure investment and rebates on specific consumer goods.

Second, governors set record low interest rates and lax loan requirements, with PRC guarantees to back the underwriting. This pure recipe for growth has worked in the short term as real estate appraisals in Hong Kong are 30 percent higher than last year, and China's money supply rose by 27.7 percent in 2009.

At face value China's economy saw GDP growth above 10 percent in 2009, while asset bubble fears barely made footnotes, given the apparent success of the ``post-Lehman'' economy.

Unfortunately, the activity on the ground floor of the public sector may house discrete risks facing China's recovery. Public finance in China has for years been an issue among World Bank discussions, but arguments have proved too flimsy, absent of visible negative outcomes.

Rising Inequality

For all of its size, voracious growth, and absolute authoritarian government, China remains a very un-united place. Contrasting claims of bustling internal demand, due to a consumer renaissance in China's middle class, the following points warrant attention:

1. The wealthiest Chinese province had 13 times the per-capita GDP and 8 times per-capita spending of the poorest province. Likewise, the richest county had approximately 40 times per-capita spending of its poorest counterpart in 2003. (World Bank 2002)

2. At the rural level, where 607 million citizens (46 percent of the population) live, the majority of education and health expenses are paid for out of pocket. In 2005, urban areas housed 80 percent of health care facilities, where only 40 percent of the population lived. (People's Daily online, January 11, 2005)

3. As of 2004, spending expenditures for education were borne 78 percent by townships and 2 percent by the central government, while the school system remained centrally unregulated. (World Bank 2008)

4. From 1993 to 2003, the top tiers of government in China have greatly increased revenues through new tax programs, yet lower tiers of government are receiving a 5 percent lesser share of expenditures. (World Bank 2008)

These conditions are synonymous with a developing nation, and were to be expected in China seven years ago, but regional wealth disparities and the organizational structure of public finance in the PRC have led to public finance shortfalls, which are surfacing right now.

Recently, decrees from top Chinese leaders and World Bank representatives for higher outlays in education, health care, and infrastructure projects have been announced.

Unfortunately, as orders funnel down from Beijing to provincial directors, county offices, and villages, more is asked of the lower tier while fewer funds are given. The townships are left with beleaguered budgets, led by individuals focused on promotions rather than sustainability.

As a result, the prospects of each town in China are directly dependent on industry or natural resources at their disposal, which they then use to leverage financing for basic social services.

Path of Least Resistance

The methods, by which towns fill the gaps between revenue and expenditure, are referred to as ``off budget sheet'' endeavors.

These sorts of activities are highlighted by Northwestern University Prof. Victor Shih's book, ``Factions and Finance in China,'' as he relays firsthand accounts of openly abused relations between private enterprises and public financial policies in the PRC.

Off balance sheet financing occurs when (a) local governments trade private loan guarantees for kickbacks, (b) invest in private projects with government funds to meet their required levels of economic growth, or (c) use land rights as collateral to finance public services.

Chips Falling

On March 8, China announced it would ``nullify all guarantees [that] local governments have provided loans taken for their finance vehicles.'' These ``vehicles,'' Prof. Shih claims, amount to approximately 11.4 trillion yuan ($1.7 trillion) in 2009.

According to Chinese official Zhou Xiaochuan, land guarantees made by local governments as a form of capital down payment for off balance sheet private loan agreements ``may pose risks for the nation's banks.''

In a country where average real estate prices rose in 70 major cities by 10.7 percent year-on-year in February 2010, it would appear that appraisals of land collateral may propose serious risks to the financial system.

Regardless of obvious parallels to the housing bubble in the United States from 2004 to 2007, the real concern with a Chinese-led global recovery is the uncertainty tied to a centrally planned economy that remains exceedingly opaque.

Behind the ``red veil,'' economic data is inconsistent, interest rates are manually set, and currency exchanges are pegged or de-pegged, in the best interest of the state.

Many are glad to have seen the end of the harsh financial contraction of the past two years, and have too tamely welcomed the Chinese-led recovery. Contrarily, this analyst would implore each investor and lawmaker to take a closer look at where this growth is founded.

Robert L. Eberenz III is editor and senior analyst of Diamond Slice, a financial market analysis service. He can be reached at
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