China: No Pain, No Gain
Andy Xie (Hong Kong)
Morgan Stanley
Apr 23, 2003
The Chinese government is launching a massive campaign to keep the
SARS virus under control. A massive migrant labor force estimated at 150
million and poor rural healthcare infrastructure make this task exceptionally
difficult. The campaign sets the country’s priorities right by putting
people’s health and safety first. It is the right choice for the country.
However, it is unavoidably disruptive to the economy. China faces rising
risk of a hard landing, in my view.
Canceling the week-long May Day break and firing key government officials
over mishandling of the SARS crisis are the first major steps in China’s
Long March toward political transparency. China is a different country
after two decades of rapid economic development. The belated political
change may ultimately improve China’s financial transparency, which would
improve the connection between growth and profitability.
Export strength remains a cushion for a slowing economy. If FDI flows are
merely delayed rather than diverted, China’s exports could remain strong for
the foreseeable future.
Putting Life First
Over the weekend, China (1) cancelled the weeklong May Day break, and
(2) made major personnel changes to reflect responsibilities in the
mishandling of the SARS crisis. The national media has also shifted from
the message of ‘everything under control’ to an education campaign on
how to avoid catching SARS. China is facing up to the harsh reality of how
a contagious illness could spread in a mobile and modern society.
These decisions are the first steps toward restoring the public and
international community’s confidence in the Chinese government. A long
road lies ahead. SARS is spreading to the underdeveloped interior
provinces that lack the sound healthcare infrastructure necessary to deal
with a major outbreak of a contagious illness. The central government has
promised to make financial resources available to deal with the virus in poor
provinces.
In my view, the short-term economic pain will be acute. Cancellation of the
weeklong May Day break could decrease this year’s GDP growth rate by
0.2-0.4%. The disruption to normal economic life could incur even more
economic costs. On April 2, we reduced our forecast for China’s 2003 GDP
growth rate to 6.5%. This is sufficient to cover the economic losses
associated with SARS for one quarter of the year.
There are three scenarios for how this crisis could unfold in the coming
months. First, the virus loses its virulence going into the summer months,
as do many other contagious respiratory diseases. Second, the virus
remains as it is but the public campaign reduces the infection rate and
brings the epidemic under control within two months. Third, the virus
mutates and hits in several waves as did Spanish flu and Hong Kong flu.
The first two scenarios are consistent with our current GDP growth
forecast. Most of the economic impact would be concentrated in the
second quarter and probably be equivalent to giving up one quarter of
growth. Normalization should take place in July.
The third scenario would imply a significantly lower growth rate than we are
currently forecasting. It is virtually impossible to make such a forecast.
The only relevant message is that it would imply much more downside than
is currently in the market.
Balance Sheet Risk
As China’s economy enters a period of rapid slowdown, it is impossible to
predict the downside associated with its balance sheet risk. Large amounts
of non-performing loans in state banks and the low profitability of
state-owned enterprises are widely known risks embedded in China’s
balance sheet. However, they may not represent the most important risk in
this cycle.
An opaque private sector represents the gravest risk to China’s economy in
the short term, in my view. A large number of private companies have
flourished in the past few years by manipulating financial accounts to
obtain bank loans. Some have even controlled local banks and used them
as their own piggybanks. A large number of private companies have
negative cash flow but present positive profits through accounting tricks.
If the cycle turns down hard, they may face bankruptcies, which would
magnify the economic cycle.
This risk is especially pronounced in the property sector. Commercial
building space under construction rose to 928 million square meters last
year from 772 million sq. m. the year before. The industry didn’t have much
equity to begin with and used mostly bank loans to fund its growth. Poor
capitalization has been partly hidden by creative accounting.
Further, purchases by Taiwan and Hong Kong residents are quite important
to this sector’s health. The SARS crisis would reduce such demand. The
balance sheet problem within this sector could be exposed in a downcycle.
The sector contributed 23% of overall economic growth last year. If it
experiences a hard landing, the impact on the economy would be large.
Financial Transparency
China must improve its financial transparency in order to reduce the
potential for a hard landing. China straddles a market and a planned
economy. The tension is often borne by the financial sector. For example, a
listed state-owned enterprise usually has a parent company that is in worse
financial shape. The wall between the two must inevitably collapse over
time.
Further, the rise of China’s private sector, especially in the non-export
sector, is modeled after Southeast Asian crony capitalism. Many, if not
most, private companies that sell into domestic demand do not make returns
above their cost of capital. They plug their cash flow problems with more
loans. This has given them incentive to control local banks to ensure their
cash source doesn’t dry up. This new risk represents an immediate
challenge to China’s economic stability.
The SARS crisis shows the costs associated with lack of transparency in
dealing with public health issues. Transparency is an even bigger problem
for the financial sector. China’s domestic credit to GDP ratio is 165% and
growing. This enormous amount of credit has been formed in an
environment of lax risk management and lack of accounting transparency.
China must deal with this issue as soon as possible to ensure economic
stability.
A Giant Step Toward Transparency
China’s government has taken extraordinary steps to correct the mistakes
made early on in its handling of the SARS crisis. The political system is
trying to adapt to a new environment. China has become much more
dependent on globalization for its economic growth. Economic growth has
increased the importance of non-economic issues to the Chinese
population. China has shown a willingness to adapt to the changing
internal and external environment. This is another example.
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