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Putting China¡¦s risks
in perspective
By Gerard Lyons
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. Given its increasing demand for
goods and commodities and the impact it has on investor sentiment toward
emerging markets, what happens in China is of growing global significance.
One challenge when analyzing China is that it is easy to compile a long list of
negatives, but also to make an even longer list of positives. The negatives
should be taken seriously. However, those who look solely at the negatives in
China are like stopped clocks: They will be right at some time, but they are of
little use.
The key message is that China is on an upward trend, but there will be setbacks
along the way.
China¡¦s policymakers clearly take the risks seriously. A number of years ago,
the leadership identified five major issues: coastal versus inland disparity,
urban versus rural disparity, social problems, environmental concerns and
foreign relations. Since then, the focus has been on achieving more sustainable
growth.
The most important thing to 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 potential for catch-up. China is the
world¡¦s second--largest economy, but its income-per-head is ranked 94th, on par
with Albania.
To complicate matters further, China is made up of a multitude of different
economies. Coastal areas, such as the Pearl and Yangtse River deltas, have
developed considerably in recent decades, while western and central China is
still heavily agricultural and poor.
Rapid wage growth, encouraged by policymakers, 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 to higher-quality
exports, as well as moving their lower-cost production inland, where land and
labor costs are lower and jobs are needed.
All of these factors suggest that we need to be looking at China¡¦s upside, as do
certain recent policy initiatives. China¡¦s rapid pace of change was demonstrated
by its 12th Five-Year Plan, unveiled earlier this year. Its aim was to shift the
economy toward domestic demand and away from low-cost exports. Boosting social
welfare, consumer spending, the ¡§green economy¡¨ and seven high-value industries
all figured prominently. This plan is likely to significantly 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.
Recently, Beijing has managed its risks well. Yet China is now a US$7 trillion
economy and as it grows, it becomes harder to control the economy. The private
sector has grown, free-market pricing 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 liberalized to allow resources to be allocated more efficiently.
Again, this takes time.
There are more immediate concerns. One is local government investment vehicles,
which have up to 14 trillion yuan (US$2.2 trillion) in loans, of which more than
20 percent 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 at
hand. Indeed, in 80 percent 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 concern recently, but worries over this may
now be easing. Over the past 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 percent in
the summer, is now 5.5 percent and could be down to 4.5 percent by the end of
the year, and average 3.2 percent next year.
With inflation easing, there has been some evidence of policy easing intentions
in recent weeks. For instance, comments from Chinese Premier Wen Jiabao (·Å®aÄ_) 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 financial 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 about 45 percent 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, policymakers in Beijing have plenty
of tools at their disposal to respond to an external shock.
Given the external headwinds, it would not be surprising if China¡¦s growth
slowed to about 8 percent in the final months of this year and the first quarter
of next year, but then the economy should get a boost from stimulus policies.
As a result, China¡¦s economy can grow strongly next year, by about 8.5 percent
and by 6.9 percent 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 current market worries in perspective. These problems 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.
Gerard Lyons is chief economist and head of global research at Standard
Chartered Bank.
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