Is China Starting To Slow?

International Perspective, by Marshall Auerback

Is China Starting To Slow?

October 21, 2003

"I would stake my reputation on employment growth happening before Christmas. I'd bet dollars to doughnuts that we're going to see a pickup in jobs in the next few months."
- US Treasury Secretary John Snow, Times of London, Oct. 20, 2003

While the industrialised world has been mired in stagnation, China and emerging Asia continue to be conspicuous beacons of growth. Emerging Asia ex China suffered a steep recession in the year and a half post the 1997/98 Asian financial crisis, but China's comparative resilience during that period, undoubtedly helped to promote a faster than expected recovery. Subsequent to that period, China has been booming: its investment ratio has gone to a level that has now exceeded the peak of 1993 (after which policy makers also embarked on a serious program of monetary retrenchment). Much of this investment is in infrastructure and housing, but its productive capacity for goods and exports have increased as well.

Many investors recognise in a perfunctory way the dramatic pace of change in the Chinese economy, but still regard it as an emerging economy in size as well as development. As a result, there is a persistent tendency to underestimate what the implications for global growth are in the event of a Chinese recession (even a "growth recession", which in the Chinese context means GDP under 6%). This perception of China is grounded in part on estimates of its GDP derived from exchange rate calculations. However, if one employs purchasing power parities (PPP) as does the World Bank, one derives a measure of the Chinese economy that is more in line with the underlying economic reality.

In addition, China's ratio of its goods production to GDP is many times larger than the comparable rate in the US economy. In many respects, one can already make the case that China has become the largest goods producing economy in the world. Its consumption of basic commodities, such as copper, provides vivid support to this argument. The Chinese economy today has an annual consumption of 3m tons of copper a year, versus a mere 2.3m tons consumed in the US.

This is a roundabout way of saying that when China threatens to tighten, the rest of the world ought to pay heed, especially US Treasury Secretary Snow, who referring to his previous Times of London interview in July when he described the US economy as "coiled like a spring," recently joked: "The spring has now sprung."

The US economic spring may indeed have sprung, but its trajectory could easily be limited by what is happening in China. Last month we noted concerns on the part of Beijing's policy makers that the economy was running out of control. With an investment ratio close to 50 per cent of GDP, this is clearly unsustainable and measures are now being adopted to tighten credit.

True, the measures introduced thus far appear not to have bitten to a significant degree just yet: New local currency loans (net) still amounted to Rmb303bn in September, even faster than the Rmb281bn in August. New FX loans (net) also increased to US$4.8bn in September, from US$3.0bn. The MoM increase may be partly due to seasonal factors, but it also shows that more work has to be done to put the loan growth under control. In fact, the increase in commercial paper is even scarier, rising by 99.6% yoy in September. The increase in outstanding commercial paper in the first nine months of this year, of Rmb457.9bn, is equivalent to 17.1% of the increase in outstanding bank loans.

Superficially, the correct interpretation of this data should be: the pain has just started, if at all, and the credit creation is still way too rapid. On the other hand, the sharp up tick in loans is also consistent with an economy in a last dash effort to derive increasingly hard to obtain credit. It echoes something the great American economist Hyman Minsky once called

"the economics of euphoria: . . . The confident expectation of a steady stream of prosperity gross profits [produces a] willingness . . . to take what would have been considered in earlier times undesirable chances in order to finance the acquisition of additional capital goods. . . . Those that supply financial resources live in the same expectational climate as those that demand them. . . . An essential aspect of a euphoric economy is the construction of liability structures which imply payments that are closely articulated . . . to cash flows due to income production. . . . Withdrawals on the supply side of financial markets may force demanding units that were under no special strain and were not directly affected by financial stringencies to look for new financing connections. An initial disturbance can cumulate through such third-party or innocent-party bystanders. . . . Financial instability occurs whenever a large number of units resort to extraordinary sources for cash."

In the economics of euphoria, lenders eagerly supply funds for the acquisition of capital assets that will not yield the borrowers sufficient returns to service the loans. Thus the borrowers become dependent on the willingness of lenders to keep increasing their loans--a situation Minsky described as "Ponzi finance." The mad dash for loans from increasingly unstable sources in China might be reflective of the beginning of this trend.

Consider the following anecdote by long-time China pundit, Simon Hunt, a frequent visitor to the country over the past decade:

"The State Reserve Bureau, the state organization that handles national stockpiles, bought some 250kt of copper last year with a central bank loan. Back in early August I was told that they would sell this holding, but that they were under no pressure from the CB to repay their 3 year loan early. In 2nd half Sept the holding was sold, one of the reasons being given was that the CB wanted the loan repaid early. Something must have happened within 2 months to make the CB change their minds."

Hunt's analysis has also been echoed by Morgan Stanley's China economist, Andy Xie, who makes the following observations:

"The market has questioned the Chinese government's resolve to slow credit expansion, believing that either the government has lost control over credit expansion or it doesn't mean what it says. Both are wrong, in my view. The four state banks accounted for 71% of the increase in household savings deposits but only 45% of the increase in lending to the non-financial sector between 1Q02 to 2Q03. The current credit boom is dependent on state bank lending to regional and local banks through the interbank market. There are indications that interbank liquidity has dried up, and the local and regional banks are no longer increasing lending given the lack of funds.

In the real economy, signs of credit distress are popping up. There are frequent complaints that the "financing chain" is broken. A large number of companies in China depend on increasing investment to cover cash shortages associated with bad investments in the past, and their survival totally depends on accelerating credit expansion. I expect a large number of companies could be under severe pressure going forward."

This is consistent with a Minsky-like drive for "Ponzi" financing. Because the Chinese economy is still heavily administered, directives and quantitative controls can lead to abrupt adjustments, and the huge overinvestment creates the risk of a severe slowdown. Any interference with this cheerful articulation of borrower and lender will push borrowers--and then lenders--into insolvency.

There has also been an important change in China's political leadership. Long time students of the country, such as Hunt, have noted the following: Ex President Jiang appears finally to have been sidelined, and according to Beijing insider rumours is confined to his home. It was Jiang and his Shanghai cohorts who set the course for a boom in mid 2001 so that they could go out on a high note and so the elite, his gang, could cash in their chips. The fact that he was neither at the astronaut launching during China's recent foray into space, nor the control centre in Beijing or in the welcoming party is a clear signal of his demise from power.

It also makes sense for Hu to get the painful adjustments that may be needed to correct for earlier excesses out of the way as early as possible, so as to have more time to ramp things back up successfully ahead of the 2008 Beijing Olympics. If this process accelerates, as now seems highly likely, such an event could easily weaken commodity prices, extend the global slowdown to Asia and thereby reinforce a shift from reflation to disinflation themes in the market. Indeed, there are already signs of industrial commodities inventory building up in the distribution channels in regard to China. Metal prices have been rising in China, and thus distributors have an incentive to pile up supply to speculate on price appreciation. This happened during the 1992-93 investment boom, and caused industrial commodities prices to decline sharply during the subsequent credit slowdown. It is possible that the same scenario will be repeated next year.

This is relevant in light of current market expectations of rapidly accelerating global growth. Indeed, the historical record of the US business cycle would suggest that the second leg of a growth surprise. Typically, a wide gap between high final demand growth and low growth in income, output and employment is followed by a catch up in the latter. This appears to be what is stoking expectations of a surge in US GDP. Some economists have estimated a growth figure as high as 7 per cent in the third quarter.

Last week, however, we pointed to the threat of a huge import surge, which could in theory short circuit the typical cumulative dynamics of the incipient US cyclical upturn. There is little question that China now has the capacity to fulfill future demand for goods for the developed world in virtually every sector of the economy, and not simply marginal, old industries. The country is now a huge producer of cell phones and semiconductors. By moving up the value added ladder, by increasing the array of high end goods that it can produce, China potential to penetrate foreign goods markets, particularly the US, has been greatly enhanced.

To be fair, the in-hand US import data from August were inconsistent with the idea of an explosion in demand for goods abroad, although (a) most of the weakness was in vehicle and parts imports, and (b) August also was a month of significant and almost certainly unsustainable inventory liquidation in the US. Consequently, it is likely unrepresentative of what we shall see in the months ahead. September export data from countries such as Korea and Singapore do suggest an imminent surge of Asian exports about to hit American shores (Singapore's key non-oil exports grew a larger than expected 25.9 per cent in September led by strong expansion in non-electronics, the government said last Friday). In addition, the Baltic Freight Dry index has exploded upward of late -- could this be indicative of a jump in traffic in goods from Asia to the US?

The strong FDI inflows seen since China joined the WTO have significantly boosted the country's export capacity. The cyclical recovery in the global economy has allowed the increased export capacity to be fully utilized. China's exports are likely to increase by 30% or US$100 billion (7.7% of 2002 GDP) this year. If China's domestic economy is truly under threat, then we would expect this dynamic to intensify which, in spite of a super strong 3^rd quarter, could abort the US economic recovery fairly abruptly in subsequent quarters, given that rapid import growth would restrain the anticipated pickup in US GDP.

The problem with the foregoing outcome is that it undercuts the ability to achieve a smooth global adjustment away from further US-centric demand. Both the providers and the users of the global capital flows have, hitherto, been happy with the world of exploding US foreign liabilities. This game has to stop at some stage, but this becomes more problematic at a time when the US is doing all it can to promote further domestic demand, which risks leaking into imports, which gives China the outlet to offset its ongoing tendency to tighten domestic demand, as well making the coming US economic acceleration very brief and very transitory.

The two principle pillars of global economic growth, therefore, look decidedly shaky just now. And just as the US/China relationship has contributed to a perpetuation of existing US and Chinese growth (even at the cost of exacerbating underlying imbalances in both economies) so too China's decision to address their current boom excesses exclusively through domestic adjustments, such as in the credit area, rather than through the expedient of a revaluation of the renminbi, could diminish import growth, shift the focus to export-driven growth and thereby perpetuate growing political and economic tensions with the US. A sharp slowdown in Chinese growth coupled with the abrupt falloff in mortgage refinancing and equity withdrawal and the non-recurring nature of the recent tax-cut stimulus might act as a triple whammy on US GDP gains. Protectionist pressures would likely intensify in Congress against that sort of backdrop. We could be on the threshold of a very important growth inflexion point which could decidedly change the complexion of today's markets. As the 1997 financial crisis demonstrated, developments in Asia can often have an uncomfortable impact on American shores, which policy makers in Washington ignore at their peril. Mr Snow might live to regret his confident pronouncements on the US economy.

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