CHINA'S ECONOMY: On the edge

02/05/2010 | Elliot Wilson

China is at a defining moment in its economic history. Having staved off recession through an unprecedented spending spree, its authorities now face the unenviable task of tempering an overheating economy

China’s banks have spent most of the past 18 months shipping out giant bundles of cheap loans to state firms and infrastructure vehicles: Rmb9.7 trillion ($1.4 trillion) was distributed by mainland lenders in 2009 – by any standard a world record – with a further Rmb7.6 trillion set to be shelled out by end-2010.

Such largesse probably prevented an outright recession in China last year – but at what cost? Beijing has only just begun to tackle a series of interlinked speculative bubbles. Real estate prices are soaring while inflation is tipped to rise strongly this year.

In recent months party leaders have belatedly moved to rein in their banks, partially curbing their enthusiasm for lending. The two questions on everyone’s lips now are can they succeed, and will their measures be enough to stop the entire Chinese economy suffering its own bone-juddering crash?

First, to China’s recent austerity measures. So far, party leaders in Beijing have rolled out a series of systemic measures designed to rein in credit growth and exert a measure of control over an economy widely viewed as being out of control. These include:

• Flooding the market. The People’s Bank of China (PBoC) has begun to sell more central bank notes to soak up excess liquidity.

• Raising the reserve requirement ratio (RRR) – the minimum reserves each bank must hold in relation to total customer deposits. The PBoC has pulled off this trick twice already in 2010, raising the rate to 16.5% from 15.5%. Expect more such incremental moves in the future.

• Cutting off the money supply. Beijing announced measures to restrict new lending growth in January 2010, slowly weaning mainland lenders off their cheap credit fix.

• Re-introducing measures designed to stem soaring property prices. Buyers of second and third homes will be taxed at a higher rate if they seek to flip their property in a quick sale, while Beijing will flood the market with new low-cost housing in an attempt to slowly deflate, rather than pop, the housing bubble.

TOO LITTLE, TOO LATE

Will these measures work – or is it a case of too little, too late? Jim Walker, the founder of Hong Kong based economic consultancy Asianomics, is dismissive of Beijing’s reference to its RRR hikes as “liquidity management”. “This puts too much of a gloss on what is actually happening,” says Walker. “Money and credit growth are out of control. To avoid an even bigger crash in two to three years’ time, Beijing will have to act forcibly all year.”

Chris Palmer, head of global emerging markets at Gartmore, says: “China’s big challenge is to slow down the rate of lending at its leading banks without creating a sharp economic slowdown. This is going to be tricky.”

So far, party leaders have chosen to wield the lesser of their credit-tightening weapons. The reserve requirement ratio has been inched, rather than ratcheted up, so far. Most expect that to change.

Kwokon Fung, China equity portfolio manager at Nikko Asset Management in Beijing, tips interest rates on both lending and deposits to rise and – in a pragmatic but likely politically charged move – for China to allow its currency, the yuan, to appreciate, freeing it slightly from its fixed rate against the US dollar. “We expect the government to [also] further increase deposit the reserve requirement ratio and to continue to slow down new loan growth and restrict the uses of new lending,” Fung says.

Asianomics’ Walker reckons the RRR will hit 20% by end-2010, with interest rates being hiked by 200–300bp over the year. “That shows how serious the inflation and mal-investment problems now are in China,” he says.

Other analysts see China playing a slower, longer game as it tries to tamp down its overheating economy. John Vail, chief global strategist at Nikko Asset Management, believes China will continue to rely mostly on administrative measures to tighten credit growth: crimping lending and hiking property taxes while ordering state-owned enterprises (SOEs) – the cause of much of the recent real estate speculation – to exit the sector.

“The key is how aggressively China implements these measures,” says Vail, who reckons an alternative is for Beijing to realign its currency incrementally against the dollar. “If they are going to start gradually appreciating the yuan, China’s leaders will not take too many tightening measures, as they measure the economic tightening effect of the appreciation.”

China is at a defining moment in its economic history. It stands at a crossroads with all paths unmarked: Beijing will have to rely solely on trial-and-error.

Stephen Green, the Shanghai-based head of Greater China research at Standard Chartered, says that now that China’s economic growth is assured, party leaders must recognize that “a fiscal crisis exceeds the risk of a growth crisis”, and move toward stopping, or at least slowing, the flow of credit through its leading banks.

But how to do this? China is imposing measures on banks designed – in theory at least – to cut out any extraneous lending. But to cut off all new lending growth would be self-harm. Much of the 2009 loan growth went to infrastructure projects: cutting off funding halfway through a project would mean double trouble, a politically undesirable move that would overnight create a pile of new non-performing loans (NPLs) for the banks and the state to dredge through.

Yet it seems inevitable that NPLs, the capital scourge of the late 1990s and the early 2000s, are set to rise again, perhaps forcing the party to dip into its $2.4 trillion of foreign reserves, possibly as early as later this year. That will inevitably lead to the vilification of bank officials by party leaders – and probably a few sackings – over the coming years, probably long before a new generation of political leaders takes the helm in 2012.

“It hardly seems fair to blame bankers or local government officials for following orders,” says Green. “Beijing shouted jump in October 2008 and all local officials and bankers were expected to respond. This mess was created the moment the Rmb4 trillion stimulus package was announced but not funded. The feeling back then was clearly: ‘We’ll sort this out when the emergency is over’.

Beijing’s other big problem is that everything these days is interlinked. China is no longer an isolated Maoist state nursing colonial-era grievances: it is a key player on the global stage. If its overheating economy stutters – or even crashes – the effects will be felt around the world.

PROPERTY BUBBLE

China’s 2009 lending boom has had two other unintended consequences: high-and-rising property prices, and worrying signs of upward inflationary pressure.

Much of this is due to the 2008 stimulus package. Banks lent to city authorities, which in turn parcelled out the cash to local SOEs. They in turn sank their money into one of the few financial instruments they understood: real estate speculation.

China’s red-hot property sector is, by any measure, out of control. Real estate prices in key cities – notably Beijing and Shanghai – rose by more than 20% year-on-year in January 2010, and by more than 50% higher in the southern coastal city of Sanya. Professionals unable to gain a foothold on the property ladder are increasingly forced to live in the outskirts of cities, overpaying for cramped, shared accommodation, while the SOEs – referred to as China’s new “land kings” – sit on prime residential buildings that are kept empty to allow them to be quickly flipped when a buyer is found.

Amid the many voices describing China’s property market as a crash waiting to happen, a few lone clarion voices call for temperance. Gao Jian, vice governor at China Development Bank, the country’s leading policy lender, admits to the existence of a property bubble, but says it is no cause for major alarm. “Rising property prices won’t trigger a financial or economic crisis,” he says. “China has learned its lesson from the subprime problems in the US. We tend to be much more cautious here.”

And yet property inflation may just be the tip of the iceberg.

Food costs have been rising for months due to a drought in the south-west of the country, while wholesale price inflation is running at between 5% and 7% in various parts of the country. Inflation will further undermine China’s suddenly wobbly banks – not least by creating a new surge of dud loans.

“The big trigger for NPLs in the future will be high inflation, which will ultimately lead to credit ceilings on banks,” says Victor Shih, an assistant professor at Northwestern University in the US. “This will mean that banks will no longer be able to roll over problematic loans. Then, we will see a large wave of NPLs.”

Party leaders in Beijing face a difficult challenge in steering the economy with only a few, fairly rudimentary, credit tightening measures at their disposal. If these don’t work, and the economy continues to overheat – gross domestic product is tipped to rise by upward of 11% year-on-year in the first quarter of 2010 – they will be in trouble.

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