Fiscal expansion? Not so fast

As expected, yesterday saw pretty awful performances on the local stock exchanges, with the SSE Composite down 5.2%, followed by a 0.7% loss today.  Given what is happening around the world this is pretty standard stuff, but it does put an effective end to the latest attempt by the government to rally markets.  Unless we get some more interference from the government, or a big rally abroad, we are going to drift back down to test last month’s lows.

Yesterday in fact there was an attempt to “signal” the market into positive territory.  The PBoC announced that they would once again permit companies to issue medium term bonds, and that the proceeds could be used to repurchase shares, but the market wasn’t impressed.  Good.  I wonder if decapitalizing companies and increasing leverage in the system is the best way to deal with upcoming volatility.  I hope companies are fairly sparing in their use of this new privilege.

Tom Holland has an interesting new piece in the South China Morning Post arguing that Beijing has much less room for fiscal expansion than is widely assumed.  I think this idea that fiscal expansion can get us out of the current mess needs to be much more seriously debated, and I am glad he is doing so.

His argument has two parts.  First, he says, the balance sheet isn’t as clean as we might think. Problems in the banking system can have a very large impact on the government budget.

As the economy slows, the proportion of non-performing loans in the state-controlled banking sector is certain to rise, bumping up the government’s contingent liabilities.  That’s important, because although the official ratio of bad loans at the end of June was just 5.6 per cent of banks’ total loan books, the absolute amount was more than 17 times the government’s budget surplus for the whole of last year. Clearly it wouldn’t take much of an increase to knock a big hole in banks’ capital and, ultimately, in the government’s own finances.

I think he is right and would actually go a little further.  There is already more debt out there than we think.  Today’s Bloomberg quotes a more optimistic Morgan Stanley analyst on the subject:

China can “afford to run multiyear fiscal deficits without running into debt sustainability problems,” because it has public debt of only 30 percent of gross domestic product, Wang said.

30% perhaps, if you ignore various contingent but very real liabilities including the obligations of the bankrupt AMCs, which are guaranteed by the MoF, or the possibility of uncollectible debt at the provincial and municipal level, which is guaranteed by the central government.  About three years ago a Chinese think tank director estimated it to be about 10% of GDP, and I would guess by now that it has grown.  Add all the pieces up and I suspect total debt is probably over 50% of GDP before we include the possibility that an economic slowdown might cause NPLs to rise.

Referring to charts accompanying with his article, he also makes the point that rapid growth in fiscal revenues and expenses in recent years makes projections very volatile and very sensitive to changes in assumptions:

As the first of the two charts below shows, both government revenues and spending have increased sharply in recent years. Beijing did indeed run a surplus in 2007, but only because revenue growth fractionally outstripped the rise in expenditure at the very peak of the cycle. Unfortunately for finance ministry officials, history tells us that when the economic cycle turns down, revenues tend to fall rapidly, while spending proves a lot more “sticky”. As a result, fiscal positions quickly deteriorate and budget surpluses soon turn into deficits.

There are ominous signs that this is happening in China. As the second chart shows, government revenue in August was just 10 per cent higher than in the same month in 2007. That compares with a rise of 32 per cent for 2007 as a whole.  And there are signals China’s fiscal position will get a great deal worse before it gets better. Tax reform earlier this year has already damped corporate tax revenue from domestic companies. Now with profit growth slowing abruptly – the country’s biggest listed aluminium producer warned yesterday that third-quarter profits would be down 50 per cent from last year – revenue from corporate taxes is set to fall steeply.

That’s not all. The property market is cooling. Home sales in Beijing and Shanghai were down around 80 per cent in September compared with the previous year. As a result, government revenues from property taxes and land sales are also likely to head south.

Needless to say I agree with Holland’s assessment.  I think we have all been a little quick to expect that fiscal expansion is the silver bullet that will kill the monster of economic contraction.  Let’s see.

Originally published at China Financial Markets on Oct 7, 2008 and reproduced here with the author’s permission.