China growth to slow down to 7%. India’s to climb to 10%!

The Chinese Premier Wen Jiabao has stated publicly that he would like the Chinese economic growth to slow down to 7% over the next five years. A little surprising considering that China has been the envy of the world for growing at over 10% per annum for the last 2 decades.I suspect that there is a reason why Wen wants the economy to slow down.....Chinese growth numbers have always been suspect and I guess there are serious problems in China which the government is not willing to reveal at the moment.

The Chinese growth model has been suspect for many reasons:

1)      Growth led by investments, not consumption: It appears that GDP growth is led by ever-increasing investments in the economy. With more investments, there is bound to be more production and hence a higher GDP growth rate. No one minded this till the time the growth was rapid. But now people are starting to question the growth story when they see the relatively low share of consumption in its GDP. Consumption is broadly to be understood as all that the domestic market consumes.....be in consumer products like cars and computers or industrial products like cement and steel. Consumption in China is just 37% of its GDP. In India, that number is 57% as it is in most of the developed world. Consumption is the right way to grow. After all, the purpose of growth is to give the citizens more.....The other way to grow is basis exports....when the country produces goods but they are not consumed by its own citizens.....such growth doesn’t add much to the standard of living of the local population except for the employment generated.

There are many examples in China of how investments have been motivated by reasons other than business logic. For eg., the world’s largest mall....the South China Mall is well known. It’s a 7 million sq. foot mall which has been 99% un-occupied since 2008. The reason: It’s in the suburbs of Dongguan and going there is pretty difficult. Begs the question: why was it built there in the first place?! The reality is that it was built for political reasons and because cheap funding was available. It was built out of guilt by the Chinese government which worries that all economic growth has happened only on the coastal areas in East China and this is causing problems in the hinterland. There are many more examples of the same type. A $3 billion airport express in Beijing runs pretty empty because of high fares and low demand, but it doesn’t really matter to the Chinese. Investments are often made in China because of the immediate impact on sales of cement, steel, electricity etc and not for its viability. This model is clearly unsustainable.

2)      Bank NPAs are a worry area: The question then is: who funds these loss making projects. The Chinese banks largely! As is well known, Chinese banks are state held and when loans go bad, it’s OK. Chinese reporting and accounting standards are amongst the most atrocious in the world. As per reports, Chinese banks have as much as 25-40% NPAs (non performing assets)....this number is just 2% in India. Can you believe it? 25-40% of the loans will go bad! Banks are pressurized to lend to even unviable projects, because the single minded focus has been on growth and no one is concerned about profitability. The West also has been fascinated with the Chinese model. No where else in the world have they seen this investment-led-growth model. That is why, when the ICBC (Industrial and Commercial Bank of China) went in for a $22 billion IPO, Western investors subscribed it many times over. Western investors are aware of the un-viability issue, but they gloss over it because they believe that high growth rates will correct everything that’s wrong. More than them, the Chinese leadership is now worried about the quality of growth. In many ways, I think Wen’s plan to reduce the growth rate (they are saying they are now focusing more on improving standards of living.....talk of euphemisms!) is to bring a semblance of economic logic to the irrationality of the past. It’s like forcing a bit of the fast-building steam out of the pressure cooker before it explodes. Without this cooling down, China would explode so badly one day that the entire world would go into a shut-down mode.

3)      China’s value add in its exports is negligible: Almost half of the Chinese GDP is comprised of manufacturing output. China is the world’s factory for all types of manufacturing. So China imports a lot of raw materials and components and exports the finished goods. The way the GDP calculation works is interesting. Take the example of the Apple i-phone. It retails for some $400 in the US, but it costs Apple just $140 to make. So Apple (the owner of the intellectual property or IP) rightfully makes a huge profit. Of the $140, China adds only about $7 of its own value (mostly labor and factory related)....it imports the rest ($133 worth) from other countries....Yet, in its GDP, $140 is counted. This leads to a misleading calculation of GDP. This method of calculating GDP is not unique to China. This is the way calculations of GDP are done in every country. However, in the case of China, the effect is huge because of its huge manufacturing industry. If GDP was measured more logically, China would appear must less a miracle than it does right now.

4)      Manipulating currency: China’s growth has been helped by its manipulation of its currency. By pegging it tightly to the $, it prevents the currency from appreciating. If the currency appreciated, its exports would suffer hugely. If the currency appreciated by 5%, the exports would suffer many times more. Because Chinese value addition is low, it works on very thin margins. If the currency appreciation increases its prices internationally by even 5-7%, it would lose many orders. But at some point in time, it will have to bite the bullet and appreciate its currency. This imbalance cannot continue for ever. As a result, it will have to reduce its low-grade exports and cut back on unprofitable manufacturing. This is why China is now saying that it wants to grow its services sector more.....where margins are better....an area of strength for India! It should also be remembered that India’s currency has always been free floating and there are no major worries on that front.

5)      Very low base of entrepreneurs: China is still a very state-controlled economy. Agreed, there is a large private sector also now, but from what I gather, the private sector entrepreneurs are largely supporters of the Chinese Communist Party. When China wanted to privatize, it simply offered its assets to its own party workers! This would be called corruption in India! There is nothing like a CAG or CBI or freedom of speech or free media or anything that would highlight such corrupt practices in China!

6)      And lastly the legal system: India’s legal system is slow but largely apolitical and reasonably fair. China’s is parochial and protects its own interest. Westerners dont like the Chinese legal system.....they bear it because of other factors.

In short, Wen’s call for lowering GDP growth rate is out of knowledge that the falsehood it has perpetrated on the world for 3 decades will definitely come out one day. If that happens, China will implode. Wen would like to leak the information out in bits and pieces so as to contain the shock. That’s all.

The real truth is that India is much better placed to grab world leadership than China. Its democracy is its biggest asset. Its entrepreneurial spirit is what gives it strength. Its weakness is the efficiency of its government and bureaucracy (this is China’s strength). If its government could overcome even some of its inefficiency, India would claim the next 2 decades to be its own.....just think about this!