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.
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