A more arcane but incredibly important area of economics, that gets overlooked, is how to measure GDP. The classical example goes like this. Assume you have two guys who live in a country and each guy has $100. The first offers to pay the second guy $100 to dig a hole. The second guy tired from digging the hole, offer the first guy $100 to fill the hole back up. According to economic accounting, this accounts for $200 of GDP even if nothing was actually accomplished.
Theoretically, GDP growth of this nature can continue infinitely. However, in reality, this type of GDP growth results ultimately in significant losses, though it can continue for some time before it collapses.
The reason I mention this relatively arcane discussion about how to calculate GDP is that this problem is incredibly relevant to understand the potential difficulties facing China. Let me emphasize that I do not have a good answer and the data on more esoteric or politically sensitive issues is even worse than the baseline numbers.
In the past week there have two pieces in Quartz about the poor quality of older Chinese housing that is now collapsing and another on whether China actually has a housing bubble because so much of the housing stock is being turned over. While it is perfectly reasonable to ask what impact China’s existing housing stock has on promoting or preventing a bubble, this overlooks two much more fundamental and important issues.
First, how efficiently is capital being allocated in China? Analysis of Chinese finances and a potential bubble typically focuses on a housing bubble or over capacity in specific industries like steel or solar. However, there is evidence that there is wide spread misallocation of capital throughout the Chinese economy and that the capital is poorly utilized. Houses are being built, torn down, and rebuilt and GDP goes up but the quality of that GDP, similar to the example of holes, is in real doubt.
Second, if capital is being poorly allocated, for instance in the case of substandard housing that is destroyed relatively soon after being built, what does that say about historical GDP and capital accumulation? Put another way, if capital is being consumed or is idle rather than deployed into productive purposes, this has the net effect of raising past GDP while depressing current or future GDP.
Let me build on the simple example from earlier about two guys digging and filling in holes. Now let’s assume the first guy builds a house and sells it to the second guy who takes out a 30 year mortgage to pay for it. Then after 10 years the house starts falling apart and guy #2 has to move and buy a new house. There will be a large capital loss by the owner, a developer to purchase the house at market rate to build a new house, or an insurance company.
Consider a second scenario where the house is fine but after 15 years a developer or the city want to tear it down to build bigger, nicer, and newer houses, a very common phenomenon in China. The developer will have to purchase at near market rate the old house in order to build a new one. This capital cost will then be passed on to the new purchaser.
This poor allocation or destruction of capital is not limited to real estate but carries over into all other industries. Over capacity in solar and steel where $500 billion in debt gets you $300 million USD in profits, are the obvious culprits, but under utilization of capital is rampant in China. According to S&P data, Sinopec and PetroChina pay less than what many governments pay on their debt but also earn an incredibly low rate of return on capital and half of what ExxonMobil earns. Put another way, in the most capital intensive industry on the planet, Sinopec and PetroChina earn a rate of return on capital that would barely break even for most competitors.
Chinese companies are coming up with ever new and creative ways to hide these capital losses. The Wall Street Journal is reporting that Chinese banks have devised a plan to sell bad loans to their investment banking arms to try and restructure them. The bank does not have to report a non-performing loan and receives a higher price for the soured loan than it would on the open market allowing the bank to mask the true picture.
Having lived in China, I can personally attest to the amazing misuse of capital. Whether it is buildings being torn down ten years after being built or looking out my window and seeing half empty office buildings. Unfortunately, measuring the “misallocation” of capital is an incredibly hard thing to do
Capital ultimately represents a cash flow, whether that is a machine that makes things or an apartment that someone lives in. Imagine the losses incurred when you learn that more than 70% of Chinese airports are operating at a loss. China Railway Corporation announced plans to put together a private investment fund after corruption scandals and losses forced it to give up its status as the Railway Ministry. The losses it currently sits on are enormous and there is valid concern over its ability to profitably exist without government handouts. The capital has to receive a stream of cash to pay for the investment or revalue the investment and the cost of the product.
Despite the pictures of gleaming skylines, brand new airports, and bullet trains the cash flows are struggling to pay for the capital used. Whether through banks, surplus capacity, or a revaluation of the asset and the product, at some point this is going to result in significant losses.