China has a struggle most countries would like – IFR Asia

IFR Asia, July 2009

If China is struggling, it’s the sort of struggle most countries would love to face. Sure, GDP growth almost halved between March 2007 and December 2008 – but that’s still from 13% to 6.8%. Even after its fall it was still dramatically higher than any developed economy in boom-time full throttle.

Better still, it looks very much like the worst has already passed. On June 29 Bank of America Merrill Lynch raised its GDP growth forecast for the second quarter of 2009 to 7.5%, from 7.2% year on year. The World Bank has raised its full year growth forecast from 6.5% to 7.2%, and OECD from 6.3% to 7.7%.

“Bolstered by supportive policies and regained confidence in the private sector, China has been recovering faster than the market had expected,” noted Bank of America Merrill Lynch’s economist Ting Lu noted while announcing the forecast upgrades. “Except exports, almost all major macro indicators surprised on the upside in May, and the momentum could be maintained in June.”

This is largely a consequence of China’s monetary and fiscal policy and its stimulus packages. Announced late last year, the investment programme is worth Y4 trillion over two years. It includes housing, infrastructure, post-earthquake reconstruction, cuts in company tax, and permission for banks to lend more to projects involving rural development or technical innovation. Alongside that, the central bank has eased policy.

It’s got to the point, in fact, that some commentators have started to worry about inflation. It’s probably some distance away, but it’s on its way. “Monetary policy is unlikely to be tightened a great deal until CPI inflation begins to appear,” says Paul Cavey, China analyst at Macquarie Research. “The biggest risk from policy probably comes next year, rather than this year.

“I don’t think inflation is going to worry people just yet,” he adds. “We’re still in a situation where growth is quite low and year on year inflation is still negative. The government has an official target of 4% CPI inflation this year and we’re still some way away from that.”

At JP Morgan, economist Frank Gong agrees. “In the manufacturing sector there’s still a lot of overcapacity globally and in China,” he says. “China’s domestic demand is picking up nicely and is filling some of the holes left from external demand. But that’s not enough [to prompt inflation].” He says capacity utilization in China’s manufacturing sector is probably at about 65 to 70%. “It’s hard to get CPI inflation in that kind of environment. And you still have unlimited labour supply migrating from rural areas, which makes it hard to get wage inflation.”

Nevertheless, the fact that it’s not here yet isn’t stopping economists worrying about it today. “Any significant change in inflation in China will have domestic as well as global implications,” notes Wensheng Peng at Barclays Capital. “A particular fear is that a belated policy reaction will lead to a sharp run-up in inflation that would force a drastic policy tightening at a later stage, causing a boom and bust cycle in growth and financial markets.”

Today, though, most are happy to find at least one good news story in an otherwise miserable world. Gong says the stimulus package is “working very well, and what’s even better has been consumers are doing much better than expected. Stimulus has turned the private sector, especially consumer confidence, around at a time when they still have money to spend, and they have saved a lot.”

Cavey thinks there’s better to come. “We haven’t really seen the true results of it [stimulus] yet,” he says.  “The effect has so far been on the leading indicators: lending growth, real estate transactions, the A share market, fixed asset investment. In those areas, the loosening from the government has been very effective, and that should mean that economic growth stats to follow through.

“I’m increasingly confident the economic recovery will begin, but it’s a bit early to say that it has or to read too much into it just yet,” Cavey says. He forecasts 7.5 to 8% GDP growth this year and 8.5% next year.

One of the biggest reasons for China’s recent improvement is the performance of real estate. “The swing factor in the economy is much more real estate than exports as far as we can see, so reviving real estate is vital to growth,” Cavey says. He believes that monetary policy has supported real estate by persuading people that prices were not going to fall further, and consequently he thinks that the contraction in construction – one of the biggest impacts on the Chinese economy in 2008 – should reverse in the next six months, with a clear benefit to GDP growth.

Gong at JP Morgan says real estate “is turning around, and is becoming a leader in terms of the Chinese economic story. Private investment housing is coming back and will come back more forcefully.”

The banking sector has helped, lacking the crashes that plagued western markets. “You didn’t have a financial crisis credit crunch in China,” says Gong. Balance sheets have been strong, lending – particularly to things like state infrastructure – is high and NPLs low. But analysts are a little more sanguine about prospects here. “The biggest change in recent years has been the monetary policy rather than internal reforms at the banks,” says Cavey, who argues that this previously tight monetary policy was the key reason banks were in good health going into the global crisis.

As policy has loosened, does he have some concerns about bad loans? “I do now, I didn’t six months ago,” he says. Whereas until recently there were no signs of a credit bubble which would normally imply an increase in NPLs, the system today is that loan growth is at 30% while economic growth is more like 6%. “That makes it more likely there will be a credit bubble in future,” he says. “If it only goes on for one year it’s not so bad. If it’s two or three years, there’s no reason we wouldn’t see the rise in NPLs every economy sees after a credit splurge.”

Indeed, levels of lending are remarkably high in the context of the lack of liquidity elsewhere in the world. According to HSBC, Chinese banks made RMB664.5 billion of new loans in May, bringing the growth in total loans outstanding to 30.6% year on year, the fastest pace of growth since 1998. “Chinese banks lent out RMB5.84 trillion in the first five months, or nearly RMB1 trillion more than the total lending last year,” notes Qu Hongbin, economist at HSBC.

The big bugbear in the Chinese economy remains exports, and the improvement in the macro picture only reflects China’s ability to shrug off this decline, not a turnaround in the export picture itself. Lu at Merrill Lynch expects exports to continue to shrink, probably 20% year on year up to November. Even that’s an improvement: it was down 26.4% year on year in May. Set against this, Lu expects fixed asset investment to be up 34.5% year on year in the first half of this year, driven mainly by infrastructure spending. Retail sales are already growing well, and Merrill expects 15.2% year on year growth in June.

China’s A share stock markets have been among the best performers in the world this year, albeit after being among the worst in 2008, and IPOs are finally returning. More than that, China is talking about the formation of a new growth enterprise second board in Shenzhen. Things like this are, says Gong, “a sign of stability not only in the economy but in the markets. The capital markets function as a fund placing or financial intermediation vehicle have been resumed and normalized. That will make private sector financing much easier.” Cavey considers the A share market “an important leading indicator” – not as an efficient barometer of earnings, but as a reflection of the flow of money in the economy. “For the market to be reflating it’s very important that the market is going up as well.” The new growth market reflects an effort to get capital to go to non-state companies, a perennial problem.

In sum, China is one of the rosiest recovery stories in the world today. The word ‘decoupled’ has gone desperately out of fashion, but the fact is if any economies have withstood the effects of global slowdown well, then China is among the leaders (Indonesia being the other clear example). The question now is when China should turn off the tap – bring some tightness back into monetary and fiscal policy before inflation kicks in. The timing of that decision is going to be a tough call.