The Javed Akhtar Syndrome in Real Estate

Javed_Aktar_2010

Poets usually write poems on love, breakups, betrayal, friendships, alcohol, the women serving alcohol, the world at large, politics and so on. But very rarely does a poet write a poem or a couplet on the unaffordability of real estate in India. But Javed Akhtar has done that:

sab kā ḳhushī se fāsla ek qadam hai.
har ghar meñ bas 
ek hī kamra kam hai

A loose translation of this in English would be as follows: “Everyone is just one step away from happiness; Every house has just one room less”.

Given the fact that Akhtar has spent a large part of his adult life in Mumbai, the above couplet reflects or rather captures the sensibilities of the city that never sleeps, very beautifully.

Dear Reader, you must be wondering, why am I talking about a couplet written by Javed Akhtar on a rather muggy Tuesday in Mumbai. Allow me to explain.

Over the weekend, I met a friend who wants to sell his one-room-kitchen (a very Mumbai thing) apartment and buy a one-bedroom-hall-kitchen (one BHK) apartment. Basically, he feels his current apartment has one room less and he wants an apartment which has one room more than his current one.

Of course, the transaction cannot be carried out, unless he is able to sell his current apartment. The money generated from that will partly be used to pay off the current home loan. The new apartment will be bought with whatever remains after selling off the current apartment and repaying the home loan; along with this a fresh larger home loan will have to be taken. Over and above this, some financial savings accumulated through investing in mutual funds through the SIP route, will also have to be used.

My friend had bought the apartment for Rs 50 lakh, nearly three years back. He is looking at a price of at least Rs 60 lakh. In fact, more than looking, he is specifically anchored on to that price and won’t sell for anything less than that price.

As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This is not the first time I am discussing the phenomena of anchoring in real estate, nevertheless, this example is interesting and different, because anchoring, as we shall see, is happening at multiple levels.

My friend is anchored on to a price of Rs 60 lakh because he feels that at that price he will be in a situation of no-profit no-loss, while selling his current apartment. The extra Rs 10 lakh, over and above the price he bought the apartment for, should take care of the home loan EMIs and the maintenance charges paid, over the last three years. This is his logic for being anchored on to a price of Rs 60 lakh.

The trouble is that at that the few buyers who have approached him do not want to pay more than Rs 55 lakh, while my friend remains stuck on the Rs 60 lakh figure.

In this case, the transaction is what we can call a relative transaction. The money that my friend gets for selling the current apartment will be used to buy a bigger apartment in the same locality that he lives in.

If he waits too long to get a price of Rs 60 lakh, chances are that the price of the bigger apartment that he wants to buy will also go up. Currently, the bigger apartment is available for a price of around Rs 80 lakh.

I tried explaining this point to him without much success. In fact, after I explained this point to him, my friend told me that he had a buyer who was willing to pay Rs 60 lakh. The trouble was that this prospective buyer needed to sell an apartment in another city to be able to raise the amount.

This buyer, because my friend had become anchored to a price of Rs 60 lakh, was also anchored to that price. Given that he was a senior citizen, he was not in a position to raise a home loan. Hence, he needed someone to pay Rs 60 lakh for his flat to be able to purchase my friend’s flat.

No one was willing to pay Rs 60 lakh for the flat. In this case, the prospective buyers were willing to pay anything in the range of Rs 55-60 lakh. But that was clearly not enough. And given this, the sale of both the flats remained stuck.

This example clearly shows as to how anchoring works at multiple level and not just at one level, as is often believed. This anchoring essentially stops the market from working. The more general conclusion from this example would be that anchoring working at multiple levels, is one of the reasons why the buying and selling of real estate has slowed down majorly.

The sellers (not necessarily the builders) are still expecting prices that their homes were worth until a few years back. But the buyers, who have paid more than their fair share over the years, are currently not willing to pay the price that the sellers want.

Ultimately, this anchoring on to a specific price will break down. It’s just that it won’t happen overnight and will take some time.

Until then writers like me will have enough masala to keep writing on real estate.

Keep watching this space!

The column originally appeared on Equitymaster on November 14, 2017.

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Economic Lessons from a Computer Printer

printer

A few years back when I quit business journalism to write fulltime, one of the first things I did was to buy a computer printer. This was primarily to help my reading habit, given that I can’t read long documents on a computer. Also, it helped me to print and send out invoices conveniently, instead of having to visit a shop every time I needed to send out an invoice.

Like any good Indian, I bought the cheapest branded printer that was available. It cost just Rs 3,000. It was only when I started printing stuff did I realise how expensive the printer really was. While, the printer cost just Rs 3,000, every time I bought a cartridge, it cost Rs 800-900. And cartridges kept running out at a very fast pace. At best, I could print around 130-150 pages with a single cartridge. It was only then I realised that the printer was just something the company sold, so that they could get the consumers to buy cartridges, which is where the actual money was made.

As Even Davis writes in Post Truth—Why We Have Reached Peak Bullshit and What We Can Do About it: “By keeping a headline price low, the hope is that we assume that the overall price is low… We judge the cost of a product on the headline price, so the headline price will be kept low… There are the up-front prices versus the ongoing charges. Teaser mortgage rates that become expensive later, cheap printers with expensive cartridges and cheap razors with expensive blades are all examples of the same thing.”

In fact, in some cases the consequences can be dire. One of the reasons behind the current financial crisis was the bursting of the home price bubble in the United States and other parts of the Western world. A major reason behind the bubble was the fact that the EMIs that needed to be paid on home loans had crashed dramatically because of teaser rate mortgages (or home loans as we call them in India). In a teaser rate home loan, the interest rate is much lower in the initial years, after which it goes up dramatically.

This led to a lot of people who shouldn’t have gotten a home loan in the first place getting one. The trouble was that once the high EMIs kicked in (remember it was a teaser loan with low EMIs initially) the borrowers simply did not have the money to keep repaying the loan. So, first the teaser loans led to the home prices going up. Once the EMI defaults started, it led to a price crash, which was one of the reasons which fuelled the financial crisis.

What is the bigger lesson here? As Davis writes: “We tend to make important judgements on the basis of a few key indicators, and so by manoeuvring those indicators our perception can be controlled.” Like anyone buying a printer for the first time looks just at the price (and possibly the brand). He or she doesn’t bother about the cost of running the printer over the longer term. Companies manufacturing the printer manipulate the situation by selling printers for low prices. This basically leads to people buying the printer.

Such manoeuvring also happens in other areas. As Davis writes: “We think that good magazines have good covers, so when we observe a good cover we infer that the magazine underneath will be worth buying. As long as editors understand this rule of thumb, then you can expect inordinate effort to go into the design of the cover, even to the possible detriment of the rest of the magazine.”

Anyone who has read Indian magazines over the last two decades would know that while magazine covers have improved dramatically, the same cannot be said about the articles being published.

The moral of the story is “that as long as we come to a judgement based on only a selection of the available evidence, canny communicators will have a disproportionate impact on our thinking by being selective in the evidence they put forward.”
As the old adage goes, what you see is what you get.

(The column was originally published in the Bangalore Mirror on July 26, 2017).

Trump’s Plan to Make America Great Again Will Fail Because of Dollar

In the early 16th century the Spaniards captured large parts of what is now known as South America. The area had large deposits of silver and gold. As I write in my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War: “The precious metals were melted and made into ingots so that they could be easily transported to Spain. Between 1500 and 1540, nearly 1,500 kg of gold came to Spain every year on an average from the New World.” i

Gold wasn’t the only precious metal coming in. A lot of silver came in as well. As I write in Easy Money: “One of the biggest silver mines was found in Potosi, which is now in Bolivia, in 1545. Potosi is one of the highest cities in the world and is situated at a height of 4,090 m. Given the height it sits on, it took Spaniards sometime to get there. Here a mountain of silver of six miles around its base was discovered.ii The mountain or the rich hill, as it came to be called, generated nearly 45,000 tonnes of silver between 1556 and 1783. iii

Most of this new found silver was shipped to Seville in Spain where the mint was. In the best years some 300 tonnes of silver came in from silver mines in various parts of South America.iv

Once the gold and silver started to land on their shores, the Spaniards became proficient at spending it rather than engaging themselves in productive activities. Easy money had spoiled them and they produced very little of their own. Once this happened everything had to be imported. Weapons came from the Dutch, woolens from the British, glassware from the Italians, and so on.v It also led to Spaniards buying goods like bangles, cheap glassware, and playing cards from foreigners for the sheer pleasure of buying them.

As Thomas Sowell writes in Wealth, Poverty and Politics: “The vast wealth pouring into Spain [in the form of gold and silver from South America]… allowed the Spanish elite to live in luxury and leisure, enjoying the products of other countries, purchased with the windfall gain of gold and silver. At one point, Spain’s imports were nearly twice as large as its exports, with the difference being covered by payments in gold and silver… It was a source of pride, however, that “all the world” served Spain, while Spain “serves nobody”.”

Dear Reader, you must be wondering, why have I chosen to point out all this history so many centuries later. The point I am trying to make is that there is an equivalent to what happened in Spain in the 16th century in this day and age. It is the United States of America.

Like Spain, the total amount of good and services that the United States imports is much more than what it exports. The ratio of the imports of the United States to its exports was around 1.23 in 2016. The difference between the imports and the exports stood at $503 billion. In fact, if we look at the imports and the exports of goods, the ratio comes to around 1.51.

The point being that like Spain, the United States imports much more than it exports. Spain had an unlimited access to money in the form of gold and silver mines of South America. This gold and silver over a period of time was mined and shipped to Spain and in turn used by Spaniards to buy stuff from other parts of the world.

What is the equivalent in case of the United States of America? The dollar. The US dollar is the international reserve currency. It is also the international trading currency. As George Gilder writes in The Scandal of Money-Why Wall Street Recovers But the Economy Never Does: “Today it [i.e. the dollar] handles more than 60 percent of world trade, denominates more than half the market capitalization of world stocks, and partakes in 87 percent of global currency trades.”

Spain had almost unlimited access to the gold and silver from South America. Along similar lines, the United States has unlimited access to the dollar. Other countries need to earn these dollars by exporting goods and services. The United States needs to simply print the dollars (or digitally create them these days) and hand it over for whatever it needs to pay for.

While the unlimited access to gold and silver was Spain’s easy money, the dollar is United States’ easy money. And given this, it isn’t surprising that like Spain, the United States imports much more than it exports. This basically means that the country consumes much more than it produces. Also, while the Spaniards had to face the risk of gold and silver ultimately running out, the United States does not face a similar risk because dollar is a fiat currency unlike gold, and can be created in unlimited amounts. As long as dollar remains the global reserve currency and trading currency, the United States can keep creating it out of thin air. Of course, the role of the United States in global politics will be to ensure that the dollar continues to remain the reserve and trading currency. Having the biggest defence budget and military in the world, will help.

The supply of silver in Spain peaked around 1600 and started to fall after that. But the spending habits of people did not change immediately, leading to Spain getting into debt to the foreigners. The government defaulted on its loans in 1557, 1575, 1607, 1627, and 1647.vi

One impact of access to the easy money in the form of gold and silver, was a huge drop in human capital in Spain. As Sowell writes: “What this meant economically was that other countries developed the human capital that produced what Spain consumed, without Spain’s having to develop its human capital… Even the maritime trade that brought products from other parts of Europe to Spain was largely in the hands of foreigners and European businessmen flocked to Spain to carry out economic functions there. The historical social consequence was that the Spanish culture’s disdain for commerce, industry and skilled labour would be a lasting economic handicap bequeathed to its descendants, not only in Spain itself but also in Latin America.”

So, what is human capital? Economist Gary Becker writes: “Economists regard expenditures on education, training, medical care, and so on as investments in human capital. They are called human capital because people cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets.”

What is happening on this front, in case of the United States? As Michael S Christian writes in a research paper titled Net Investment and Stocks of Human Capital in the United States, 1975-2013, published in January 2016: “The stock of human capital rose at an annual rate of 1.0 percent between 1977 and 2013, with population growth as the primary driver of human capital growth. Per capita human capital remained much the same over this period.”

So, over a period of more than 35 years, the per capita American human capital has remained the same. And this is clearly not a good sign.

Further, unlike Spain which ultimately ran out of gold and silver, given that there was only so much of it going around in South America, the United States does not face any such risks given that dollar is a fiat currency and can be printed or simply created digitally.

But like Spain, the access to this easy money will ensure that in the years to come, the United States will continue to import more than it exports. This will go against the new President Donald Trump’s plan to make America great again. His basic plan envisages increasing American exports and bringing down its imports. But as long as America has access to easy money in the form of the dollar, the chances of that happening are pretty low because it will always be easier to import stuff by paying in dollars that can be created from thin air, than manufacture it locally.

The column was originally published on Equitymaster on March 14, 2017

4 Things Modi Could Have Done Instead of Demonetisation

narendra_modi

The decision to demonetise Rs 500 and Rs 1,000 notes when it was first announced was to tackle black money and fake currency. As the ministry of finance press release accompanying the decision said: “High denomination notes are known to facilitate generation of black money”.

What the Modi government was essentially saying is that it is easier to store black money in the form of high denomination notes. Having demonetised Rs 500 and Rs 1,000 notes, the government decided to launch a Rs 2,000 note, going precisely against its own statement.

The assumption was that people had stored black money in their homes in the form of cash. And by demonetising Rs 500 and Rs 1,000 notes, these notes would be rendered useless. Holders of black money in the form of currency would deposit it into banks and post offices, for the fear of generating an audit trail. Demonetised currency can be deposited into banks and post offices up to December 30, 2016. This money will be credited into the bank account or the post office savings account.

Things haven’t turned out like that. By December 6, 2016, close to 75 per cent of the demonetised currency had already made it back into the banks. Government officials are now saying that they expect almost all the demonetised currency to come back to the banks.

What this essentially means is that those who had black money in the form of cash have managed to get it converted into currency which continues to be legal tender. The hope now is that the government will use information technology to identify people who have deposited their black money into banks, tax them and raise some money in the process.

To what extent this happens remains to be seen. Nevertheless, if the idea was to attack black money in India, there are four things that the Modi government could have done, instead of demonetising high denomination notes and disrupting the entire economy. This would have hit at the heart of the nexus between politicians and builders, which thrives on black money.

1) Stop cash donations to political parties: Currently, political parties need to declare a donation only if it is greater than Rs 20,000. In 2014-2015, 55 per cent of the donation of the national political parties came from those making donations of Rs 20,000 or lower. Hence, the details of these donors are unknown.

If citizens are expected to share their identity with the bank or the post office while depositing their demonetised notes, why should donors of political parties be allowed to hide behind an archaic law, is a question worth asking. This needs to change.

2) Political parties should be brought under Right to Information(RTI): This is currently not the case. If the political parties are brought under the ambit of RTI, they will have to function in a much more transparent way in comparison to what they do now. This would mean keeping proper records of where the funds to finance them are coming from.

3) Real estate should be brought under the Goods and Services Tax(GST): If real estate is brought under GST, builders if they want to claim input tax credit must request documentation from all the suppliers and the contractors that they work with. This will hopefully start cleaning up the real estate business as more and more builders will have to operate through legitimate means. Once they stop using cash in dealings with their suppliers, their proclivity to ask for cash from their customers will also go down.

4) Slash stamp duty rates on real estate transactions: This is one reason why the real estate sector is at the heart of black money. If stamp duties across states are reduced and brought to realistic level, the tendency of people to under-declare the value of real estate transactions will come down. Hence, the proportion of cash transactions will come down.

These four moves would have hit at the heart of the generation of black money. What the government chose to do instead was to demonetise Rs 500 and Rs 1,000 notes, and throw the entire country in a huge disarray.

The column originally appeared in Bangalore Mirror on December 14, 2016

 

Why Jats of Haryana Want Reservation

Jat_Agitation_for_reservation

I normally do not write on political issues but the recent demand of the Jats of Haryana to be counted as other backward castes(OBCs), is a part of a larger issue that I have been writing about. Hence, this column.

Castes which are categorised as OBCs have 27% reservation in public sector jobs and higher education. The Mandal Commission Report of 1980 had said that OBCs form 52% of the country’s population. In comparison, a survey carried out by the National Sample Survey Organisation in 2006 said that the OBCs form 40.96% of the country’s population.

Jats form 29% of Haryana’s population and own three-fourths of its land media reports point out. As Harish Damodaran writes in a brilliant column in The Indian Express: “The community probably owns three-fourths of agricultural land in Haryana, with the Jat being synonymous with the ‘zamindar’ just as much as the Bania with the trader.”

Given this, why do zamindars actually want reservation? Before I get around to answering this, it is important to understand how Jats ended up owning as much land as they do now.

As Surinder S Jodhka writes in Caste: “One of the most important developmental initiatives taken by the Indian State soon after independence was the introduction of Land Reform legislations. These legislations were designed to weaken the hold of the non-cultivating intermediaries (the so-called landlords) by transferring ownership rights to the tillers of the land.”

And how did this help the Jats? As Jodhka writes: “The Rajputs, traditionally upper-caste and the erstwhile landlords, possessed far less land after the Land Reforms than they had done before. Most of the village land moved into the hands of those who were traditionally identified as tillers of the land, the middle caste groups such as Jats and Gujars.”

This essentially ensured that Jats became what sociologist MN Srinivas called a dominant caste in the state of Haryana. As Srinivas wrote: “A caste may be said to be ‘dominant’ when it preponderates numerically over the other castes, and when it also wields preponderant economic and political power.” (As quoted in Jodhka’s book).

After land came the agricultural revolution which increased the crop yields and in the process increased the economic power of the Jats. Given their numbers, they already had the political power.

This explains why Jats have dominated the politics of Haryana for more than a few decades. It also explains why Manhohar Lal Khattar became the first non-Jat chief minister of Haryana in over two decades. And given that Khattar was a first time MLA with little administrative experience, he was caught napping as the movement built up all over the state.

One theory is that the movement was instigated by those not in power in the state. This might very well be true given the scale it finally reached, but it still doesn’t do away with the fact that Khattar was caught napping.

Now to answer the question that I had raised as to why do Jats wants reservation.

The Agriculture Census of 2010 points out that the average size of an individual holding in Haryana has fallen to 1.57 hectares. In 1995-1996, the average size of individual holding was at 1.74 hectares, a fall of around 10%. This means that the land holdings in Haryana over the years have gotten more fragmented, leaving a lesser area for every farmer to farm on.

This is in line with the broader trend that prevails in the country. As per Agriculture Census of 2010-11: “The average size of holdings for all operational classes (small & marginal, medium and large) have declined over the years and for all classes put together it has come down to 1.16 hectare in 2010-11 from 2.82 hectare in 1970-71.” The situation could have only gotten worse since then. Hence, many more people are dependent on agriculture and farming than should be. This means lower income per capita from agriculture.

In this scenario, the importance of jobs has gone up. Nevertheless, as the Economic Survey released in February 2015 points out: “Regardless of which data source is used, it seems clear that employment growth is lagging behind growth in the labour force. For example, according to the Census, between 2001 and 2011, labour force growth was 2.23 percent (male and female combined). This is lower than most estimates of employment growth in this decade of closer to 1.4 percent.”

The jobs which would have moved people away from agriculture and farming have not materliased. Further, with 49.5% of government jobs being reserved (22.5% for SCs and STs, 27% for OBCs) the Jats (as well as others who fall in the general category) have probably found the competition to get into a government job very tough.

It further needs to be pointed out here that the government jobs at lower levels are significantly better paying than similar jobs in the private sector.

As the Report of the Seventh Pay Commission points out: “To obtain a comparative picture of the salaries paid in the government with that in the private sector enterprises the Commission engaged the Indian Institute of Management, Ahmedabad to conduct a study. According to the study the total emoluments of a General Helper, who is the lowest ranked employee in the government is Rs 22,579, more than two times the emoluments of a General Helper in the private sector organizations surveyed at Rs 8,000-9,500.”

Hence, the IIM Ahmedabad study “on comparing job families between the government and private/public sector has brought out the fact that…at lower levels salaries are much lower in the private sector as compared to government jobs.”

What this clearly tells us is that the reason Jats want to be categorised as OBCs is the same reason why engineers, MBAs and PhDs apply for government jobs at lower levels—they are significantly better paying than similar jobs in the private sector.

Further, what does not help is the fact that Haryana has the worst sex ratio in the country at 879 females for every 1000 males, as per the 2011 census. As Christophe Jaffrelot writes in The Indian Express: “The search for government jobs…is also influenced by their particularly skewed sex ratio. Parents of girls prefer grooms with stable income – those with government jobs are often their preferred choice. With fewer girls compared to boys in these castes, there is competition in the marriage market.”

The Haryana state government has plans of introducing a Bill to grant OBC status to Jats. This won’t go down well with 74 other castes who are already categorised as OBCs in Haryana. To them, Jats are the well-off land-owning people who really do not need any reservation. Also, with Jats forming 29% of the state’s population competition among the OBC aspirants for government jobs will go up significantly. The situation might become easier for the Jats but not for the castes categorised as OBCs as of now. Hence, be ready for another share of agitations.

Further, any attempt to categorise Jats as OBCs will lead to similar demand from other land-owning castes across the country who are seeing difficult days due to their land-holdings shrinking. In fact, similar demands have already been made by the Kapus in Andhra Pradesh, the Marathas in Maharashtra, the Patels in Gujarat (their leader Hardik Patel is currently in jail) and the Gujars in Rajasthan.

In fact, the Rajasthan government has already passed the Rajasthan Special Backward Classes (Reservation of Seats in Educational Institutions in the State and of Appointments and Posts in Services under the State) Bil, 2015. The Gujars are expected to be the main beneficiaries of this Bill.

In fact, at the heart of all this is an issue which I have discussed multiple times in the past. India has more people in agriculture than it needs. These people need to be moved away from agriculture. This needs the creation of many semi-skilled and unskilled jobs, something which is not happening, given that Indian industry is not exactly known to be labour-intensive. And the social consequences of this economic drawback are now coming to the fore.

The column originally appeared in the Vivek Kaul’s Diary on February 24, 2016

Chinese Growth is Bad for Global Economy

china

In yesterday’s edition of the Diary I talked about how Chinese banks have unleashed another round of easy money, in order to push up economic growth. The Chinese economic growth for 2015 was at 6.9% which is a two-decade low. Many China watchers and economists believe that the real economic growth is significantly lower than this number and is likely to be more in the region of 4-5%.

In order to push up economic growth Chinese banks lent out a whopping 2.5 trillion yuan (around $385 billion) in January 2016, the highest they ever have during the course of a month. This increased borrowing and spending if it continues, as it is likely to, will lead to creation of more capacity in China.
The creation of this excess capacity will provide a short-term fillip to the Chinese economic growth as more infrastructure, homes and factories get built. The trouble is that the Chinese economy is unlikely to absorb the creation of this excess capacity.

As Satyajit Das writes in The Age of Stagnation: “China continues to add capacity to maintain growth. If it is unable to absorb this new capacity domestically, it might seek to increase exports to maintain production and growth. This would exacerbate global supply gluts and increase deflationary pressures in the global economy.” Deflation is the opposite of inflation and essentially means a scenario of falling prices.

Household consumption as a proportion of the Chinese economy has fallen over the years. In 1981, household consumption made up for 51.7% of the gross domestic product(GDP). Starting in 1990, the household consumption as a proportion of the Chinese economy started to fall and by 1999, it was at 45.6% of the GDP.

By 2009, the number had fallen to 35.3% of the GDP. In 2014, the household consumption to GDP ratio stood at 36.6%, not very different from where it was in 2009.

What does this tell us? As Michael Pettis writes in The Great Rebalancing—Trade, Conflict and the Perilous Road Ahead for the World Economy: “In any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and trade surplus to generate growth.” Trade surplus is essentially the situation where the exports of a country are more than its imports.

This is precisely how it has played out in China. In 1981, the Chinese investment to GDP ratio was at 33%. In 2014, the number stood at 46%. What does this tell us? By limiting consumption, the Chinese were able to create savings. These savings were then diverted into investments and the investment created excess capacity in the Chinese economic system. In 1982, the Chinese savings had stood at 35% of the GDP. By 2013, Chinese savings had jumped to 50% of the GDP. The investment to GDP ratio during the same year stood at 48%.

The excess capacity was taken care of by exporting more. And that is how the Chinese economic growth model worked all these years. What this means that with a low consumption rate, the Chinese have always been more dependent on investment and exports to create economic demand. In the 1980s and 1990s, the high rate of investment made immense sense, when China lacked both infrastructure as well as industry. But over the years China has ended up overinvesting and creating excess capacity, and in the process become overly dependent on exports, if it wants to continue to grow at a fast rate.

As Pettis writes: “With consumption so low, it would mean that China was overly reliant for growth on two sources of demand that were unsustainable and hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure rapid economic growth. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.”

In 2014, the household consumption to GDP ratio stood at 36.6%. Hence, the shift towards consumption driving economic growth has clearly not happened. The point being that the country is now addicted to the investment-exports driven growth model. In this scenario, every time there is a slowdown in economic growth, China resorts to the tried and tested investment led economic growth model. And the first step in this model is to get banks to lend more.

As Pettis writes: “The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economists politely call rent-seeking behaviour, while costs are spread through the entire country through the banking system and over the many years during which the debt is repaid.”

This explains why Chinese banks lent 2.5 trillion yuan in January 2016, the most that they ever have. The trouble is that this round of economic expansion will lead to more excess capacity. And this will lead to a push towards higher exports and in the process hurt the global economy.

As Pettis writes: “China is not currently the engine of world growth. With its huge trade surplus, it actually extracts from the world more than its share of what is now the most valuable economic source in the world—demand. A rebalancing will mean a declining current account surplus and reduction of its excess claim on demand. This will be positive for the world.”

What Pettis basically means is that the Chinese household consumption to GDP ratio needs to go up i.e. the Chinese need to consume more of what they produce. But recent evidence clearly suggests that the Chinese government has no such plans and the investment-exports driven led economic growth strategy is likely to continue.

The column originally appeared in Vivek Kaul’s Diary on February 23, 2016

China Unleashes Another Round of Easy Money

chinaIn 2015, China grew by 6.9%. This is the slowest the country has grown in more than two decades. For a country which has been used to growing in double digits for a very long time, an economic growth rate of 6.9% is very low. Further, there are many economists who believe that even the 6.9% number isn’t correct.

A recent report in the Wall Street Journal quotes, an economics professor Xu Dianqing, as saying “that China’s gross domestic product growth rate might just be between 4.3% and 5.2%”.

The Chinese manufacturing sector which makes up for 40.5% of the economy grew by 6% in 2015. Nevertheless, many underlying indicators like power generation, railway freight movements, steel, cement and iron output, paint a different picture. As the Wall Street Journal points out: “Of some 60 major industrial products, nearly half saw output contract in the January to November period, while railway cargo volume fell 11.9% for all of last year, according to official sources.” (Doesn’t this sound similar to what is happening in India as well?)

Given this, it is only fair to ask how did the Chinese manufacturing sector grow by 6% in 2015? And how did the overall economy grow by 6.9%?

The point being that China is not growing as fast as it was and not as fast as it claims it is. Of course, if economists outside the government can figure this out, the government obviously realises this. Nevertheless, like all governments they need to maintain a position of strength and try and revive a flagging economy.

In the world that we live in, economists and politicians have limited ideas on how to tackle an economy that is slowing down. The solution is to get people to borrow and spend more. In a country like China where the government controls large parts of the economy, it means encouraging banks to lend more.

And that is precisely what has happened. In January 2016, responding to the low economic growth in 2015, the Chinese banks gave out loans worth 2.5 trillion yuan or around $385 billion. This is “a new record for a single month!” point out Dr Jim Walker and Dr Justin Pyvis of Asianomics Macro.

To give you a sense of how big the lending number is, let’s compare it to what the scheduled commercial banks in India lent during a similar period. Between January 8 and February 5 2016, the Indian banks loaned out around Rs 72,580 crore or $10.6 billion, assuming that one dollar is worth Rs 68.7. The way RBI declares lending data of banks, it is not possible to figure out how much the banks lend during the course of any month and hence, I have picked up the nearest comparable period.

The Chinese banks lent around 36 times more than Indian banks during a similar period. Of course, the Chinese economy is bigger than India is one factor for this difference.

A number of explanations have been offered for this huge jump in Chinese lending.  One is the revival of the Chinese property sector. Further, with the yuan depreciating against the dollar in the recent past, many Chinese companies are replacing their dollar debt with yuan debt, in order to ensure that they don’t have to pay more yuan in order to repay their dollar loans in the future.

But these reasons clearly do not explain this huge jump in lending. Chinese banks are lending out so much money because the government wants them to increase their lending dramatically.

The idea, as always, is to get people to borrow and spend money, and companies to borrow and expand, and in the process hope to create faster economic growth. The trouble is that all this borrowing and spending will only add to the excess capacity that already exists in China.

As Satyajit Das writes in The Age of Stagnation: “It would take decades for China to absorb this excess capacity, which in many cases will become obsolete before it can be utilised. Yet China continues to add capacity to maintain growth.”

Further, the credit intensity or the amount of new debt needed to create additional economic activity has gone up in China, over the years. As Das writes: “The incremental capital-output ratio(ICOR), calculated as the annual investment divided by the annual increase in GDP, measures investment efficiency. China’s ICOR has more than doubled since the 1980s, reflecting the marginal nature of new investment. China now needs around $3-5 to generate $1 of additional economic growth; some economists put it even higher at $6-8. This is an increase from the $1-2 needed for each dollar of growth 8-10 years ago, consistent with declining investment returns.”

The point being that China now needs more and more money to create the same amount of growth. And this means the effectiveness of borrowing in creating economic growth has come down over the years. This also means that the chances of money that the banks are lending out now, not being returned, is higher now than it was in the past.

In fact, as Walker and Pyvis of Asianomics Macro point out: “The China Banking Regulatory Commission reported that official nonperforming loans had jumped 51% year to 1.3 trillion renminbi [yuan] by December, now greater than at the last peak in 2009. While small in terms of the total number of loans out there – the bad loan ratio increased from just 1.25% to 1.67% – it is the direction that is bothersome, particularly given the well-publicised concerns over the accuracy of the data (hint: NPLs are much higher than 1.67%).”

Further, the Reuters reports that the special mention loans (loans which could turn into bad loans or what we call stressed loans in India), rose by 37% in 2015. And bad loans and special mention loans together form around 5.5% of total lending by Chinese lending. Indeed, this is worrying.

This huge increase in lending will obviously push up the economic growth in the short-term. But in the long-term it can’t be possibly good for the economy, as it will only lead to the non-performing loans going up and creation of many useless assets which the country really does not require. The current jump in bad loans of banks happened because of the huge jump in bank lending that happened in 2009, after the current financial crisis started.

Whatever happens, in the short-term, the era of “easy money” seems to be continuing in China. And that can’t possibly be a good thing.

The column originally appeared on the Vivek Kaul’s Diary on February 22, 2016.