Putting China’s risks in perspective
One of the key questions being asked about the world economy is whether China will have a hard or a soft landing.
Although no part of the world is totally immune to what happens in Europe, events in China are more important for many. What happens in China is of growing global significance, given its increasing demand for goods and commodities and the impact it has on investor sentiment towards the emerging world.
One challenge with analysing China is that it is easy to compile a long list of negatives. Yet, at the same time, it is possible to make an even longer list of positives. The negatives should be taken seriously. Yet, those who look solely at the negatives in China are akin to stopped clocks: They will be right at some stage, but they are of no use in telling the time.
The risks need to be taken seriously but it would be a mistake to use those as the sole criteria for determining a business or investment strategy towards China. The key message is that the trend in China is up, but that there will be setbacks along the way.
China’s policy makers clearly take the risks seriously. A number of years ago, the leadership identified China’s five imbalances: coastal versus inland areas; urban versus rural; social issues; environmental concerns, and international issues. Since then, the focus has been on achieving a more sustainable pace of growth.
The most important thing to fully appreciate about China is the scale and the pace of change. It is breathtaking. China is experiencing an industrial revolution. Despite this, there is still considerable catch-up potential. China is the world’s second-largest economy, but its income-per-head is ranked ninety-fourth, on par with Albania.
To complicate matters further, China is made up of a multitude of different economies. The coastal areas, such as the Pearl and Yangtse River Deltas, have developed considerably over recent decades, while western and central China is still heavily agricultural and poor.
Rapid wage growth, encouraged by policy makers, is not only seen as an alternative to currency appreciation, but also as an incentive for businesses in the coastal areas to move up the value curve by switching into higher-quality exports as well as moving their lower-cost production inland, where land and labour costs are lower and jobs are needed.
All of these factors suggest that we need to be looking at China’s upside. So too do some recent policy initiatives. China’s rapid pace of change was demonstrated by its Twelfth Five-Year Plan, unveiled earlier this year. Its clear message was to shift the economy towards domestic demand and away from low-cost exports. Boosting social welfare, consumer spending, the green economy and prioritising seven high-value industries all figured prominently. This plan is likely to lead to a significant boost in spending in these areas in the coming years.
While these are big positives, it is the negatives that have grabbed market attention lately. There is no doubt that even inside China, sentiment has cooled.
In the recent past, China managed its risks well. Yet China is now a USD7 trillion economy and, as it grows, it becomes harder to control the economy in the same way as in the past. The private sector has grown, the price mechanism is more entrenched and thus central control from Beijing is more difficult to administer.
Given its scale and complexity, China now requires powerful and independent policy institutions and regulators. The trouble is, it takes time to achieve this. In parallel, China’s financial sector needs to develop, and interest rates need to be liberalised to allow resources to be allocated more efficiently. Again, this takes time.
There are more immediate concerns. One is China’s local government investment vehicles, which have up to RMB 14 trillion in loans, of which more than 20% are in trouble, and two-thirds of whose projects are currently in arrears. The good news is that liquidity is being provided and a workable solution is in hand. Indeed, in four-fifths of cases, the future income stream from projects may be sufficient to cover the loans. The central government would like any costs to be borne by the local government. Whether this happens or not, the key thing is that the country’s debt and fiscal position is strong enough to be able to cope.
Inflation has also been a prominent recent concern, but worries over this may now be easing. Over the last year, China has implemented an aggressive anti-inflationary policy of higher rates, lending controls and a substantial rise in reserve requirements. This seems to have broken the back of inflation and, in turn, the economy has cooled with cash flow tightening. Headline inflation peaked at 6.5% in the summer, is now 5.5%, and could reach 4.5% by year-end and average 3.2% in 2012.
With inflation easing, there has been some evidence of policy easing intentions in recent weeks. For instance, comments from Premier Wen Jiabao in late October hinted at policy fine-tuning. Meanwhile, central bank bills were recently auctioned at lower rates for the first time in 28 months. There has also been anecdotal evidence of targeted credit loosening, especially aimed at small- and medium-sized enterprises.
Despite this, the authorities appear to be in no rush to ease monetary policy aggressively. They are still acutely aware of the need to avoid the lethal combination of cheap money, leverage and one-way expectations that was seen in economies such as the US and the UK prior to the crisis.
Although leverage in China is relatively low, there has clearly been some speculative borrowing linked to property. The determination to squeeze speculators has already led to some casualties in cities such as Wenzhou.
There is still concern about property prices. Although prices have either stagnated or started to ease recently, they remain high in first-tier cities including Shanghai and Beijing.
Despite all these issues, China’s biggest challenge is its high overall level of investment. There is no magic level, but economies that have seen excessive investment in the past have been more prone to boom-bust cycles. It is easy to understand why firms want to invest in China. But it is possible to have too much of a good thing, and an investment level of around 45% of GDP suggests that this may already be the case.
The trouble is, at these high levels, any downturn in the investment cycle can slow an economy sharply. Perhaps the real question is not when a set-back is likely to happen, as that is difficult to predict, but how quickly China can rebound when it does.
As was seen at the height of the financial crisis three years ago, a fall in world trade can hit Asia hard. Now, as then, policy makers in Beijing have plenty of tools at their disposal to respond to an external shock.
Given the external headwinds, it would not be a surprise if China slowed to around 8% in the final months of this year and the first quarter of 2012. But then the economy should get a boost from the policy stimulus. As a result, China’s economy can grow strongly next year, by around 8.5%, and by 6.9% on average over the next two decades, allowing for its ageing population.
The outlook depends on the interaction between the fundamentals, confidence and policy. In China, the fundamentals are good, confidence is likely to prove resilient and the policy cupboard is still pretty full.
All this should put in perspective current market worries. These should not be ignored, but they do need to be kept in context. After all, a few years ago in Beijing, the story was that when officials were asked whether China would have a hard or soft landing, their reply was neither. Instead, they said, all the repairs would be made in mid-flight!
By Gerard Lyons
Dr Gerard Lyons is Chief Economist and Head of Global Research at Standard Chartered Bank
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