January 16, 2014 12:00 am JST

China crisis may be unavoidable

JUNHENG LI

Mainland policymakers and analysts commonly argue that China's public debt burden in itself is not a problem. They say that as long as gross domestic product growth outpaces credit growth, and that credit-driven growth generates a positive return on investments, all will be fine.

     The accuracy of the numbers reported last month by the National Audit Office is of course questionable. We see that, though, as less relevant than the government's intended message to the market: that overall debt is still manageable.

     I, however, question the idea China can grow its way out of this problem.

     That's because, first of all, the debt issuers are not the primary beneficiaries of gross domestic product growth. The primary beneficiary of GDP growth is the central government, which gains in the form of tax revenues. Debt issuers, on the other hand, are mostly local and their primary revenue source is land sales.

     There is no direct, mechanical or automatic link between economic growth and local authorities' debt service capacities, as we have witnessed since 2008 as total social financing, a broad measure of credit, has exploded.

     The argument that China can grow out of its credit bubble is valid if and only if GDP growth increases the debt service capacity of the debtors. As GDP is only a measure of economic activity, not efficiency or profitability, GDP growth alone does not guarantee a proportional increase in the revenue of local authorities that could be used to pay down the debt issued via financing vehicles.

     However, local authorities could stand to benefit from growth indirectly, if land values increase alongside GDP. But again, the link between the growth in the size of the economy and the debt service capacity of local government financing vehicles is by no means direct.

Hard assets no help

Investments in city construction, land reserves, transportation facilities and social housing in mid-2013 made up 35%, 11%, 24% and 7%, respectively, of total spending by local authorities, according to Citigroup analysts.

     Bulls would argue that these hard assets could be drawn on to repay the debt. But common sense dictates that financial returns from the physical assets funded by local government are largely unknown and most likely negative. If these projects were financially viable, why didn't local authorities invest in them prior to 2008 rather than waiting till the onset of the global financial crisis? 

     Studies show that few passenger railways in the world, including the longest running ones in Japan and Germany, are profitable if engines and carriages as well as tracks are included in the capital cost. In the U.K., for example, a separate company owns the track from those running the trains. The revenues of the consolidated track and train companies do not cover their full costs. In Spain, revenues from actual and proposed high-speed railways cover less than half of operating costs, let alone capital costs, according to research by Pedro Casares and Pablo Coto-Millan.

     It is clear that policymakers in China are focused on engineering a transition to slower but more sustainable growth without causing a sharp cyclical slowdown. From an empirical perspective, however, the number of economies that have historically succeeded in letting the air out of a credit balloon in a gradual fashion, without creating a credit crunch and a short-lived recession, cannot be counted even on one finger. 

     Whether China will be different, given its unique policy tools and central planning instruments such as quantitative credit controls, is yet to be seen. Nevertheless, policy intervention comes with costs, mostly higher and more convoluted than anticipated.

     One thing is certain: The consequences will be profound and long lasting for global economies and investors.

Junheng Li is head of research at JL Warren Capital, a China-focused equity research firm in New York, and author of the recent book "Tiger Woman on Wall Street"