beyondbrics

By Ben Simpfendorfer of Silk Road Associates

I visited Changde’s still unfinished international marathon track last week. It’s not likely to feature on the international circuit anytime soon. Changde is a third-tier city in the largely agricultural province of Hunan, more famous for exporting migrant workers to export factories in the coastal provinces.

The idea of building a track was conceived in 2008, in the afterglow of Beijing’s Olympics. A local government financing vehicle (LGFV) subsequently issued $136m in debt to help finance its construction. Today, the track is little more than sticky red mud, a blue hoarding sign and discarded steel drums.

In short, the track is a good example of how Beijing’s emergency policy easing in 2008 might have spurred growth, but simultaneously worsened bad debts.

It’s also reason to worry in the event that a looming global recession results in Beijing rolling out “Fiscal Stimulus II”. Even if the stimulus isn’t quite as large as the 2008 policy easing, the chances of it resulting in more international marathon tracks, and other white elephants, are equally large.

To be fair, not all these projects are bad. And to Changde’s credit, the city is also spending heavily on water-related infrastructure, including water-treatment, flood-prevention, and sewage pipes, all greatly needed in a country where water scarcity is a growing concern.

In fact, a majority of the LGFV debt prospectus we recently looked through included spending on water-related infrastructure. So while Changde’s international marathon track captures attention, it also risks exaggerating the amount of local debt used to fund unproductive investments.

Local debt worries aren’t new. But with Europe’s debt costs rising fast, it’s worth another look at two major risks for China’s own outlook.

The first is that the interior provinces have significantly worse fiscal positions than the coastal provinces: fiscal deficits average -8 per cent, -10 per cent, and -20 per cent, for the central, northern, and central regions, respectively, over the past five years, against just -3 per cent for the coastal provinces. Those are Greece-levels, or worse.

Sure, China is a fiscal union, so the central government can and does make up the shortfall. But the interior provinces are crucial to the country’s efforts to rebalance it’s economic model towards stronger domestic demand. And if the central government finds itself cash-strapped, such as after a debt crisis, these interior provinces are going to be squeezed.

Is a debt crisis likely? Not immediately. But the risk is that China’s nominal GDP growth rate slows before the “good” investments have time to reap productivity gains. It was average 15 per cent nominal GDP growth during the past decade, rather than debt restructuring, that shrunk China’s bad debts from the 1990s. (Japan’s nominal GDP growth rate was just -0.3% during the same period).

But there’s no guarantee of a similar result this time. Whether it’s the risks of an inflation shock, global recession, or housing bubble, the threat of a sharp slowdown in nominal GDP growth is higher. (Recall that China’s GDP deflator fell around -2 per cent year-on-year, for three full quarters, during the worst of the 2009 economic slowdown).

And if a slowdown is sustained, then the massive borrowing by LGFVs, especially if used for funding international marathon tracks, will seriously drag on the economy.

Ben Simpfendorfer is Managing Director of Silk Road Associates, a Hong Kong-based economic consultancy and corporate advisory. He is also publisher of the monthly “China Insider” and author of “The New Silk Road”.

More on China’s debt problems:
China: a debt baby’s photo album, beyondbrics
Guest post: China’s local debt problem is bigger than it looks, beyondbrics
Guest post: China’s non-bank credit bubble, beyondbrics

More from Simpfendorfer on beyondbrics:
Guest post: China’s private banks are fuelling bubbles
Guest post: The end of ‘Made in China’?
China’s local governments spoil the party