Development Bank Research Bulletin

What US stocks China may want to buy with its foreign reserve?

China has decided to diversify away from US treasury bonds, and invest up to $200 billion of its huge foreign reserve in equities in order to boost the return on its foreign reserve holdings.

Making financial profits is certainly one of the major objectives of the foreign reserve managers, but it is also expected that Chinese government may want to create benefits for its own economy (and Chinese employment) as much as possible. In short, they don’t want too much net capital outflow. In any case, a poor country is certainly in greater need of capital. But how can Chinese achieve these goals?

One possible way is to link the portfolio allocation decision to US corporations investment decision in China. Chinese government may want to invest more in US multinationals that promise to invest more in China-based projects.

According to the Commerce Department’s “2007 Investment Climate Statement”, these large US corporations active in China include (ranking by their Chinese asset size):

Motorola, General Motors, Wal-Mart, General Electric, Kodak, DaimlerChrysler, Coca-Cola, Exxon Mobil, Ford, Intel, Anheuser-Busch, DuPont, Alcoa, United Technologies, IBM, Cummins,  and Microsoft.

In any case, these are large and liquid US stocks and are thus perfect candidates for foreign reserve investments.

Moreover, strategically speaking, some of them can be very valuable for Chinese if the Chinese can acquire significant block of shares and have a say in the management.

Wal-Mart for example can give Chinese a perfect retail distribution channel in the US for Chinese products. General Motors, which has run into financial troubles, may help Chinese build up its domestic car industry, in exchange for financial injection from the Chinese. Motorola, IBM, and Microsoft can help Chinese upgrade their information technology.

It is predictable that there will be a huge political backlash in the US when the Chinese acquire significant share block in any one of these corporations.  But who are you going to blame? If Americans save less than invest, and America has to let foreigners in to bring in the money.

Return to Capital is not low in China

There are two famous myths about China.

The first one is that the savings rate is high because ordinary Chinese worry about the lack of safety net. This myth has been busted because evidence has shown that Chinese household savings rate is actually lower than the Indian one. The overall saving rate is high because businesses heavily save their self-generated profit for re-investment. For private business, the reason is the lack of access to other forms of external finance. For state-owned enterprises, managers always prefer re-investing the profits to paying dividends to the government. Therefore, the right solution is: (a) to reform the financial sector and improve the access to finance for private sector businesses; (b) force state-owned enterprises to pay dividends! Building a safety certainly will help, but only at the margin.

The second famous myth is that return to capital is very low in China, and that the current high investment rate is a sign of money being wasted. A NBER working paper "The return to capital in China", written by three prominent Chinese economists, however shows that the return to capital in China has been remained flat at roughly 20% since 1998, which is not low compared to the rest of the world. Olivier Blanchard also provides a nice discussion (PDF file) of of the results.

As a matter of fact, the myth about the high investment rate per se has also been overturned. Goldman Sachs economist Hong Liang show that the investment rate is between 36%-40%, and the incremental capital-output ratio (ICOR) is about 3.1 in recent years. These are two very reasonable numbers for a rapidly growing economy. In at least the export-oriented sectors in China, improvement in productivity still remains that greatest driver of growth.

I have long been the subscriber of the view that China is still a very poor country; the gap to the productivity frontier is still so wide that the main decision to make is still how much to invest rather than where to invest. Chinese are starting to worry about investment efficiency, but at this moment it is still of second order importance. The nation’s production is still so inefficient that there are numerous easy opportunities waiting for entrepreneurs to capitalize on. In order for this to happen, the government should remove the planning-economy-era regulations that create the inefficiency, and protect the property rights of entrepreneurs. These reforms will create prosperity much more than will any scientific breakthrough.

Newspapers like to repeat the same punch line “the money is wasted in building roads that lead to nowhere” when describing the government investment in infrastructure in China. But people familiar with the geography of China would find it difficult to find any such “roads that lead to nowhere.” Even if an idiot randomly draw a line on the map in the eastern seaboard and build a toll road; in five years the road capacity will be full. That’s exactly why there are so many corruptions in such infrastructure projects: high returns are guaranteed so long as you can get the license to build the toll roads that almost always lead to somewhere. The new Chinese saying: money follows the roads.

The Return to Capital in China (download pdf file)
Chong-En Bai, Chang-Tai Hsieh, and Yingyi Qian
NBER Working Paper No. 12755
December 2006
ABSTRACT: China's investment rate is one of the highest in the world, which naturally leads one to suspect that the return to capital in China must be quite low. Using the data from China's national accounts, we estimate the rate of return to capital in China. We find that the aggregate rate of return to capital averaged 25% during 1978-1993, fell during 1993-1998, and has become flat at roughly 20% since 1998. This evidence suggests that the  aggregate return to capital in China does not appear to be significantly lower than the return to capital in the rest of the world. We also find that the standard deviation of the rate of return to capital across Chinese provinces has fallen since 1978.

China's lobbying industry spends $2.5 billion annually

According to an article "The harder they fall" in the Economist (Sep 30, 2006):

"More than 5,000 localities from provincial down to county level have opened offices in Beijing in recnet years, spending some $2.5 billion annually on lobbying, according to China's media..."

A huge industry!

Chinese private sector firms are twice more productive than state-owned firms

An OECD report “Fast-falling barriers and growing concentration” (pdf file) shows that Chinese private firms are twice more productive than state-owned firms.

This seems to be a very clear and common sense fact that shouldn’t need to be studied in the first place, but there are actually many people who still believe that state-owned firms, with proper restructuring and introduction of modern management expertise, can turn around, and do much better than private sector firms.

The favorite example they always cite is the higher profitability of giant state-owned firms listed in Hong Kong, particularly those in the energy and telecommunication sector, compared to low profit margin private sector firms in the consumer electronic industry. They are comparing apples with organs though. Even an idiot can run a very profitable state-owned firm in the energy sector: a monopoly can charge whatever price it wants and realizes any level of profitability it wants . Consumers are losing out and paying the bill though.

This OECD report sends a hard blow to people who still believe in the viability of state-owned firms. The report uses data from the government statistics bureau: if anything, it should have underestimated the productivity of private sector firms, for they always understate their revenue for tax purpose.

State-owned firms, go kill yourself, you are wasting everyone’s resources.

Indian households save more than Chinese!

According to a new report by McKinsey “Putting China's capital to work”, Chinese households save 23.8% of their disposable income, not particularly high compared to the saving rates of Asian tigers in their high growth period.

Indian households save 31.9% of their income, a ratio that is much higher than Chinese. The current saving rate of French is 16.6%

Chinese = high saving rate? Myth busted!

The report points out that the high total saving rate of China is mostly the result of higher corporate saving rate, which stands at twice world average. The report however also cautions readers that the higher household saving rate of Indians could be the result of small and micro businesses reporting themselves as households.

Nevertheless, the Chinese saving rate could be overestimated too, as Chinese disposable income, the denominator of the ratio,  is severely under-reported because of the huge underground economy.

Note that saving rate of an average Chinese household could be much lower than the headline number. In 2003, 1.86% of the wealthiest Chinese households control 60% of the total stock of liquid financial assets in China, and they certainly have much higher saving rate than poor people. A McKinsey survey indeed shows that the lowest income quintile of Chinese households save only 20% of their income.

A new political economy: China grew at 10.9% in 1H06

China grew at 10.9% in the first half of 2006, and 11.3% in the 2Q, surprising almost all major investment banks.

"Maybe this is a new economy" said Stephen Green, China economist for Standard Chartered Bank, "Maybe China can grow fast without inflation"

I am not sure whether China can grow fast without inflation, but I am expecting the fast growth this year and I am not surprised at all.

As I wrote in the Bulletin back in April, things are changing in China. It may not be a "new economy", but it is certainly a "new political economy!"

The Communist Party's 17th national convention is upcoming in the second half of 2007, and thus major personnel promotion decisions will be made in the first half of 2007. Every provinical boss is working hard to secure political capital before the event, and GDP is the key political capital. In today's new political landscape where strongman politics is phasing out, GDP becomes more and more important a bargaining stake for provincial bosses.

So don't expect a slowdown in the second half. The economy is going to operate at full speed.

As I wrote in that article:

"Year 2006, however, is the last year of the 2002-2006 political cycle, and based on past experience, should grow at the lowest speed. The economy however grew at the highest speed in ten years. Something must have changed. One speculation is that the incentive structure has changed. In the past, provincial heads worked hard in the first and second year of the cycle to impress their national boss. Now they work hard in the last year to pro-actively build up political capital for their future career which will be decided in the 2007 national meeting of the Communist Party, and the best political capital in China is GDP, GDP, GDP!  At national level, central government wants to slow down the investment boom, but provincial bosses have made up their own minds. "

Goldman Sachs: China makes largest progress in energy efficiency than other developing countries

Goldman Sachs publishes a note "Improving energy intensity across the BRICs"  (pdf file). There are several interesting take-away points:

(1) China’s energy use per unit of output in industry fell by 56% between 1994 and 2003, which is the largest energy-efficiency improvement progress in developing world. In the same period, India only achieves reduction of 30%, and Brazil almost makes no progress.

Why is everyone blaming China for using too much energy?! China uses more energy simply the population is larger and the economy is still in the early stage of industrialization, and as such a large economy, China is already making much better progress than others.

(2) Russia remains the most energy-intensive countries in the world, The country’s energy intensity is close to three times that of US.

Not surprising, considering that the government is subsidizing energy (for Russian residents) to such an extend that electricity is almost free. By the way, Venezuela always consumes a lot of gasoline, because the price is heavily subsidized. I always say that letting market to determine the price is the best weapon against energy waste.

(3) In China, non-industrial sector is twice more energy-intensive than industry.

I have no idea why!

(4) Projection results show that BRICs (except Russia) will consume much less energy per capita than the current level in more developed economies (U.S., Japan, etc) when  they reach the same income level of developed economies.

I.e., both now and in the future, Americans will remain the heaviest user of energy, even on per capita term.  Why do Americans still point fingers at developing countries and keep on blaming China for exhausting the energy resources of the planet?

Implication for the relationship between growth and environment : as a country gets richer, it will use less energy (because industry becomes more productive and structural shift to service sector will also save energy). The best weapon against pollution is economic growth, not to turn Africa into a zoo.

Year-half assessment of investment banks’ forecast accuracy on China’s GDP growth

In a previous Bulletin article written back in February, I summarized several major investment banks’ forecast of China’s 2006GDP growth rate.

Now it is time to assess the accuracy of these forecasts after six months have passed.

In the first half of 2006, China was growing at unprecedented and unexpected pace, at 10.9% on year-to-year basis. Only Credit Suisse’s forecast of 10.1% can be said to be in line with the actual outcome. CSFB’s China economist Dong Tao is doing well

Thus most investment banks are revising their forecast up ward:  Deutsche from 9% to 9.9%, Citigroup from 8.7% to 9.3%, and Morgan Stanley from 7.8% to 9.5%. The consensus now is 9.7% (based on data from Consensus Economics).  (Deutsche Bank again is following the herd in setting their forecast! Can they be a little bit braver?)

Morgan Stanley, after two years of very poor performance in forecasting China’s GDP growth finally makes a large upward revision of the number. They have been voicing their worry about China slowdown for a long time, and have been the most pessimistic about growth rate of India and China back in 2004, and 2005.

Stephen Roach in his commentary (10/21/2005) in MS’s Global Economic Forum supplied some explanations on why they were wrong on the "China slowdown", and why they still believed that slowdown in American consumption (as a result of oil shock and low saving rate) may “ultimately” causes a China slowdown. Well, he is wrong again.... I am expecting a follow-up execuse from him

I think China's potential slowdown in the future is more likley to be caused by domestic problem instead of external factors. China is not exporting many durable goods to the U.S., and I think Americans even in recessions have to buy clothes and have to give Christmas gifts to children. I don’t deny that China is dependent on U.S. market, but not in the same way as Japanese do (they export cars, the demand of which is more cyclical)

McKinsey says financial sector reform could raise Chinese GDP by 17% a year

A study recently published in May by the McKinsey Global Institute, titled "Putting China's Capital to Work: The Value of Financial System Reform", has found that financial sector reforms in China, if properly executed, would raise gross domestic product by an astounding 17 per cent, or $321bn.

According to the report: better capital allocation would raise GDP by $259bn, while improving the efficiency of the banking system, switching from paper-based to electronic payments, and diversifying the mix of funding vehicles for corporations would raise GDP by $62bn annually.

Another report by McKinsey points out that Chinese domestic banks are more fragile then we thought, when facing foreign competition likely incoming in 2007.

We usually think that foreign banks cannot compete with Chinese local banks in retail banking, because it is prohibitively expensive for any foreign banks to attempt to replicate a nationwide branch network.  McKinsey report however identify an opportunity: just 2 per cent of local banks’ customers account for half of total household deposits and the bulk of banking profits in retail banking. 

This means that it is actually not that difficult for foreign banks to poach away these small number of "high net-worth individuals"  without setting up a huge branch network. These wealthy customers are more likely to have private transport vehicles and shouldn’t care that much about the location of the bank branches, so long as they are located in the posh financial districts.

Bad news for gigantic Chinese local banks though. The report warns that "If even a small number of customers from this group shift to the foreign competitors, existing banks could face a liquidity crisis"

Hat tip: Financial Time: Ready to compete in global markets

Inefficient banking sector in China is actually an optimal way of taxation

It is well perceived that China's state-monopoly banking sector (with the help of capital control) is a powerful tool in channelling private sector wealth into loss-making state-owned enterprises and numerous white-elephants public infrastructure projects.

A paper written by several Chinese economists however argues that such a mechanism is actually optimal. The idea is as follows.

In developing countries, it is usually very difficult for the government to collect taxes (everyone hides their income), and official taxation is usually very inefficient (it creates a lot of distortion in the economy and a disproportionate burden on hard-working and smart people). Formal taxation thus becomes very costly and creates a lot of dead-weight costs.

But the government needs money and by whatever means the government will try to extract revenue from the private sector. Conditional on the "grabbing hand" nature of the government, an “implicit taxation” by channeling private sector wealth into low-return public projects, through the monopoly banking sector, becomes an optimal and efficient solution:  it is efficient because (1) the cost of “tax “collection is low (you can avoid it only if you completely go underground) (2) the “taxation” is relatively fair and less distorting (it is proportionate to your existing wealth).

Certainly it is even better if the government does not try to extort the private sector in the first place. But if the government does do it, it is better that it does it through the banking sector. At least you don’t need to pay the robber to rob you, and at least hard-working people don’t have higher chance of being robbed.

When a gun is pointed at you, it makes no sense to fight. Take my money but don't hurt me.

Financial Repression and Optimal Taxation (pdf file)

Chong-en Bai, David D. Li, Yingyi Qian, Yijiang Wang

Financial repression entails an implicit taxation on savings. When effective income-tax rates are very uneven, as common in developing countries, raising some government revenue through mild financial repression can be more efficient than collecting income tax only.