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China’s debt/GDP ratio of 20-30% isn’t as attractive as it looks, writes Patrick Chovanec


Toss in contingent liabilities for the banks, local governments, and things like the railway system, and even optimists put the number at 90%. Pessimists put it at 200% or higher, Greek territory. Remember, Irish government finances were the envy of the world until its real estate boom went bust. In any case, “China’s fiscal resources are not as limitless as they seem.”

http://chovanec.wordpress.com/2011/12/17/bloomberg-hard-landing-in-sight/

Earlier this week, I appeared on Bloomberg, and the interview was posted online under the cheerful headline “Chovanec says China faces harder landing than expected.”  I know, I’m a bundle of Christmas cheer these days — but as I said at the Economist conference a few weeks ago (in an allusion to Game of Thrones), “Winter is coming,” and these days, it’s hard to avoid noticing a distinct nip in the air.  You can watch me comments here (Bloomberg), here (Washington Post), or here (YouTube), depending on which connection works best for you.

I actually thought the Bloomberg interview was going to focus on the tax cuts and/or reforms that Chinese policymakers have been discussing as part of their effort to (a) re-stimulate the economy, and (b) encourage a substantive economic adjustment toward greater domestic consumption.  But the conversation never turned in that direction.  So I’ll share the thoughts I would have shared here:

  • Smart tax cuts can play a role in stimulating innovation and consumption in China, and hence growth.  But the key is cutting the right taxes, and stimulating the right things.  China’s current tax system is geared towards subsidizing production (particularly exports) and investment (particularly real estate) at the expense of savers and consumers.  This needs to change, but unfortunately many of the tax “reforms” officials are currently talking about go in the wrong direction.  Let me give three examples:
  1. Lower and middle-income earners account for over half of all income tax revenue in China (compared to the U.S., where the top 10% of income earners pay 71% of federal income taxes, and the bottom half pay only 3%).  This places a huge burden on lower-income earners and suppresses consumption.  The solution, some Chinese policymakers believe, is simple:  make the tax code more progressive.  They even started to shift in this direction earlier this year.  The problem, though, isn’t the tax rate — China’s top marginal rate is 45%.  The problem is uneven enforcement and collection.  SOE employees — including top management – receive a lot of their compensation in-kind (free food, free housing, free car with driver, etc) and tax-free.  Business owners can classify their income in ways that avoid taxes.  Officials, we all know, receive much of their income under the table.  The only people who actually pay 45% of their real income are foreigners or Chinese nationals working for foreign companies.  Raising their tax rates — which are already high — will just drive people to Hong Kong.
  2. One stimulus tax cut the Chinese government is talking about is increasing the VAT rebate for exports.  All that will do is reinforce the existing imbalances in the Chinese and global economies.
  3. One way the Chinese can potentially boost consumption is by creating a social safety net (either public or private in nature) that might allow people to lock up less savings to provide against unemployment, medical bills, or old age.  But the new National Social Security Law requires foreigners working in China to contribute to the payroll tax, even though they have no way of collecting the benefits (for instance, if you lose your job in China, you lose your visa, so you can’t collect unemployment).  Worse, Dalian is considering plans to remove the cap on payroll tax liability (now limited to three times the local average wage), which would effectively impose a 30% tax on top of the 45% income tax, for a total effective tax rate of 75%.  This is supposed to stimulate the economy?
  • As China does look at more meaningful ways to cut taxes, policymakers should keep in mind that China’s fiscal resources are not as limitless as they seem.  Officially, China’s public debt to GDP ratio is somewhere around 20-30% (depending on who’s doing the counting).  This ignores, however, the contingent liabilities that the Chinese government is on the hook for — bailouts for banks, local governments, ministries (like the Ministry of Railways), SOEs, the property sector (in the form of subsidized housing campaigns).  Relative optimists (like the folks at Dragonomics) put China’s actual debt to GDP ratio at 90%.  Pessimists (like Victor Shih, Michael Pettis, or the folks at Fitch) put it at 200% or higher — Greek levels.  Not to say that China shouldn’t be looking at ways to improve its tax system, and reorient its incentives — it should — but it does not have, as many seem to think, money to burn.

If you’re not thoroughly depressed already, you can check out an interview I did on CNNabout a week ago (and only just located the link for) on latest summit held by EU leaders to resolve the Euro debt crisis.  A week later, I think my comments — I said that European leaders have no growth plan, and “are rearranging deck chairs on the Titanic” — have held up rather well.  At first, German Chancellor Angela Merkel was quite confident in describing the meeting as a success, producing a landmark agreement that would bind the Eurozone together.  Now, a growing number of countries aren’t so sure.  The Czechs say they want to see the details, the Irish say they might have to hold a referendum.  And so it goes . . . no wonder the Chinese are nervous.

On my better days, I figure this is what the American Founding Fathers must have looked like when they were foundering around under the Articles of Confederation, before they sat down and drafted the Constitution.  And maybe that’s precisely what Merkel and Sarkozy are driving at.  But I can’t help seeing a whole lot of Rhode Islands here (which didn’t ratify the Constitution until more than a year after President Washington was sworn into office) who have no intention of signing up for the French or German idea of “a more perfect union.”

Last, on a much-needed lighter note, check out this wonderful parody from The Onion on Facebook as a not-so-secret CIA program.  My favorite line, on Twitter as a failed CIA program: “Funding for that should be cut entirely … 400 billion tweets and not one useful bit of data was ever transmitted.”  Second best part:  “Operation Farmville”.

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