China's Ghost Cities: Bumps on the Road or Highway to Hell

An AFP headline caught my attention the other day, "Some debt defaults 'healthy' for China market: central bank." This is interesting to me because I am currently using Michael Pettis' (2013) analysis of China's economy as my working hypothesis or analytic framework for sifting through information about China's economy (there are others in my head, but this one has been getting a lot of play). According to this view, China's adherence to what Pettis calls the Asian Growth Model has overstimulated investment in China leading to many investments that will never never pay off. In short, without major reforms, the loans associated with these investments will eventually go into default leading to a credit or banking crisis.

One of the things that has been fueling the supposed over-investment is the high level of government spending (both at the central and local levels) on investments. Loans associated with government projects are implicitly guaranteed by the government, which makes them seem like good bets for banks even if the prospects of the investment actually paying off are dubious. Therefore, banks will loan more money to more of these projects than they would to private investors. Also, when you have government banks lending money for government projects, there is always the suspicion that these loans are not being scrutinized enough by the banks.

Therefore, it is interesting to see People's Bank of China (PBC) deputy governor Pan Gongsheng acknowledge the problem by saying "Guaranteed repayment... although it will ensure short-term stability, won’t help the market to effectively differentiate risks and will eventually lead to accumulated risks." Even more interesting is his suggestion that allowing defaults on some of these loan might help the banking system do a better job of managing risk by injecting some risk into the system. Presumably doing so would force banks to be more selective in evaluating and approving loans.

However, there is the danger that doing this now amounts to closing the barn door after the horse got out. This would be the case if Chinese banks had already issued lots of bad loans, or what would be bad loans if they were not based on the belief that payments would be guaranteed by the government. Weakening the payment guarantees on these loans now cannot effect decisions that have already been made.

The question then is whether China already has a dangerous amount of these loans on the books. I have previously discussed the possibility that China's large investments in High Speed Rail might turn out to be wealth destroying in nature.

But, perhaps a better example of over investment may lie in the so-called Ghost Cities of China. These are massive urban development projects that have remained largely uninhabited. Adrian Brown reported on several such examples in a 2011 SBS Dateline Report. The report notes that China was building 10 new cities a year, but found several of the cities remain empty several years after being built. Against a back drop of modern high rises under construction, a Hong Kong analyst likens the urban construction to Pyramid building in that it contributes to measured GDP growth while doing nothing for the quality of the population's life. The report notes that the apartments being constructed are priced way above the ability of most Chinese to afford. So, while there is a huge demand for better housing, these cities remain mostly vacant. The report suggests that China may creating a massive real estate bubble.

About a year later, Yale economist Stephen Roach made the counter argument that China needed to build these cities in anticipation of a massive migration of the population from rural to urban areas. With 15 to 20 million people moving from rural to urban areas each year, Roach argues that China cannot wait to build infrastructure and housing to accommodate them. He points to the city of Shanghai Pudong as an urban project that was empty when it was built in the 1990s, but had grown to a population of 5.5 million by 2013.

However, last September, Brown revisited a city in his earlier report for another Dateline report, and found that little had changed over the previous 2 years except that the government did not want him there. He also found new cities under construction.

Also, this week the Sydney Morning Herald reports that at least one of these cities are now on the brink of financial collapse. The city of Ningbo has $570 million in debt, mostly to banks, and is one the verge of collapse.  The report estimates that there are 10 other cities that y find themselves in a similar situation. As for the migrations of people from rural areas, the report noted that China's workforce has decreased in the last two years and the flow of rural workers to urban areas halved since 2010, from 12.3 million to 6.3 million per year.

If, as PBC's Pan Gongsheng suggests, the government lets local governments default on loans, this will not only jeopardize outstanding loans to these cities but make it much harder for them to get new loans. These cities will need new loans to roll-over current loans and to get additional funds for operating and maintaining their property. Therefore, unless delicately handled, such a change in policy might bring the situation to a head and spark a crisis in more ghost cities. In deed, it might uncover problems in cities that don't appear to be ghosts at first glance.

So, we may have a good old fashioned real estate bubble here. The government, both at the central and local levels, may have acted like a real estate developer that see a trend (i.e., the growth of urban populations and the success of cities like Shanghai Pudong) and bets heavily on it continuing unabated in the future. The trend then abates leaving the developer with a very bad investment and a bunch of bad loans.

Also, we may have something unique to China due to the planned nature of its economy. As suggested by the analyst in the 2011 Dateline report, China may have been using urban construction to meet GDP growth targets. In this scenario, the central government set growth quotas for regional governments to meet. This created an incentive to not only engage in urban construction, but also to focus on constructing high value property like luxury high rises and shopping malls. Doing so inflates the paper value of the property constructed and justifies higher costs of construction which adds to the short term stimulative effect of the project.

The downside of doing this is that, years later, the actual value of the real estate may fall short of the property's paper value and the inflated cost of constructing it. At that point, the value of the property will have to be written down and the loans allowed to default with a negative impact on GDP. Pettis (2013) argues that because of this much of China's recent growth in GDP may turn out to be illusory and show up as future decreases in GDP if/when the loans go into default.

While you might think that this would discourage such  short sighted decision making, the incentive structure of local and regional bureaucrats might encourage it. From the bureaucrat's point of view, meeting the growth target is the key to keeping his/her job and exceeding the target is the key to being promoted. Once promoted, the bureaucrat's responsibilities will shift and the project will become somebody else's problem by the time it collapses. Therefore, the bureaucrat has an incentive to focus on the short term effects of the policy and place minimal emphasis on its long term effects.  Pettis (2013) notes that this is a recognized problem with government planning known as the Commonwealth Effect.

Factoids: US Current Account Deficit Down, Petroleum Exports and Financial Account Up

Here are some news tidbits about US trade and net flows of dollars into and out of the US.

AP reports that the US current account deficit from October to December of 2013 was at its lowest level in 14 years. The biggest component of the current account is the trade balance (exports - imports) which is generally in deficit for the US. However, the current account also includes the balance of transfer payments such as income on investments, private transfers of money (such as people sending money to relatives in other countries), and government transfers between nations (such as foreign aid).

The current account deficit for last quarter of 2013 was $81.1 billion (down from $96.4 billion from July-September 2013). The US received more income on its investments than it paid on foreign investments in the US so there was a $64 in that part of the current account. The balance of trade in services was also positive with a surplus of $57.9 billion.

The balance of trade in goods was negative with a deficit of $171.8 billion dollars. Both exports and imports increased in the last of quarter of 2013. If we look at the Bureau of Economic Analysis' (BEA's) new release, we see that the US exported $405.4 in goods (up from $7.6 billion from the previous quarter) and imported $577.2 billion in goods (up just $1 billion from the previous quarter).

US Oil Imports and Petroleum Exports: Part of the reason that US exports rose faster than US imports is that US oil production has been increasing, thereby decreasing imports of oil. At the same time, US exports of petroleum products (refined products such as gasoline, diesel, aviation fuel and heating oil) have been increasing. Indeed, US petroleum exports have almost doubled since 2008.  Mark Perry has some good graphics that show the dramatic increases in US oil production and petroleum product exports, as well as the equally dramatic decrease in the percentage of oil the US imports.

It is important to note that US exports of petroleum products are driven by more than just increases of crude oil production.  Bloomberg reports that US demand for distillate fuels (which includes gasoline, diesel and heating oil) fell to its lowest level in 16 years. Part of this is blamed on the recent bad weather which resulted in people driving less, but this is also part of a larger trend in distillate fuel consumption in the US. As people drive more fuel efficient cars, airlines buy more fuel efficient planes, and people switch from oil to natural gas for more heating, they demand less distillates. Also, since 2005, federal mandates have required that increasing amounts of ethanol be blended with gasoline and diesel, thereby decreasing the amount of oil distillates we use when we pump a gallon of fuel into our cars. All of this leaves refiners with excess capacity which they sell overseas (mainly in Latin America).

Current Account versus Capital (or Financial) Account: Another thing to keep in mind when looking at, or thinking about, the US current account deficit is the the capital account surplus that inevitably goes along with it. News reports never mention this even though the capital account information is usually included in the same BEA news release they are using as a source under the heading of Financial Account. The BEA's Financial Account tracks changes in US owned assets abroad and foreign owned assets in the US (for some reason BEA does not use the generic economic term of capital account). An increase in US owned assets abroad shows up as a negative number or deficit here as it reflects an out-flow of dollars. Conversely, an increase in foreign owned assets in the US shows up as a positive number or surplus because it reflects an in-flow of dollars to the US.

In the last quarter of 2013, there was a surplus of $173.7 billion in the Financial Account (up from $68.2 billion in the third quarter of 2013). This increase probably has something to do with the Dow Jones Industrial average steadily increasing 1000 points (or 6%) from October to December of 2013, which might have attracted foreign investment. Alternatively, the large inflows of foreign investment may have been behind the increase in the US stock market if foreign investors were driven by a lack of good investment alternatives in the rest of the world.

Note that the financial account surplus increased 154% from one quarter to another and was 114% larger than the current account deficit in the same quarter.  This is probably the bigger news in the BEA press release because it means that there was a net inflow of $92.6 billion in the US from October to December last year. It also shows the problem with only focusing on one side of the national accounting equation. If all you look at is the trade or current account deficit, you think that the US bled dollars into the world and the best news is that the bleeding slowed down a bit in the end of 2013.

Of course, in the long run the current and financial accounts must balance. The dollars that go out must come back to the US because their value lies in the fact that they are a claim on the goods and services produced in the US. Also, in technical terms, the zero balance between the two accounts is an accounting identity that results from how the two accounts are defined. In practice, the floating exchange rate of the dollar (or its market value) keeps the two accounts in balance over long periods of time.

This is more obvious when we look at yearly figures. For all of 2013, BEA estimates that the US current account deficit was $379.3 billion and the financial account surplus was $351.2 billion (these numbers were both down from $440.4 billion and $439.4 billion respectively in 2012). You may mote that there is a $28.1 difference between BEA's estimate of the current and financial accounts. This is known as the statistical discrepancy and it is running at between 7.4% and 8%. This discrepancy is largely due to inaccuracies in the available data upon which BEA bases its preliminary estimates. You will note that in 2012 the statistical discrepancy was only $1 billion (or about 0.2%) and this reflects the fact that BEA revises its estimates over the course of the year as it gets better data. Undoubtedly the difference in the 2013 numbers will shrink as BEA revises it preliminary estimates over the course of this year.

Jagdish Bhagwhati and Gung-ho Global Finance

Jagdish Bhagwati is arguably the most prominent proponent of trade liberalization and globalization, and so he caused a bit of a stir when he came out against the complete liberalization of capital in 1998. In a Foreign Affairs essay entitled the "Capital Myth: The Difference between Trade in Widgets and Dollars" he criticized the push to liberalize financial markets and remove all restrictions on capital flows, something he would later call  'Gung-ho International Financial Capitalism.'  [Bhagwati has made this essay, along with other writings on the subject, available in PDF form on his faculty website] Talking about the push for free international capital flows, he says:

This is a seductive idea: freeing up trade is good, why not also let capital move freely across borders? But the claims of enormous benefits from free capital mobility are not persuasive. Substantial gains have been asserted, not demonstrated, and most of the payoff can be obtained by direct equity investment. And even a richer IMF with attendant changes in its methods of operation will probably not rule out crises or reduce their costs significantly. The myth to the contrary has been created by what one might christen the Wall Street-Treasury complex, following in the footsteps of President Eisenhower, who had warned of the military- industrial complex. (Bhagwati, 1998)

With regard to the problems associated with unfettered capital mobility, Bhagwati argues that capital flows, especially short term credit, are more prone to (in Kindleberger's terms) panics and manias than trade in goods and services. That is, that financial investors, working with incomplete information and subject to herding influences, are more likely to overestimate the returns and stability of a nation capital market (which producing a mania of capital inflows) and/or to underestimate the strength of a market when confronted with adverse news (which produces a panic in the form of sudden and massive capital outflows). 

Writing on this in The Defense of Globalization, Bhagwati contrasted the Mexican Peso crisis with the Asian financial crisis. He argued, while that the Mexican crisis exposed fundamental problems in the Mexican financial system that may have warranted reactions from investors, the same was not true of the Asian crisis. The fundamentals of the Asians were fairly strong in comparison to other nations. While problems such as cronyism existed, these problems were generally previously known to exist and there was nothing in the crisis that suggested they had suddenly become acute. 

The problem in Asia in the 1990s, as Bhagwati (2004) sees it was that Asian banks were using short term capital inflows to finance long term domestic loans.  When the short term inflows suddenly turned into outflows, there was simply not enough cash (in foreign currency) to cover the outflow even though the long term loans were generally sound. Note that, in such a case, it makes sense for a lender of last resort to loan banks money to cover the short term outflows based on the strength of the long term loans. In fact, in the case of a panic, one can make money doing so (think Old Man Potter backing the bank during the panic in It's A Wonderful Life).

However, unlike the US, where the Federal Reserve can print all the dollars it wants and act as lender of last resort, the central banks of the Asian countries could not do so to the same extent as they print domestic currency, not dollars. So, once their supply of foriegn reserves was expended, central banks and their governments had to beg the dollars they could from the IMF and other countries. More importantly, they had to implement severe macroeconomic measures, notably raising interest rates and selling assets. These measures rippled through their economies undercutting its fundamental strength. Businesses, which carried debt and depended on access to credit to operate, were decimated (and those, formerly sound, long term longs to them were no longer quite so sound). Owners of assets were forced to sell to foreign purchasers at greatly reduced prices. 

In general, Bhagwati argues that the gains of financial liberalization, in terms of economic growth, are questionable. Many other countries, such as China, have grown without open capital markets (though this is eerily similar to claims by opponents of trade liberalization). Furthermore, if there are benefits, the results can be achieved by opening markets to foreign direct investment, which is inherently longer term and less mobile in nature, and, therefore, not as susceptible to panics.

In the end, Bhagwati attributes much of the push for unfettered financial flows to interest groups in the developed nations, particularly the financial sector in the US. This sector directly benefits from expansion of global credit markets and exerts great influence on the US government and the IMF. Bhagwati notes that US economists frequently move back and forth between the US financial sector and government positions. This elite network, along with the financial sector lobbying efforts, creates what he calls the Wall Street-Treasury Complex, whose effect describes as follows:.

This powerful network, which may aptly, if loosely, be called the Wall Street-Treasury complex, is unable to look much beyond the interest of Wall Street, which it equates with the good of the world. Thus the IMF has been relentlessly propelled toward embracing the goal of capital account convertibility. The Mexican bailout of 1994 was presented as necessary, which was true. But so too was the flip side, that the Wall Street investors had to be bailed out as well, which was not. Surely other policy instruments, such as a surcharge, could have been deployed simultaneously to punish Wall Street for its mistakes. Even in the current Asian crisis, particularly in South Korea, U.S. banks could all have been forced to the bargaining table, absorbing far larger losses than they did, but they were cushioned by the IMF acting virtually as a lender of first, rather than last, resort.

The last sentence suggests an argument that Bhagwati doesn't explicitly develop, i.e., that the IMF is not a good lender of last resort because of its motivation. The obvious the limiting factor on the IMF serving as lender of last resort is its  limited supply of funds (remember that when the Federal Reserve acts as lender of last resort in the US, it theoretically has an infinite supply of dollars).  Here, Bhagwati suggests that IMF is biased towards insulating foreign creditors from the downside of the crisis;  whereas an ideal lender of last resort would focus on minimizing the crisis in total (especially its long term impact n the economy) and remain neutral with regard to the distribution of losses. 

References:

Bhagwati, Jagdish. (1998, May 1). "The Capital Myth: The Difference between Trade in Widgets and Dollars."  Foreign Affairs. Retrieved February 4, 2014, from http://www.foreignaffairs.com/articles/54010/jagdish-n-bhagwati/the-capital-myth-the-difference-between-trade-in-widgets-and-dol

Bhagwati, Jagdish. (2004) "Chapter 13: The Perils of Gung-ho International Financial Capitalism." In Defense of Globalization. New York, NY: Oxford University Press.