“I was recently in Shanghai and I took their high-speed train to Hangzhou. The brand new high-speed train is half-empty and the brand new station is three-quarters empty. Parallel to that train line, there is also a new highway that looked three-quarters empty. Next to the train station is also the new local airport of Shanghai and you can fly to Hangzhou. There is no rationale for a country at that level of economic development to have not just duplication but triplication of those infrastructure projects.”
– Nouriel Roubini
On the heels of debt concerns globally and accounting scandals in China, Mr Roubini’s reminder to beware of debt, overcapacity and bridges to nowhere seems timely. Nevertheless, several of our team members who regularly travel by train found the excerpt above surprising.
One case in point: earlier this month, a Lunar team boarded the Shanghai-Hangzhou high speed train to attend a meeting with the management team of Project Jaw, which has an executive office in Hangzhou. In terms of the capacity and utilization, what we observed differed sharply from Mr. Roubini’s description. While the first class section of the train was nearly empty, the economy section was packed. Given the crowds we have grown accustomed to on older, slower trains, where tickets are less expensive and often sold out, this seemed logical.
Perhaps Mr. Roubini travelled first class and overlooked the economy class crowd? Prompted by the divergence between Mr. Roubini’s experience and our own, we would like to revisit the following questions:
1. Is China overleveraged?
2. Where are the white elephants?
3. Is there a right time for China to build capacity? and, finally:
4. Who will ride all these trains?
1. Is China overleveraged?
“Carmen Reinhart and Kenneth Rogoff, the leading international scholars of government debt, argue that countries’ growth starts to suffer once their debts exceed 90% of GDP. This argument would be more satisfying if there were a theory to explain why 90% is the trigger point, rather than 80% or 100%. But the broad point that government debts cannot expand without limit is hardly controversial… China’s public debt load is now 90% of 2010 GDP… A very large proportion of China’s debt has been used to construct assets such as infrastructure projects, which generate cash and improve the productive capacity of the economy. These debts will only become net government liabilities if the investment turns out to be unproductive. Many of the projects rushed through during the stimulus will of course prove to be duds. But the actual amount of debt that will have to be paid off by taxpayers will certainly be much lower than our grand total. In short, the servicing costs of the government’s explicit liabilities are clearly manageable, and the likelihood of all contingent liabilities coming due is low.”
– Gavekal Economics
Is China’s economic rise is being fueled by excessive government spending? Proponents of this view point to (a) rapidly increasing debt levels among local governments and (b) recent stimulus projects of seemingly questionable value.
It remains difficult to determine the full scale of China’s public debt obligations. China does not have a transparent system for reporting public debt figures, which has exacerbated speculation that China’s total public debt obligations could far exceed current estimates. Further, local governments conduct a significant portion of their borrowing through off-the-balance sheet local investment corporations, which are not officially sanctioned by the central government, and there is concern within China and from outside that many of these local governments are borrowing beyond their means.
We believe China’s public debt levels are high, but not abnormal by historical standards. Total government liabilities have remained relatively constant at around 80% of GDP for the past decade. It is true that local governments have taken on a markedly higher percentage of overall government debt to fund stimulus projects, but the risk of a sovereign debt crisis is miniscule — less than 1% of China’s public debt is held by foreign investors.
Another way to gauge the soundness of China’s public borrowing is by looking at where the money is going, and this is where much of the controversy lies. Because a significant portion has gone towards funding China’s recent stimulus package, which has invested heavily in infrastructure projects throughout the country, the question all want answered is whether China is building projects with lasting social and economic benefits, or bridges to nowhere.
2. Where are the white elephants?
We won’t deny that “bridges to nowhere” exist in China. There is strong pressure on provincial- and city-level governments to boost performance figures through infrastructure spending. Directing bank loans to state-owned enterprises, or funding local investment corporations, encourages white elephant projects. The most frequently reported are real estate ghost towns – unoccupied flats, under-occupied shopping malls, and empty office towers.
As we have often noted, China has been characterized by overcapacity since the earliest days of reform and opening up. In 1997, Business Week published an article titled “Year of the White Elephant” critiquing Guangdong’s “surplus of power generation,” noting that “authorities plan to nearly quadruple capacity, to 39,000 megawatts, by 2010” even though “foreign analysts estimated that the region's needs will fall far short.”
To-date, however, we’ve witnessed increased utilization cannibalize overcapacity. In 2011, installed power generation capacity in China will exceed that of the United States. Guangdong will represent 80,000 megawatts alone, or over two times the level Business Week predicted would represent a “white elephant. That notwithstanding, the region is braced for the worst electricity shortages in years. Additionally, visitors to Shanghai a decade ago will surely remember hat Pudong and Xintiandi were once considered “white elephants”, and are now held up as examples of the city’s spectacular success.
We would argue that infrastructure spending in China poses less of a threat, and more upside, than elsewhere in the world due to the following:
• Supply/Demand Dynamics – China remains poor. Per capita GDP in 2010 was RMB 3,744, far below more developed Asian peers. (Table 1) GDP growth has exceeded 10% for the past decade
• Urbanization – McKinsey predicts that by 2025, China’s urban regions will have added 350 million people, bringing China’s urban population to 1 billion by 2030 versus 600 million today. This will add to already immense logistical demands.
• Fiscal Health – China’s fiscal situation, inclusive of the most nervous forecasts in respect of local borrowings, is comparably better than most major economies.
3. Is there a right time for China to build capacity?
“[The National System of Interstate and Defense Highways] was heralded as the greatest public works project ever. That it was. And it did, as promised, lead to an America that is more mobile, less plagued by regional differences, and vastly wealthier than before.”
– Justin Fox/Fortune 2004
China could invest in infrastructure projects later, when there is clearer ability to model cost/benefit analysis and mitigate risk, and when the benefits are purely economic with limited national security or social stability benefits.
Conversely, by investing in infrastructure now, China risks overcapacity and overborrowing, but has the opportunity to minimize regional disparities, spur economic development, build up regions that have historically lagged, and emerge as a leader in a sector with clear societal benefits.
The US Interstate Highway System faced similar skepticism. Critics labeled it “another ascent into the stratosphere of jitterbug economics.” It took 35 years to build and cost $114bn ($425bn in inflation adjusted 2006 dollars). It is now heralded as one of the major successes of the post-war era.
Our view is that China has room to eat up overcapacity for the foreseeable future, and to find ways, sensible, creative and dangerous, to manage the borrowing that has fueled public works expansion.
4. Who will ride all these trains?
Specific to Mr. Roubini’s trip, we believe we can speak with some degree of authority given the amount of time we spend travelling between Shanghai (population 17.8m), Hangzhou (population 6.9m) and the second- and third- tier cities in their vicinity. Below we list 18 cities with populations in excess of 2 million that are located within a 200 mile (320 km) radius of either Shanghai or Hangzhou (Table 2).
To rationalize the “duplication or triplication of infrastructure” Mr. Roubini observed between Shanghai and Hangzhou, we compared the city pair with London and Paris, which are also connected by a well-known, arguably notorious, high speed rail link, the Eurostar (Tables 3 and 4). Combined, Shanghai and Hangzhou have more people than London and Paris, but a lower GDP. Shanghai and Hangzhou are also home to fewer airports and flights. We do not believe that Shanghai and Hangzhou are flooded with transport links in comparison to London and Paris, either on a population-weighted or GDP-weighted basis, irrespective of future growth prospects.
The Shanghai- Hangzhou link is one small part of the overall Chinese high speed rail network. Despite legitimate concerns over the project’s cost, estimated at USD 400 billion, and affordability for everyday travellers, we believe China’s High-Speed Rail Network is needed, and will, in time, provide lasting social and economic benefits to the country.
• Living standards are rising rapidly. Automobile sales and air traffic grew at a CAGR of 25.7% and 14.8% from 2006-2010, respectively. Gone unchecked, this will present huge logistical constraints.
• Demand exists. We estimate that 130,000 people travel between Hangzhou and Shanghai every day (inclusive of all trains). The network currently covers 10,000km and will cover 20,000km by 2020, connecting more than 30 cities with populations in excess of 5m and an additional 24 cities with populations between 1-5m.
• High-Speed Rail is an attractive travel option – Our team frequently travels by high-speed train. On the whole, we prefer it over air (comparable travel time, fewer delays, ability to access e-mail and make calls, and heightened comfort) or automobile (less travel time, more convenient, ability to work in transit, etc) travel.
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Like Mr. Roubini, we are always on the lookout for white elephants and signs that they are becoming too commonplace. In China, however, we believe this requires making the run between Shanghai and Hangzhou many times, on all modes of transport, and occasionally onward to central Wuhan or western Chongqing. Should Mr. Roubini or any of you visit us in the near future, we would welcome the chance to introduce you to China’s high speed railways, as well as their slower cousins – assuming, of course, that tickets have not been sold out.