china at a crossroads: key challenges

Alicia Garcia-Herrero

Chief Economist Emerging Markets BBVA

Real Instituto Elcano, 4 noviembre 2014

China at a crossroads:Key challenges

What is really the issue?

• Not even the riks of a banking or corporate crisis

• Possibly not even a political disruption

—It boils down to fiscal and social (medium term) issues

Is China´s leadership aware?• Fully!• Good example is the joint World Bank-NDRC Report China 2030

• The reformist faction of the leadership uses the World Bank to push reform ahead of November 2013 Plenum

• Key messages in ReportoReform towards a market-based economyoStrengthening fiscal systemoContinued globalizationoAn open innovation system linked to the global R&D networkoGreen developmentoEqual opportunity and social protection

–In line with our ideas but with clearer grouping: social and fiscal

The fiscal world• China’s publich debt nominally low but whith huge contigent

liabilities

• Which are the key sources of such liabilities?

1. The banking system

2. Corporate debt in a “full bailout” and SOE model

3. Local government indebtness

4. Pension bomb

5. Environmental costs

The social world• Labor factor has been under paid in a capital intensive model• Increasing income inequality not helping to rebalance towardsconsumption• Rebalancing needed a change• Happening on the income side

• Huge real wage increases• Productivity nof following

• But not on the wealth side• Negative real interest rates on savings

• Excess labor becoming a story of the past• Labor factor more demanding• Aging of such labor factor increasing the collateral cost

The bankings systemThe Acheles hill in the early 2000s coming back

to the forefront

Bank restructuring before global crisis nominally succesful but in a costly way

• Large fiscal cost deluted by high nominal growth

• Entrenched corporate governance problems

• Signalling effect that the state can take care of banks’ problems at no

cost for its management

Complex bank restructuring process dilutes responsibilities• Since the 1980s, financial sector in China is a central element but trapped in stimuli-NPLs-restructuring cycles.

• In 1998, the PBC began what was meant to be a multi-year restructuring process. The SOCB restructuring was carried out in four waves, each with four sequential phases:

And facilitates hiding the fiscal losses

• During the banking reform, the authorities have injected (mainly FX reserves) into major commercial banks around 7% of GDP in terms of capital.

But problem is repeating itself • Moral hazard and the authorities push for the banks to intemediate the huge 2008-09 stimulus package behind’s Even in our baseline scenario, banks’ profit is likely to slide into a multi-year decline

• We estimate that banks need additional RMB 1.5-2.0 trillion to replenish capital over the next five years in our base scenario, which is higher than the aggregate capital of RMB 1.2 trillion raised since 2010.

2011 2012 2013 2014 2015 2016 2017 2018GDP grow th 9.2% 7.8% 7.7% 7.2% 7.0% 7.0% 6.8% 6.5%CPI average 5.4% 2.6% 3.0% 4.0% 4.0% 4.0% 4.0% 4.0%

Credit grow th 19.2% 17.9% 14.3% 13.5% 13.0% 12.5% 12.0% 11.0%Net interest margin 2.7% 2.6% 2.3% 2.0% 1.9% 1.8% 1.7% 1.6%

% of fee and investment Income 33.8% 35.0% 36.5% 38.0% 40.0% 40.0% 40.0% 40.0%NPL ratio 1.0% 1.0% 1.0% 1.3% 1.8% 2.3% 2.7% 3.0%

Provision / NPL 278.1% 296.0% 282.7% 220.0% 170.0% 150.0% 150.0% 150.0%Profit growth 36.3% 19.0% 14.5% 9.3% -14.7% -7.7% -8.7% 4.5%

Note: Net Interest margin assumed to decline to 1.6% due to interest rate liberalization, close to average NIM for high-income countries

However, risks to the baselinescenario coming from other quasi-fiscal challenges

Three key pending issues1. Local government debt: the mistery of LGFVs

2. Corporate debt

3. Shadow banking

LGFVs: what is their role?• LGFVs have mushroomed as a way for local governments to finance the projects approved under China’s huge

fiscal package.

LGFVs are:

• Owned by local governments

• Funded by banks

• Loan guarantee by local governments

• Closely connected to land and housing markets

• Closely connected to local economic growthLocal GDP

subsidiesasset injectionguaranteetax benefit, etc.

LGFVs

public utilities loaninfrastructure funding bondpublic transportaion equity/trustpre-development of land & industrial parks

BanksSource: BBVA Research

ownership

Development Projects

with revenues from land sales, taxes, and fees, etc.

Local Governments

LGFVs indebtness adds pressure to banks’ asset quality

• The latest audit of local government debt shows an increase to RMB 17.9 trillion at end-June 2013• A clean-up of local government debt may require central government funds, and bank write-offs

Local government debt has risenSource: BBVA Research

The government estimated around 20% of LGFVs debt at risk Source: BBVA Research

Why LGFV´s issue needs to be solved?• Crowding out private investment, and creating fiscal and bank

problemso How losses are going to be distributed between the state and the banks is the key question

• Since incentive is to continue to invest in infrastructure, creating

social/environmental problems o Land sales accounted for around one-third of local governments’ budgetary revenue, which

makes local governments as a key player in creating bubbles in the housing market.

o A hard landing in the housing market would affect their finance very negatively.

How to address it?– Scenario 1: Government bailout

• If government assumes all local government debt, including both agency debt and problem LGFV debt, its debt would increase to 53% from current level of 22%

– Scenario 2: Bank write-offs of LGFV debt• Banks provision and write-off these loans in next five years • Banks need another RMB 1.4 trillion during the period to maintain its CAR ratio

– The likely outcome is a combination of the above two extreme scenarios. – Local governments need to sell their assets to pay the bill.

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Corporate debt: another drag for asset quality• As a share of GDP, China’s corporate debt is high by international standards.• High corporate debt may constrain growth and weigh on bank asset quality

Corporate debt level is high by international standards… Source: BBVA Research

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…as corporate debt stress ratios rise to new highsSource: BBVA Research

Shadow banking first seen as a solution and increasingly as a huge problem

• Its size has grown rapidly in recent years as banks circumvent tightening regulations

• Involvement of banks in shadow banking activities could eventually impact their balance sheets.Shadow banking activities have risen…

Source: Wind, CEIC, PBoC and BBVA Research estimates

…leading to an increase in the size of the shadow banking sector in the

economySource: PBoC and BBVA Research

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Looming pressure on China’s pension system stemming from ageing population

Projection of demography in China (Mn People)Source:UN Statistics Division and BBVA Research

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Pension deficit?

China’s one-child policy has led to lower birth rates, which have in turn reduced the number of working-age population, putting pressure on

China’s pension system.

China’s one-child policy has led to lower birth rates, which have in turn reduced the number of working-age population, putting pressure on

China’s pension system.

In 2010, the elderly (60+) accounted for 12.5% of total population. According to UN

estimates, this figure will increase to 31.1% in 2050.

In 2010, the elderly (60+) accounted for 12.5% of total population. According to UN

estimates, this figure will increase to 31.1% in 2050.

Under the current pension system, four working people support one retiree, but this

ratio could change to 1 : 1.5 by 2050

Under the current pension system, four working people support one retiree, but this

ratio could change to 1 : 1.5 by 2050

According to the Chinese Academy of Social Sciences (CASS) as many as 14 provinces

are currently experiencing pension deficits. On a nationwide basis, the pension surplus at the

end of 2013 stood at RMB 3.1 trillion (US$ 500 billion). Nearly a decade ago, estimated

deficit already 6 trillion RMB (MOHRSS) up to 9 trillion RMB (World Bank). Probably much

more now

According to the Chinese Academy of Social Sciences (CASS) as many as 14 provinces

are currently experiencing pension deficits. On a nationwide basis, the pension surplus at the

end of 2013 stood at RMB 3.1 trillion (US$ 500 billion). Nearly a decade ago, estimated

deficit already 6 trillion RMB (MOHRSS) up to 9 trillion RMB (World Bank). Probably much

more now

Pension reform may help to alleviate some of the budget pressures

• Gradually rising retirement age o Europe´s problems look moderate compared with the 55 years retirement age for men and 50 for women o And not revised since the 1950’s despite life expectancy has risen from an average of 45 to over 73o The key was the limited coverage of the population but rural pension reforms opens venue for additional liabilities

• A looser stance on China’s one-child policy may help neutralize some of the pressures stemming from unfavorable demographics but will increase pension bill

• Allocating part of the government-held shares of listed state-owned enterprises to the national social security network to raise its profitability but can also be a source of SOE support at a time of huge leverage (i.e., will dividends continue?)

• Resolving the urban-rural divide by unifying the various components of the pension system under one. Pension harmonization would also help to remove barriers to labor mobility.

Ageing population leads to labour shortages and rising wages

Urban labor demand-supply ratio in China Source: CEIC and BBVA Research

China real wage index (1978=100)Source: CEIC and BBVA Research

A shrinking labor pool and higher labor costs have played a role in eroding China’s competitiveness as a global manufacturing hub versus its competitors

A shrinking labor pool and higher labor costs have played a role in eroding China’s competitiveness as a global manufacturing hub versus its competitors

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CN: City Labor Market: Demand-Supply Ratio

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CN: Real Wage Index: Urban Non-private

Not only increasing labor shortagebut in a dual (and costly) way

• In contrast to the shortage of migrant labor, college graduates suffer from unemployment.

• The quality of college graduates may have deteriorated due to expansionary enrollment policy. Job applicants may not possess skills desired by employers.

Excess supply of college graduates Source: CEIC and BBVA Research

Excess supply of high school/vocational training Source: CEIC and BBVA Research

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GINI index by counties (2013)Source: World Bank, NBS, HKMA, CIA Library and BBVA Research

High Income Disparity in China shown as GINI Index. Potential undervaluation of Chinese Gini

Index according to some sources

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Propensity to consume in urban China byincome groupSource: CEIC and BBVA Research

Propensity to consume decreases with income level. Reducing inequality and increasing market access to

low income households could provide boost to domestic consumption

Rising income inequality to hamper domestic consumption and lead to social discontent

The great rebalancing project and the social challenges: what to do?• Public spending on social welfare could help mitigate the

negative effect of inequality, and therefore increase domestic demand.

• Measures taken very limited aware of the huge fiscal cost of generalizing them

o Subsidize consumption in rural areas (specially white goods)

o Offer minimum pension and health services (under a pilot project)

• All in all, China is lagging well behind in public spending on social welfare: 14% of GDP (which probably includes other issues) vs. 20% of GDP by OECD countries.

Before the fiscal and social costs surface fully, China’s growth model slowly wearing down

Diminishing returns on capital investment (y/y %)Source: BBVA Research

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CAPITAL LABOUR TOTAL FACTOR PRODUCTIVITY

China’s diminishing returns on capital point towards a loss of competitiveness


In order to sustain growth in the long term, China will have to implement deep reforms that

promote technological innovation



Every extra dollar in capital investments leads to decreasing GDP gains


Neither rebalancing not technical innovation seems to be taking over

…but patent registrations per Mn ppl (2012) reflect relatively lower technology levelsSource: WIPO and BBVA Research

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Patent registrations have increased significantly in nominal terms …Source: WIPO and BBVA Research

Increased investments have not translated into significant technical advancesIncreased investments have not translated into significant technical advances

In order to sustain growth in the long term China will have to implement deep reforms that promote technical innovation

In order to sustain growth in the long term China will have to implement deep reforms that promote technical innovation

China is posed to take over the US in terms of GDP in 2014, but technology levels remain low versus other advanced economies

China is posed to take over the US in terms of GDP in 2014, but technology levels remain low versus other advanced economies

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Overall, both fiscal and social issues and the model´s waning call for bold changes• More market based economy

– SOE reform (dismantling oligopolies) – At least transfer of dividends from SOEs to State (improvement in public finances freeing space to finance larger welfare state).– Privatization and opening up to foreign competition needed

Plenum announces more competition between private and public corporations but not a revolution

• No larger role for foreign investors• No privatization

• Government shifting towards providing intangible public goods

– Some measures during global financial crisis but very limited – Not much more announced in 2013 Plenum– Rural pensions– Affordable housing Financial reform (specially liberalizing the deposit rate) key for savers not to lose purchasing power

The leadership is awarebut the boldness to act shiftly might not be there

Challenges remain challengesbut for how long?

The return on capital has started to decline Diminishing returns on capital investment (y/y %)Source: BBVA Research

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Technical innovation remains relatively lower than that of regional competitors

…but patent registrations per Mn ppl (2012) reflect relatively lower technology levelsSource: WIPO and BBVA Research

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Patent registrations have increased significantly in nominal terms …Source: WIPO and BBVA Research

Thank you!

For comments and questions [email protected]

November 2014

china at a crossroads: key challenges

Economy & Finance

local governments

local government indebtness4

fiscal losses

offslocal government

fiscal package

banks profit

lgfvs issue

social world labor factor