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China's Problem Economy

Although the exploding Chinese economy may have been the envy of the world, there are potential economic, political and demographic problems. Major areas of concern are that the economy might be overheating, that countries on which China relies to buy its exports may become protectionist, that growing economic inequality could produce internal strife, and that the rapid aging of the population may create economic difficulties. Other significant problems exist as well. The regulatory environment is uncertain, and a large unwieldy government bureaucracy continues to play a crucial role in many areas of business operation.

China’s total corporate, household and government debt more than doubled, from 141 percent of GDP in 2008 to 335 percent of GDP in 2020, and might start to look a lot like Japan, which reached an all time high of 372% debt-to-GDP level 2018. Japan's national debt ranks first among countries with the highest debt levels in the world, far surpassing the debt levels of Greece. The CBO projects that US debt-to-GDP will hold between 101% and 107% through 2031. However, the CBO also projects that, unless things change, the US would reach 195% in 2050.

The beneficial ownership of Chinese companies can be opaque. It is usually hidden behind corporate shells, which invariably lead to a government entity. The government entity in turn is often controlled by a relative of a Chinese leader.

During the CCP 19th Party Congress held in October 2017, CCP leadership underscored Party Chairman Xi Jinping’s primacy by adding “Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era” to the Party Charter. In addition to significant personnel changes, the Party announced large-scale government and Party restructuring plans in early 2018 that further strengthened Xi’s leadership and expanded the role of the Party in all facets of Chinese life: cultural, social, military, and economic. An increasingly assertive CCP caused concern among the foreign business community about the ability of future foreign investors to make decisions based on commercial and profit considerations, rather than political dictates from the Party.

The PRC legal system is based on written statutes and prior court decisions have limited value as precedents. Since these laws and regulations are relatively new and the PRC legal system continues to rapidly evolve, the interpretations of many laws, regulations and rules are not always uniform and enforcement of these laws, regulations and rules involves uncertainties. Furthermore, the PRC legal system is based in part on government policies and internal rules (some of which are not published in a timely manner or at all) that may have retroactive effect.

A lack of transparency in the investment process and lack of rule of law in China’s regulatory and legal systems leave foreign investors vulnerable to discriminatory practices such as selective enforcement of regulations and interference by the Chinese Communist Party (CCP) in judicial proceedings. The PRC legal system is less developed and is fraught with uncertainties, which may limit the ability to enforce rights under contractual arrangements. Further, there are limited precedents and formal guidance on the interpretation and enforcement of contractual arrangements with variable interest entities in the PRC. In relation to the certainty of arbitral awards in the context of legal action, the final outcome is uncertain.

During the CCP 19th Party Congress held in October 2017, CCP leadership underscored Party Chairman Xi Jinping’s primacy by adding “Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era” to the Party Charter. In addition to significant personnel changes, the Party announced large-scale government and Party restructuring plans in early 2018 that further strengthened Xi’s leadership and expanded the role of the Party in all facets of Chinese life: cultural, social, military, and economic. An increasingly assertive CCP has caused concern among the foreign business community about the ability of future foreign investors to make decisions based on commercial and profit considerations, rather than political dictates from the Party.

During the CCP 19th Party Congress held in October 2017, CCP leadership underscored Party Chairman Xi Jinping’s primacy by adding “Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era” to the Party Charter. In addition to significant personnel changes, the Party announced large-scale government and Party restructuring plans in early 2018 that further strengthened Xi’s leadership and expanded the role of the Party in all facets of Chinese life: cultural, social, military, and economic. An increasingly assertive CCP has caused concern among the foreign business community about the ability of future foreign investors to make decisions based on commercial and profit considerations, rather than political dictates from the Party.

By 2017 financial risks were mounting on the back of rising enterprise debt and over-capacity in some sectors, as well as real estate price exuberance. Debt owed by non-financial firms in China, encouraged by implicit state guarantees to state-owned enterprises (SOEs) and public entities, reached 170% of GDP in 2016, the highest level among leading economies. Two-thirds of enterprise debt is owed by SOEs. Steps to tackle financial risks should include gradually removing implicit guarantees to SOEs and restricting leveraged investment in asset markets.

These so-called ‘zombie’ firms should be allowed to exit and get out of the market, or reform or consolidate. The Chinese leadership has not moved forward on SOE reform because the leadership does not believe in this approach. Instead, they want to keep SOEs afloat because they are keys to the Communist Party’s power and international influence.

The tax and transfer system reduces income inequality less than in other leading economies. For example, many low-income households pay a higher share of income in social contributions than richer ones. The Survey suggests basing those contributions on actual income earned, but also broadening the personal income tax base and increasing tax progressivity. Vast disparities also exist in access to quality education. The Survey argues for increasing public funding for childcare and encouraging the participation of rural children in early childhood education. It also advocates greater central and provincial government social assistance transfers to poorer areas.

The Shanghai Composite Index dropped by a third from the middle of June 2015 to early July after rising around 150 per cent over the past year. Fears of a deeper plunge and uncertainty over policy have fuelled wild volatility, with prices at times swinging in a 10 percent range in a single day.

China's securities regulator relaxed rules on using borrowed money to speculate on stock markets on 03 July 2015, the latest in a flurry of government measures aimed at stemming two weeks of panic selling that posed a growing risk to the world's second- largest economy. But the move failed to revive confidence, as the Shanghai Composite Index fell below the 4,000 level for the first time since April 2015, with margin traders continuing to unwind positions amid doubts over the effectiveness of the measures to support equities. The sudden market slide was likely a contributing factor to the central bank's decision to cut interest rates last weekend for the fourth time since November 2014.

On 06 July 2015 there was a mixed result after the government moved to halt the three-week stock slide by suspending fresh initial public offerings and backing a plan by brokers to buy shares.The China sell-off — the steepest plunge in two decades — since June 12 had seen as much as $3 trillion shorn from the mainland market. Trading was dominated by domestic retail investors who had shifted their money from the deflated Chinese property market.

Consumption accounts for a starkly low chunk of China's GDP, about 35 percent. Normally a 50 percent figure of consumption is a nation in distress.

Michael Pettis wrote in July 2013 that "China must rebalance. Rapid consumption growth, not investment, must drive future growth, or else debt-capacity limits will cause a sharp contraction in GDP... the continued rapid increase in Chinese investment could no longer generate the same sustainable increases in real worker productivity. As this happened it became increasingly evident that capital was being misallocated on a large and growing scale.... at least part of the investments of the past decade or more, whose value to the economy was calculated as the cost of the inputs and not as the value of the outputs, resulted in overstated GDP."

Economists and the government have known for years that China's economic data is inflated, usually by provincial and local officials seeking promotion by claiming higher production and growth rates. In one case reported by National People's Congress (NPC) investigators and state media in 2009, officials pressured data collectors in southwestern Chonqing Municipality to multiply the output of an enterprise by a factor of 10. In 2012, the Communist Party flagship paper People's Daily charged local officials with fabrication to enhance their careers. "In some regions or public organizations, leaders are engaged in lying, empty talk, fabricating statistics, or trumping up political achievements," the editorial said. The government tried to stop the practice with a new statistics law that provides harsher penalties for falsification. In February 2012, the NBS also launched a direct reporting system for 700,000 companies accounting for some 80 percent of GDP to bypass local distortions. But the tampering has continued with reports of "convergence" efforts by local officials, pressing companies to report figures that match inflated data from the past to protect the local authorities.

Local party officials and local government officials are powerful and often corrupt and obstructionist. Within the banks themselves, corruption is widespread. There is also significant corruption and cronyism in the four asset management companies created by the government to dispose of the banks' bad loans. The management companies are staffed with many of the same bankers who made the bad loans in the first place; and not surprisingly, the corruption and self-dealing have continued.

China is the world's second-largest bad-loan market (after Japan). S&P estimates that there are approximately $700 billion in bad loans in China; other analysts suggest a higher figure. The government has pressured the state-owned banks to dispose of bad loans in preparation for their IPOs, and it has created four asset management companies to dispose of the loans. Through the end of 2004, the companies had sold only one-third of the $230 billion in bad loans acquired from the banks since 1999.

Some foreign banks have shown interest in this area. Citigroup purchased over 16 percent of Silver Grant International, a real estate affiliate of China Cinda Asset Management, one of the four asset management companies. Credit Suisse First Boston has also been active in this market, recently purchasing a 2.4 billion yuan ($290 million) package of distressed loans from China Orient Asset Management Corporation, another of the four asset management companies.

China's growth since the early 1980s has been phenomenal. Much of this growth is investment-based: gross fixed investment constituted 45 percent of China's GDP in 2004. This high level of investment has resulted in overbuilding and excess capacity in some sectors. The government has responded by trying to stop this overbuilding so that business profitability remains strong and the banks are not engulfed with new nonperforming loans. Rising inflation is also a concern: if increasing investment-led demand for workers and materials results in inflation, it is feared that the value of savings will be eaten away, interest rates will increase, and the gains in the standard of living that many Chinese have attained in recent years will be pushed back. This could very well create political as well as economic reverberations.



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Page last modified: 01-08-2021 14:07:08 ZULU