What's happening in China's economy?

Corbett | September 21, 2008 9:15 AM

I've been asked by HQ to summarize in as few words as possible the implications of the current mess in the US on our business here in China. Believe me, I was thinking, Hmm, now let me get out my crystal ball. After talking to my various colleagues - all doing business in different sectors - I realized I needed to avoid focusing on any one sector and try to understand the big picture key drivers.

Here's a summary of my understanding of the most obvious drivers, which will go to HQ in hopefully less than 5 pages. (I've taken out sensitive internal commentary, but you can still get the drift.)

1) Foreign Exchange Reserves

China's cash reserves, now estimated at 1.8 trillion, have grown in large part due to the central government's policy of boosting exports by fixing the value of the yuan to the U.S. dollar. The central bank does this by buying up the dollars brought to China by foreign investors and Chinese exporters. Keeping the yuan cheap has been an important part of China's export oriented policy. If left to market forces, the yuan would be more expensive. The common rationale for a cheaper yuan, is that if the yuan rises too much, China will lose business to other cheaper territories such as Vietnam, India, and Eastern Europe.

With it's monopoly on currency exchange, the Chinese government has kept the value of the yuan from going to where it should be, providing continuing cheaper exports and more factory jobs, fueling the world's biggest manufacturing machine.

Western governments have diplomatically pressed China to stop buying up so much counterweight dollars, and allow the yuan to float, but China doesn't want to do this, and instead buys foreign bonds, mainly US Treasury and mortgage backed bonds.

2) Credit

For the past year it has been difficult for developers to get loans as Beijing has implemented strict restrictions to ease the impending property bubble and slow down speculation. Those measures worked, too well, and now local developers are scrambling for funds. This credit crunch has humbled many developers, who are now forced to look elsewhere for capital, and foreigners are getting more deal action. But strict foreign investment restrictions for real estate make it more and more difficult for foreign money to reach developer's pockets. Still, it is possible for foreign investors to buy a stake in an existing project requiring capital, which is not yet restricted.

I've assembled some recent news briefs as a snap shot of the current credit situation, likely to change again at the next National Congress in November.

A) Xinhua recently reported that there was a slowdown in real estate loans during the first half of 2008. "Chinese bankers held loans totaling 5.2 trillion yuan (about 580 billion U.S. dollars) to real estate developers and housing buyers by the end of June, up 22.5 percent year-on-year, the People's Bank of China (PBoC) said Friday. The central bank said the growth rate was two percentage points lower than the same period last year, representing a decline for seven consecutive months since last December. Loans to real estate development stood at 1.9 trillion yuan by June, up 17.7 percent year on year. The growth rate was eight percentage points lower than the same period last year. The country's lenders granted 3.3 trillion yuan to housing buyers buy June, representing an increase of 25.6 percent year on year. The growth rate was 1.8 percentage points higher than the same period last year. Real estate developers and housing buyers received 398.84 billion yuan in loans between January and June, which was 170.66 billion yuan less than the same period last year, said the PBoC. "

B) In an unexpected move, the central bank just this week cut the benchmark lending rate by 0.27 of a percentage point to 7.2 percent, the first time it has reduced the rate since 2002.

C) The most recent (9/17/08) Asian Development Bank report expects bank lending controls to ease beginning in the second half of 2008 to assist small firms and avoid downsizing. Fiscal policy is projected to remain slightly expansionary.

On 9/15/08 PBoC announced it would reduce the benchmark loan interest rate and the reserve requirement ratio for commercial banks to ensure a steady and rapid economic growth. In addition, the ratio of deposit lenders are required to set aside will be down 1 percentage point from Sept. 25. After adjustment, the interest rate for one-year loans in the Chinese currency will be 7.20 percent. The overall reserve requirement ratio will be 16.5 percent, down from a record 17.5 percent after five consecutive increases this year.

The move reflected the government's concern over the slowing economy and was a result of long-time consideration, said Zhuang Jian, a senior economist with the Asian Development Bank Resident Mission in China. "It showed the government was eager to maintain the economic growth as enterprises faced difficulties, especially funding strain. The eased inflationary pressure also provided more room and time for the adjustment."

3) Inflation

Where does China's inflation come from? It comes via all the dollars from exports needing conversion into RMB. As demand for the yuan increases, Beijing prints new money rather than let the value of the yuan rise too quickly. Even with bonds, China's monetary system cannot mop up all the extra cash, so prices have risen as a result and the stock and real estate markets have become inflated.

There is a see-saw relationship between inflation and RMB appreciation. The balance hinges on exports. On one side is the Bank of China (PBoC), who argue for RMB appreciation and have made the case that RMB appreciation is important in fighting inflation. On the other side is the Ministry of Commerce (MoFCom), who are strongly pro-export, who argue that RMB appreciation hurts exports. MoFCom has strong allies in the cabinet, including the National Development and Reform Committee (NDRC), the Ministry of Finance (MoF), and the Customs Authority.

However the see-saw tilts, it is generally agreed by economic experts outside of China that the RMB needs to rise in order to slow the inflow of hot money, otherwise domestic monetary expansion will continue.

4) Domestic Consumption and Monetary Expansion

What is monetary expansion? China's large trade surpluses and capital inflows (mainly hot money) lead to domestic monetary expansion as the excess capital is reinvested into industrial production. This results in over-expansion and over-investment. As production outpaces domestic consumption, the trade surplus continues to increase, feeding further monetary expansion, and the cycle repeats itself, over and over. This cycle works as long as a strong economy (which has mainly been the US) can continue buying all these Chinese products. But as the US buys less and less, due to it's own financial woes, there is the strong possibility of excess production in China. The slowing global economy means that Chinese manufacturers will be forced to turn towards the pre-nascent domestic consumer market, which currently cannot consume nearly as much as the West.

The most recent government figures show that industrial output grew by 12.8% year on year in August, versus 14.7% in July, and 17.5% last August. Nearly all sectors slowed, meaning there will be more pressure on domestic consumption to keep the economy strong.

We already know that the retail market is crowded in China, and getting more crowded every day. Pumping exports fell strongly in line with the old political narrative of "Feed the People." Now that this golden goose is cooked, will the "People Feed Themselves"? If exports drop, millions of jobs will be lost, and if inflation continues, food, clothing, housing will be out of reach for millions.

5) US/China economic coupling

As the Fannie and Freddie fallout has made very clear, China has clearly bankrolled much of the US debt. By supporting the US debt, the Chinese are supporting the US appetite for more Chinese goods, which in turn provides more jobs and a better future for people in China. So in many ways US and China are just different sides of the same coin. One side produces, the other buys. The buy side spends more money, which goes over to the produce side, which in turn sends more money back over to the buy side. It's a relationship that has been working for many years to both countries' advantage until Fannie and Freddie, and the more recent Wall Street meltdown. It turns out that this tag team affair was heavily leveraged on something called derivatives - typically collateralised debt obligations and credit default swaps - which are essentially calculus-esque financial products created by an unregulated Wall Street to make money on product "derived" from actual market indices, but don't really have a shape or form - and are carried OBS, or off balance sheet. Things like loan commitments, futures, forwards, etc. One can think of these derivatives as kind of like selling shares in products called "promises" and "wishful thinking."

6) Out of Control Money Growth

Many economists and world think tanks feel that China will soon have to have a major adjustment - either a sharp rise in inflation or a sudden debt deflation.

For an interesting historical reference, equally valid today, here are Irving Fisher's 9 steps that occur in Debt Deflation, from his "Debt-Deflation Theory of Great Depressions" (1933).
1) Debt liquidation leads to distress selling, and to
2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of the velocity of circulation. This contraction of deposits and their velocity, precipitated by distress selling, causes
3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4) A greater fall in the net worth of business, precipitating bankruptcies, and
5) A like fall in profits, which in a "capitalistic," that is private-profit society, leads the concerns which are running at a loss to make
6) A reduction in output, in trade, and in employment of labor. These losses, bankruptcies, and unemployment, lead to
7) Pessimism and loss of confidence, which in turns lead to
8) Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause:
9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Japan is currently dealing with 13 years of this situation, and has an enormous stockpile of NPLs to show for it. The same situation could occur in China if the property bubble continues, exports drop, monetary expansion goes unchecked, and policy continues to see-saw.

Implications on foreign property investment in China

Residential
Chinese consumers, banks and corporates are far more heavily invested in real estate than in stocks, and falling prices are already starting to show from Shenzhen up to Shanghai. This momentum coupled with a general slow down fear (stocks, prices, US markets) can potentially create a negative snowball effect in pricing. This is already happening as homeowners are waiting to see what happens, and developers are getting choked, reducing prices dramatically. September/October is the peak home-buying season, and we can expect a slowdown to effect developers dramatically as the sky is falling sentiment grows. It usually takes about 6-12mo for cause to turn into effect, so any potential effect will probably be seen by next summer.

Retail
As the Chinese stock market is still small relative to GDP, it's rapid fall will more than likely only give people the shivers, without seriously impact spending. If things get messy, which is quite possible, and people start having trouble paying their mortgages (people are more invested in property than the stock market), there will be an impact in spending, which will impact retail, and an impact in retail will logically spill over to retail real estate. Yields will become more difficult to achieve as tenants will argue that people are not spending, and there will be too much available stock in the market, as is evident already in Beijing.

Commercial
China is clearly on the world's stage, even more so after the recent Olympics, and businesses will continue to come here, and they will all need offices. The market in 2nd tier cities will more than likely be soft.

In The News
A recent South China Morning Post article reports: "Mainland property developers have resorted to steep price discounting to lure buyers back to the market this month and next, the traditional peak home-buying season....However, the tactic has so far shown no sign of reversing the decline in property sales and analysts do not expect lower prices alone will be enough to restore buyer confidence."

Wang Qing, chief economist for Greater China of Morgan Stanley, said in a report released recently that he's in favor of China's real estate market, and predicted that China would loose its policy on the industry in the first quarter next year, then in a later report released on September 12, he said that since the housing price in big Chinese cities dropped sharply, China's real estate industry is very likely to crush, and may cause significant impact on profit performance of banking industry. MS have now begun unloading properties in Shanghai. Hmm...

To add to the pile, Goldman Sachs said that "the worst time that weak Chinese real estate market striking banking industry has not come yet, and risks induced by the industry's bad loans will emerge in the fourth quarter this year and the first half of 2009."

Today's (9/19/08 ) China Daily reports on a financial forum just held in Beijing, "It is time to lift excessive regulatory restrictions on private sector financing, which could help boost the dynamics of enterprises as well as improve the capital efficiency of the financial industry as a whole," said Wu Xiaoling, vice-chairwoman of the Financial and Economic Committee of the National People's Congress. Wu said encouraging private companies to raise money directly from investors could also help reduce pressure on the government to relax its monetary policy, which is central to the fight against inflation. Wu Xiaoling and other officials agreed that fiscal policies should be further relaxed to help stimulate domestic demand and encourage domestic consumption to offset declining external demand triggered by global economic uncertainties.

Changes

The policy winds seem to be blowing towards the domestic consumption side of the see-saw which potentially means less control in the hands of MoFCom and MOF and their allies, and potentially more power in the hands of the PBoC. PBoC by nature wants to stoke domestic consumption, which would require some further softening of the current credit restrictions. Whether a softening will include property developers is another story, as real estate exposure in the banks is a huge worry for the PBoC in case of a slowdown in economic growth, which looks likely to occur.

NOTE: This summary is compiled from many different sources, including Michael Pettis' very informative writings, current news articles in IHT, WSJ, Financial Times, etc, and a wide variety of economic reports and sites, as well as white papers from banks, consultants, and real estate firms. My own commentary is sprinkled in and out.

Category: Mr. Asia

Comments (3)

Comments

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Paul Denlinger

September 23, 2008 12:30 AM

I think that the Chinese government pursued the current path of development because it would allow China to build a strong export economy, with pressuring the Chinese government to cede to much control to China's private sector, which is strongest in Zhejiang province.

Now, though, my guess is that they will have no choice except to allow Chinese private companies access to capital and credit to expand. If that happens, you can expect the private sector to be much more internationally competitive than China's SOEs.

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Michael Turton

October 23, 2008 9:42 PM

Totally scary analysis. And greatly in-depth. Thanks, Corbett, I know the work that went into it.

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corbett

November 3, 2008 11:26 PM

Michael, thanks for the pat on the back. Now all we can do is sit back and watch what happens.

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