Friday, 2 March 2012

2012 China - The Wild Card

The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.

The most likely trajectories of the US and the Eurozone are not too difficult to determine: getting China right, however, is a far harder task both for economists and, much more importantly, for policy-makers. The bad news is that the situation is complicated, since China's economy is beset with both cyclical and structural difficulties. The better news is that there is no-one more keenly aware of the fact than China's policymakers, and they have the financial resources available to act effectively.

If those resources are deployed cleverly, China should avoid a hard landing (which is generally defined as growth falling below 8%). If they don't – well, there are easily enough cyclical and structural problems to drag the economy down. One is given confidence by the the extreme attentiveness with which China's policymakers have tracked and measured the build-up of problems over the last two and a half years, and the clarity with which they explain what they are attempting to do. Nonetheless, the cyclical and structural problems are complicated and interlinked, and economic history offers many examples of promising economies which have flunked similar tests.

Cyclical Problems
The most obviously element of China's cyclical problem is easily stated: as one of the world's largest exporters, China is exposed to any major cyclical downturn in world trade.

This vulnerability is easy to overstate: in recent years the surge in domestic demand has cut the overall importance of exports to China's economy. Back in 2007, exports were equivalent to 35% of GDP – this proportion had fallen to 26% in 2011. In net terms, China's current account surplus peaked at 11% of GDP in mid-2007, but had fallen to 3.9% by the end of 2011. Moreover, if one models carefully, the scenarios under which China's exports grow much less than 10% this year require some quite extreme assumptions about the US and Eurozone demand. A rise of 10% in exports during 2012 would be half the 20.3% recorded in 2011.

The external sector will be a modest drag on growth, but China's domestic economy has more worrying cyclical problems – most particularly the overhang of (probably bad) debt from local government spending during 2009 and 2010. Last year, the National Audit Office put the amount of outstanding loans to local governments at Rmb 10.7tr, equivalent to 23% of 2011 GDP. Local governments almost certainly wasted a lot of borrowed money on projects which will struggle to generate the cashflow to make repayments. This puts the onus back directly onto local governments themselves. But their revenues are also linked to property sales: in 2010, income from property sales amounted to no less than 27% of total local government revenues. Since the central government is quite determined to deflate existing property bubbles and deflate any that it suspects might be forming, this compromises the health of those local government loans even more.

No doubt these problems are not overstated, but China's bureaucrats - world-class worriers by inclination - have been assiduously tracking them since at least early 2010. If the Chinese government had not resources with which to bolster both local government finances and/or the capital of the banking system, they would be as dangerous as they are regularly described. But they have. Between 2007 and 2011 China's central bank raised reserve ratios on deposits from 8% to a peak of 21.5%, mainly to sterilize net capital inflows. By the end of 2011, the 'reserved' deposits commandeered by the central bank amounted to just under Rmb 17tr, equivalent to 36% of GDP.

The central bank and will release those deposits back into the monetary system as required – and they are surely enough to offset liquidity pressures stemming from any foreseeable deterioration in the loan-book (which, after all, currently totals only Rmb 55.5 trillion). Indeed, the process has already started, with reserve ratios being cut by 50bps in both December and February, in response to a sharp slowdown in monetary aggregates.

The conclusion is straightforward: despite its deteriorating internal cashflow and emerging credit-quality problems in the banking system, China's economy need not be forced into a 'hard landing' in 2011 by financial or liquidity constraints.

Structural Problems
The cyclical problems on their own are manageable. But China faces extremely difficult structural problems too, which policymakers are unwilling to ignore any longer, and which complicate economic management hugely this year.

Of course, the structural problems also intensify the cyclical problems. For example, the deterioration in China's cashflows are ultimately linked to deteriorating return on capital, and in 2011 China's private sector savings surplus had shrunk to 5% of GDP from a peak of 11.5% in 2009. On current trajectories, this surplus will contract nearly to zero over the coming two years.

The structural problem stems from the approaching exhaustion of China's existing growth model, in which huge saving levels are encouraged in order to finance correspondingly huge investment programmes, which subsequently turn out more goods than the domestic economy needs, and which therefore has to find markets for its surplus production abroad. There are two reasons this model has reached its sell-by date. First, it is increasingly difficult to either ignore or control the swathe of inefficient investment which depressed return on capital (and compromises banks loan portfolios). Secondly, China has grown so big that the rest of the world can no longer be expected to find an appetite for all the surplus production China wants to sell them: every percentage point of export market share won is gained at an ever-increasing investment cost.

If China is to switch to a growth model in which consumption rises more quickly than investment, the whole structure of savings and capital allocation (banking, bond markets, stock markets) will have to change radically. This is the most difficult policy traverse in the world, and one which the IMF has been poring over with the Chinese government in order to discover what sort of sequencing of financial reform will cause the least disruption.

And here we come to the real difficulty: there is every sign that China's government intends to press ahead with these reforms even in the face of the cyclical difficulties. What no-one knows is:
  • How quickly and radically they intend to act;
  • Whether they will press ahead even if cyclical pressures are more intense than expected;
  • What effective resistance can be expected from the major beneficiaries of the current system of capital allocation (principally State Owned Enterprises, and the personnel of the Chinese Communist Party);
  • Whether the forthcoming generational mass change in leadership will disrupt the agenda. (The change in leadership takes place throughout 2012 and 2013 and encompasses all parts of China's structures of political and administrative governance);
  • What the economic impact of financial reform will be in terms of savings rates, investment rates, consumption rates.
The truth is, China is a wild-card in the global economy in 2012. A 'hard landing' will almost certainly be avoided, because China has the financial resources to generate cashflows to avoid one. And it will choose to avoid one. But at the same time, if China's policymakers believe they can safely advance structural financial reform at the cost of a growth slowdown, they'll probably choose to do it. Currently the consensus forecasts for China in 2012 and 2013 are 8.5% and 8.4% respectively – my own view is that it will be somewhat slower at around 8% in both years.

No comments:

Post a Comment