- (february 2022)
China Cracks down on Big Giants but Raises Little Giants.
There is no doubt
(see The Effects of the Trump Trade War on China: Waking up the Giant)
that Trump's trade war woke up the sleeping giant: China, that for decades had relied on the West's R&D
(China offsourced research to the West and was happy to focus
on the practical applications
of the winning technologies)
learned from Trump's trade war how vulnerable it has become to the whims of the USA.
China saw how much ZTE and Huawei suffered from sudden US boycotts,
and later how TikTok and Tencent almost lost all their US business.
That was China's "Sputnik moment": China realized its weaknesses and found the motivation to become
self-sufficient and self-reliant in fundamental science and technology.
This is not my opinion. This what China says openly. For example, Tian Yun, vice director of the Beijing Economic Operation Association, in the Global Times in February 2022: "This is a lesson that we learned from the US' crackdown against China's technology rise. In the 13th Five-year Plan (2016-20) period, we prioritized market scale and industry output, but the heated technology war between China and the US exposed the risks of lacking 'hidden champions' in bottlenecked industries".
China has therefore embarked on a massive program to redirect capital and human resources (i.e. talents) towards sectors like semiconductors where it had been
happy to rely on Western suppliers (people routinely underestimate how many
semiconductors the likes of Qualcomm and Intel sell to China).
In 2021 China started cracking down on the giants of consumer internet.
This has widely been interpreted as an ideological decision to thwart possible
political ambitions by the likes of billionaire Jack Ma (founder of Alibaba).
That could be one reason. But the other reason is that China has realized
that consumer Internet is not a priority compared with, for example, semiconductors. The BAT giants (Baidu, Alibaba, Tencent) were stifling innovation, something that China learned from all the Silicon Valley experts who have lectured in China (i'm not sure that Silicon Valley remembers what it used to teach the rest of the world, that giant corporations stifle innovation).
Proof of this second motivation is that China's government not only cracked down on the giants but also revived the little known program of "little giants".
This is a program that dates back to 2005, when Hunan province's local government decided to help smaller enterprises with grants and tax cuts. Other provinces borrowed that model but it remained a low-profile affair. Then
in 2018, after Trump started the trade war,
the central government's powerful Ministry of Industry and Information Technology (MIIT) appropriated the program with national (not provincial) funding and tax incentives.
Since then the MIIT has graduated about 5,000 such little giants, mostly in
the semiconductors and pharmaceutical industries.
At the same time that Alibaba and Tencent were forced to eliminate anti-competitive practices, small startups were funded by the government.
Rarely has the USA acted so decisively to help smaller firms against big corporations.
The MIIT clearly favors favor little giants who work in strategic fields, away from the consumer Internet applications that used to suck the best talents and most of the venture capital following the success of the BAT.
The goal is now to create 10,000 little giants and 1,000 industry leaders by 2025: it was announced by six ministries (led by the MIIT) in February 2022.
Note: 1,000 industry leaders. You'd be hard pressed to name 1,000 different industrial fields.
At the same time China is changing the way talents are trained and raised.
For decades the Chinese universities have focused on engineering. Now they
are introducing classes on entrepreneurship across the board.
China wants its engineers to be able to manage a business cycle and a business model.
An old refrain in China is that the nation has the talents but doesn't understand the business.
Hence the low-profile reform in education to create R&D managers.
A little bit of history. China came out of Mao's era with technology that was worth nothing. The Chinese were incredibly skilled at learning from Western
technology, but it was mostly state-owned enterprises that led the technological revolution. The real success stories came after the reforms of
prime minister Jiabao Wen, who eliminated waste and inefficiency in the way
China was sponsoring technology.
Wen had an amazing career. He survived the Tiannamen Square riots (he belonged
to the current that wanted to negotiate with the protesters) and was appointed prime minister in 2003 by Zemin Jiang and was reappointed under Jiang's successor Jintao Hu. Wen was so influential that he is credited with writing a famous speech delivered by Hu at
the 17th National Congress of the Communist Party in October 2007, the speech
in which Hu introduced the pillars of "scientific development" and "socialist harmony".
In 2011-2013 Wen reformed the funding of science to foster innovation.
Wen retired in March 2013, but in
September 2013 the new president, Jinping Xi, delivered his own
speech to the Communist Party in which he emphasized the need to improve
China's innovation by removing
institutional obstacles
and improving efficiency of the innovation system,
which is what Wen had been doing.
In October 2014 the central government removed the power of ministries like MIIT and created relatively independent institutes to run the national science and technology programs.
In March 2015 the new prime minister, Keqiang Li, released a report about the importance of entrepreneurship and innovation.
Wen's 2011-2013 reforms were therefore a watershed moment for China's high-tech, and they led directly to the high-tech boom of the 2010s.
What is happening now is similar: China's central government steps, not for improving the system, but for steering science and technology towards a different direction.
This is causing software engineers to be recycled as hardware engineers or biotech researchers. It rests to be seen if this can work.
While the USA keeps panicking about how poweful China has become
(check out this report by the National Science Foundation),
the Chinese are painfully aware of how far behind they are:
for a few hours the Chinese censors couldn't stop
a
7,600-character
report by
Peking University's Institute of International and Strategic Studies
that spread on social media in February 2022.
That report highlighted that China is still far behind in most sectors and
that China would suffer more than the USA from a "decoupling".
Chinese scientists sometimes joke that China is advancing very rapidly but
it's like someone riding the bicycle and pedaling faster and faster while the USA is driving a car.
The USA is helping the Chinese Communist Party by making it harder for Chinese talents to emigrate to the USA. Trump's gifts to China changed the course of Chinese history.
- (february 2022)
China's Debt.
China's GDP is about 15 trillion dollars.
China's government debt has been exploding over the last 20 years and it is now one of the largest in the world as % of GDP (more than 270% according to China's own National Institution for Finance and Development), and it is growing faster than GDP (an average annual rate of 20% since 2008, i.e. the debt-to-GDP ratio is growing at a yearly rate of about 11%).
As bad as it looks on paper, most of it is not worrying.
However, there is one component of China's debt that is seriously in danger of
getting out of control: local government debt (debts by the provincial governments and by the big cities).
This is now bigger than the debt of the central government.
It all goes back to a 1994 law that was aimed at enforcing good governance in
the provinces: it made it illegal for local governments to issue local
government bonds. In 1995 and 1996 further laws were passed to prohibit
borrowing by provincial governments.
The "tax assignment reform" of 1994 ("fenshuzhi") also redirected tax revenues from the provinces to the central government. By reducing tax revenues for local governments while forcing them to balance their budget, the central government caused an unsustainable deficit. The central governments was obviously aware of
this and granted local governments the right to raise non-tax revenues.
These turn out to be mostly land sales. China is a communist country and all land belongs to the government. Prime minister Rongji Zhu famously stated that he didn't care how local governments made money and how it spent the money ("the center will not intervene").
Therefore Zhu's reforms of 1994 were a mixture of re-centralization (tax revenues flowing back to Beijing) and de-centralization (more autonomy for the local government to find other way to raise money).
Incidentally, Zhu's reforms were the direct consequence of the collapse of the Soviet Union: the Chinese Communist Party was determined to avoid that the provinces would have the power to split.
Local governments, forbidden to issue bonds and borrow money in normal ways, came up with what is known in the West as "local government financing vehicles" (LGFVs), which basically allowed governments to borrow from banks but in an indirect way. It was very smart finance to circumvent the central government's restrictions.
Much has been written about the debts held by the "Big Four" banks of China
(the Industrial & Commercial Bank of China, the China Construction Bank, the Agricultural Bank), but after 1994 local state banks have been equally important for
China's development. In 1985 the Big Four owned all asset shares of banks. By 2019 their share had been reduced to just a bit more than 50%, with the rest owned by more than 100 local banks.
Local governments were borrowing via LGFVs and paying the loans through land sales. This was particularly true in rich provinces like Zhejiang (whose governor
was future president Jinping Xi between 2002 and 2007).
Property developers were eager to buy the land, mostly to build apartment buildings.
Then came the global financial crisis of 2008.
In 2009 China's central government approved a stimulus package of
4 trillion yuan (US$572 billion)
with a condition to avoid abuses: the local governments had to match whatever portion of the stimulus package they used.
Local governments used liberally the stimulus money but that resulted in an
exponential rise of their debt, from about 1.7 trillion yuan before the
financial crisis to 10.7 trillion yuan at the end of 2010 ($1 = about 7 yuan).
Land sales were no longer enough to pay off the debt.
Local governments used LGFV to issue municipal bonds while using the stimulus
money to fund projects in line with the central government's objective of economic growth.
The benefits of those projects will be seen in the long term while the bonds have to be repaid in the short term (mostly 3 or 5 years).
"Hidden debt", or "implicit debt" (LGFV debt)
is not recorded in official documents but it is estimated that it increased dramatically.
It's called "implicit" debt because LGFVs are not government but investors assume an "implicit" guarantee that the local government will repay LGFV bonds.
City and rural banks became the major lenders to government projects after the global financial crisis.
In 2014 the central government introduced the "public-private-partnership" (PPP) to incentivize
private investors to fund infrastructure investment. This was meant to reduce local government's debt. However, local governments turned PPPs into another form of "hidden debt".
In 2015 the central government enacted a program to swap high-interest local government debts with low-cost municipal bonds
(i.e. Beijing authorized local governments to sell debt in the open market in the form of bonds)
in return for more control on the shady finances of local governments; and in 2019 the central government redirected to the local governments a share of the taxes (50% of value-added taxes and assorted taxes on luxury items).
The central government seems oriented towards approving a property tax (right now there is no property tax in China - everything, technically speaking, belongs to the government, and "home owners" only get a 70-year lease) or, better, approving that local governments and institute such a tax.
In any event, the covid pandemic changed the scenario yet again.
Whether related to the pandemic or not, the central government suddenly
decided to crack down on property developers who had accumulated unsustainable
amount of debt, at the same time that economic growth slowed down.
The business model of property developers had always consisted in borrowing to grow, but now the government imposed the "three red lines", each red line corresponding in a limit on debt and triggering a limitation on new loans.
Hence the collapse of heavily-indebted property developer Evergrande.
This means that property developers are no longer interested in buying land for sale, a blow to local government's main source of revenue.
In any case most land sales went into residential buildings but there's already overcapacity so the hunger for sale was bound to shrink even without the "three red lines".
At the same time the central government cut taxes to help businesses struggling during the covid pandemic. That was another blow to local government's revenues.
Local governments were already under stress because the
return on their investments is long-term while
debt servicing is short term.
Their only solution was to sell land but now nobody is buying it.
Inevitably, this is leading to more (not less) LGFVs, and therefore to more risk.
Lu Ting (an economist at Nomura) estimates that
at the end of 2020 the hidden debts amounted to about 45 trillion yuan (US$7.5 trillion), four times what it was ten years earlier and equivalent to almost half of China's GDP.
Goldman Sachs estimated more than 50 trillion yuan (US$8.5 trillion).
In 2020 (the first year when official numbers were disclosed) Chinese local governments issued new bonds for 4.55 trillion yuan (US$700 billion), and
$3.65 trillion in 2021. About 60% of the proceeds from these bond sales have gone into repaying maturing debt.
Each year about one trillion of this debt will mature, i.e. will need to be serviced.
Property developers account for about 30% of all loans at financial institutions.
Who owns their debt? Mainly the local state banks (city banks and rural banks), not the Big Four, and after 2014 it is not clear who is responsible for local government debt (the central government did approve the "swap" program of 2015).
Foreign investors own only about 3% of this debt.
Until 2020 there were only minor LGFV bond defaults: one in Xinjiang (August 2018), one in Inner Mongolia (December 2019), one in Henan (November 2020).
Then in June 2021 Evergrande, China's second largest real-estate developer, failed to pay part of its $305 billion (equal to 2% of China's GDP), quickly followed by Fantasia Holdings Group (October 2021), Cheergain Group, Modern Land China, Sinic Holdings, etc.
Keep in mind that the property industry accounts for almost one third of China's GDP.
The chance that local governments will default on their debt is significant.
Each local government is basically a kind of Evergrande.
- Articles about China before 2022
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