IFR Asia: reasons to be nervous about China

IFR Asia, Greater China report, July 2010

 When an economy delivers first quarter year-on-year growth of 12%, it seems churlish to moan. Chinese exports grew 48.5% year on year in May; the trade surplus is widening; and the latest eye-popping figure for foreign reserves is $2.44 trillion. On the face of it, things could hardly be going better.

 But people are looking nervously at China, for a number of reasons. Most obviously, such a rate of growth is both unsustainable and undesirable; already there are fears of overheating across the economy, particularly in property. Reining in liquidity through new austerity measures is a balancing act between avoiding asset bubbles and maintaining growth. Banks will one day have to reckon with their vast extension of credit over the last year, some of which will inevitably sour. And, more than anything, the world relies on China to be its economic engine: its ability not only to navigate its own domestic challenges but ride out storms in the US and Europe is vital to global growth.

 One area of absolute consensus is that growth must slow; it’s a question of how, and how much. Frederic Neumann, co-head of Asian Economic Research at HSBC expects a drop to about 9% by the fourth quarter; Wang To, China analyst at UBS, expects it to slow to 8 or 8.5% in the fourth quarter, “assuming there is no double dip in the rest of the world” (UBS’s house view is that there will not be). “The long term future is pretty good for China,” she says. “A slowdown is inevitable because what happened last year was not meant to last and cannot last.”

 This is a common position. “I think growth this year will be perfectly decent,” says Eric Fishwick, chief economist at CLSA. “It will slow down – but it needs to slow down. The current pace of just shy of 12% is well above trend, and there is a correct recognition that such rapid rates of growth – in concert with institutional factors such as urbanization, the closed capital account and the way in which local government finances are organized – does mean the economy is prone to speculative excess. The authorities are to be applauded for recognizing those risks and stepping in early to deal with them.”

 China-watchers are, though, keeping a careful eye on Europe. China’s outstanding growth this year is partly a consequence of the export recovery, which in turn is mainly because of the bounce in demand from the key markets of the US, Europe and the rest of Asia. Exports to the US were up 44% year on year in May, and 50% to the EU, but the problem is this trade data does not yet demonstrate the impact of the European debt crisis or a weaker euro. That will take time to come through and will illustrate just how resilient exports are going to be this time around. “The exports recovery is so sharp partly because last year things really fell off a cliff,” says Wang. “It’s not related too much to China’s increased or decreased competitiveness, just that demand came back.” (That said, not everyone believes exports are quite that important. “The contribution of exports to the economy was fairly negligible,” Neumann says.)

 Even if exports do stay sturdy, there’s a general recognition that China’s recovery is, in some sense, not real: a bounty of stimulus, built on bank credit, that must inevitably be withdrawn. “You should anticipate growth will come down, but that’s absolutely desired by policy makers,” says Fishwick. And this is the hardest part: a pragmatic withdrawal of stimulus that does not stall growth.

 Still, one could argue that a recent, rather momentous decision reflected confidence at a state level in China’s economy. This was the announcement by the People’s Bank of China in June that it would resume its previous trading bands for the renminbi, removing the US dollar peg it had put in place during the global financial crisis. “It means they’ve gone back to their medium term agenda of appreciating the currency. All economists would applaud that, myself included,” says Fishwick. “The exact timing is driven by politics but it does recognize that growth is in good shape in China, and certainly that there is more risk from not pre-emptively tightening, be it macro measures like currency and exchange rates, or micro like property regulations.”

 Economists are pondering just what the measure means for policy. Jun Ma, chief economist for Greater China at Deutsche Bank, expects a flexible peg to a reference basket, leading to modest appreciation versus the dollar. “The reform will be part of the structural changes to reduce the reliance of economic growth on exports and facilitate the transition to a consumption-driven economy,” Jun Ma says, adding that the policy change will reduce the risk of an escalation in China-US trade tensions and will have a positive impact on a range of asset classes from H-share equities to commodities and commodity currencies. Certainly, he’s not alone in his feeling that appreciation will be modest; western economists have taken a far more tentative view on appreciation than mass media, which appears to be expecting a major revaluation with a considerable impact on, among other things, the US economy. “We’re a bit more cautious on that,” says Neumann. “A lot of people have hailed this as a move that [the PBOC is] about to aggressively revalue the currency. But we think it is more about volatility than an actual appreciation – there could even be a scenario by which China depreciates against the dollar as the euro continues to fall. Policy makers are still very risk averse in China: they don’t want to rock the boat by seeing the currency strengthen too rapidly.”

 Domestically, two areas of scrutiny are property and banking: one that is considered an issue today, and one that is likely to become one.

 When Asian economists are asked if asset bubbles are forming in Asia, the one area they tend to focus on is Chinese residential property. At a state policy level, China has spotted this early, implementing a range of measures to curb speculation, and recognizing that different cities represent different challenges and dynamics. “I don’t think a big bubble has accumulated nationwide,” says Wang. “Sure, there are pockets where prices go up 200% in a period of a few months and you have to think that’s not natural. But the government policy has aimed to stabilize prices and at the same time increase supply to prevent a bubble. You may see a downside in property construction and probably in prices, but not a crash in the sector or the broader economy.”

 Tightening measures are being closely watched. For example, China will extend the holding tax for commercial property to investment purpose-residential ones; media in China has suggested this could trigger a 40% crash in Chinese property prices. Analysts tend to be more sanguine. “We believe… the property tax may signal a bottoming for China property stock’s prices, and is unlikely to crash the physical property markets,” argues analyst Jinsong Du at Credit Suisse.

 Early signs are positive. May property data showed a slowdown in growth in Chinese property prices month-on-month; new housing construction is increasing; and sales have dropped. “This is exactly what the government wanted,” Wang says: “Prices to stabilize and construction activity to remain strong.” Neumann adds: “The more relevant question is whether the markets in Beijing and Shanghai have cooled, and there is considerable evidence that they have.”

 But Wang is cautious about reading too much into the May numbers. “Does this mean that the government’s precision property measures worked and will continue to work, and the concerns of a sharp slowdown in property-related activity is overblown?” she asked in a June report. “Well, not so fast. While we do not expect China’s property sector or economic growth to collapse, we do see a visible slowdown in housing starts and housing construction towards the end of this year.”

 After all, underpinning property is an intractable problem: it is almost custom-designed to invite speculation because of various structural elements distinct to China. “China has a savings surplus, contained within the country through capital controls, it has structural demand factors – it’s hardly surprising property prices are seen as almost a one way bet and people are jumping on the bandwagon,” says Fishwick. “The property market is prone to being used for investment purposes, and in those situations if you have a lot of domestic liquidity it is easy to see prices driven beyond where the supply-demand imbalance would suggest they should be. Clearly there are local bubbles in China’s property market and the authorities recognize that.”

 Another closely watched area is banking – not a problem today, but something that prompts the occasional nervous prediction. Bank liquidity was central to China’s performance through the financial crisis. But China’s banking sector has plenty of painful experience to draw from that can tell it just what happens when you lend too much without sufficient scrutiny of where it is going. An increase in non-performing loan ratios is almost inevitable; really it’s a question of when, and how big the impact is if that happens. “I’d be worried that in two, three, four years down the line there might be a deterioration of credit quality in the banking sector,” says Neumann. “For the time being there is no sign that’s a real issue.” He adds that most loans were to infrastructure projects which carried government guarantees, implicitly if not explicitly, which is seen as an insulation against risk. “The real test will come if the economy slows down. As long as growth can be maintained at 9%, there’s no real issue of credit quality; the risk comes if it falls to 6% or so.”

 Fishwick questions just how much of the surge in infrastructure and municipal building work that took place in the first half of 2009 will generate a monetary rate of return to cover its cost of funds. “That investment surge was disproportionately financed out of bank credit,” he says. “There are clearly potential problems on Chinese banks’ balance sheets.”

 But he adds: “China is a rapidly growing economy and can potentially grow its way out of a lot of capital wastage problems, which include NPLs. That process isn’t always market friendly. But the NPL overhang is not going to be too severe an economic problem.”