Global: China Test
Stephen Roach (New York)
The world has discovered China. And with good reason: I continue to believe that China is the greatest economic development story of the 21st century. But no economy is perfect. There are often bumps on the road to prosperity — some minor and some serious — that pose important challenges to any growth strategy. China is no exception, and in fact is facing just such a challenge today. Chinese authorities are now in the process of tempering some of the economy’s recent growth excesses. That suggests that the next China growth surprise is likely to be on the downside — a development which could have important implications for the global economy and world financial markets.
There are two ingredients to the China slowdown story — an economy that must face up to both a credit bubble and inflation. Beginning in late 2002, Chinese bank lending accelerated dramatically; in the 12 months ending November 2003, the outstanding volume of such loans was up 21.4% — nearly double the average gains of 11.9% over the 1997–2002 period. It quickly became evident that the acceleration was concentrated in the four state policy banks, whose primary focus is to provide funding for China’s vast network of state-owned enterprises (SOEs). Unfortunately, this segment of the Chinese economy is still the shakiest. With excess lending flowing into SOEs, there was a growing risk of a new wave of nonperforming bank loans, precisely the opposite of what Chinese financial sector reform is attempting to achieve. At the same time, there was mounting evidence of a property bubble, especially in the Shanghai area but also in other pockets of the relatively wealthy coastal region. This, too, appears to have been largely a by-product of excessive bank lending that was funding increasingly speculative property development projects. There have also been indications of excess spending on infrastructure.
Meanwhile, there has been an important shift in the Chinese inflation dynamic: After 15 months of deflation, China transitioned back into positive inflation territory at the start of 2003. And slowly but surely, the rate of inflation has begun to accelerate. The just-released inflation report for November 2003 was mildly disturbing — a 3.0% y-o-y increase, which represents the sharpest rise in nearly seven years. The mix of Chinese inflation is important, but not for the reasons we stress in the industrial world. The recent surge is concentrated in food prices, where annualized inflation is now running at an 8.1% rate. Weather-related or not, this is a big deal in a nation that still has about two-thirds of its population living at poverty levels. Unlike the West, where we strip out food in an effort to come up with “core” inflation, the Chinese have no such luxury. At the same time, there are also indications of accelerating pricing elsewhere in the Chinese economy — especially for consumer essentials such as utilities (4.6%), medical care (8.1%), and education (3.9%). The same can be said in the property sector, where inflation in housing rents hit 3.7% in November; this reinforces sharply rising prices in many construction materials such as steel and cement, a development that has caught the attention of China’s central bank. At the same time, China’s manufacturing sector remains in deflation as the confluence of rapidly expanding capacity and intense competition continues to limit pricing leverage — even in areas such as motor vehicles and mobile phones, where demand is expanding most rapidly; prices of transportation and telecommunications equipment are down 2.2% in the first 11 months of 2003.
Has the Chinese economy overheated? The answer is no — at least, not yet. But it certainly could if the authorities stood by and did nothing. Precisely for that reason, China’s central bank has already taken preemptive action to stem the excesses of this credit-induced inflation. As announced in late August and implemented in late September, the People’s Bank of China raised reserve requirements on bank deposits from 6% to 7%. Reflecting the legacy effects of a centrally controlled system, China does not have yet have an instrument-based monetary transmission mechanism as we know it in the West. Banks, especially the four dominant state-owned policy institutions, take their cue more from the rhetoric of policy pronouncements and the allocation of credit supply that stems from such moral suasion. Whatever the transmission channel, the medicine is working. Bank loan growth averaged just Rmb 80 billion in October and November —down sharply from average monthly gains of Rmb 275 billion in the first three quarters of this year. The Chinese credit cycle has turned — precisely what China needs in order to temper its financial and economic excesses.
That could have important global implications, in my view. The rest of Asia is especially vulnerable to a China slowdown. China’s import surge —year-to-date gains of 39% — have become an important source of external demand elsewhere in the region (see my November 4 dispatch, “China Pull”). In the first nine months of 2003, China accounted for 66% of Japan’s total export growth; for Korea the figure was 40% and for Taiwan, an astonishing 97%; for the smaller and more diversified ASEAN economies, the China share of this year’s export growth is in the 20–30% range. Nor is Asia alone in drawing sustenance from Chinese demand. China accounted for fully 56% of Germany’s total export growth in the first eight months of 2003 and 21% in America. Should China now slow, as we suspect, the rest of Asia, along with Europe and the US, will not be spared. Interestingly enough, the early warning signs of a slowing in Chinese import demand are now evident: The November trade statistics revealed a sharp deceleration of import growth to 28.4% y-o-y, still vigorous to be sure but well below the 40% pace over the first 10 months of the year. This could be the first hard indication of the coming slowdown in Chinese domestic demand. With China now qualifying as an important engine of growth in a still sluggish world, a slowdown in the Chinese economy underscores the risk of a global growth disappointment in the first half of 2004.
This chain of events is very much consistent with the conclusions that Andy Xie and I have both been stressing for the past several months (see Andy’s October 20 dispatch, “Sharp Slowdown Ahead” and my October 13 essay, “Payback Time”). Yet this remains very much an out-of-consensus view. Surging commodity prices and shipping rates, together with a constant outpouring of euphoric press reports on China, still have most observers convinced that there’s no stopping the Chinese economy or, for that matter, an increasingly China-centric Asian economy. There’s a certain irony in all this: The world has rushed to one side of the China boat at precisely the moment when the authorities are putting the brakes on. As is all too often the case with respect to China, the West just doesn’t get it.
Missing in the outside world’s assessment of China, in my view, is the perspective from the inside — the overarching imperative to manage the Chinese reform process without disturbing the nation’s social stability. Reforms in China are proceeding at a pace that is almost impossible to fathom from the outside looking in. A critical ingredient of this process is the unrelenting restructuring of China’s vast network of state-owned enterprises, and the annual elimination of some 7–9 million state-funded jobs associated with this extraordinary transition. China’s reforms are all about creating a market-based alternative to its network of antiquated SOEs and sustaining a vigorous growth climate that is capable of absorbing the concomitant influx of displaced state workers. As such, China cannot afford a “growth accident” that might destabilize this process. And the bigger the Chinese economy gets and the further it goes down the road to reform, the more the consequences of any such accident are magnified. The excesses of the credit cycle, the risks of a new wave of nonperforming bank loans, emerging inflationary pressures, and selected property bubbles need to be seen in that context. To the extent these developments raise the risks of a hard landing, Chinese authorities can be expected to take preemptive action to engineer a soft landing. The good news is that’s exactly what they’ve done. The bad news is that the rest of the world doesn’t get it.
As is typically the case, the Western consensus can be expected to go from one extreme to another in assessing prospects for the Chinese economy — with euphoria over the boom quickly giving way to fears of the coming bust. None other than Fed Chairman Alan Greenspan has recently warned of just such a possibility in voicing concerns over China’s currency peg — underscoring the risk of recession that would stem from the excess domestic liquidity creation that defense of such a currency regime implies (see his December 11 remarks before the World Affairs Council of Greater Dallas). His view only adds to the growing chorus of Western sentiment arguing for China to revalue the RMB. The arguments, in most cases, are thinly veiled efforts to get China to temper the pressures that are bearing down elsewhere in the world. Japan and Europe want China to share the burden of the dollar’s inevitable adjustment — a stance that I believe is steeped in hypocrisy: Two of the wealthiest regions of the world that remain reluctant to reform are demanding assistance from a poor nation that has been aggressive in embracing reforms. A similar consideration has probably not been lost on Greenspan as he does his best to facilitate an orderly correction in the greenback. And, of course, there’s the political angle, led increasingly by a bipartisan coalition of protectionist politicians in the US who would like nothing more than to see China cave on the currency issue.
I’ve seen this movie before. In the minds of the West, the China hard landing is always the risk. Yet time and again, China has proved the doubters wrong, especially in recent years. That was the case during the Asian financial crisis of 1997–98, when fears of a Chinese currency devaluation were rampant. It was also the case in the global recession of 2001, when China was widely thought to be at serious risk. And I suspect that could also be the case today. Yet China is dealing with its growth excesses on its own terms — not on terms that are politically expedient in the West. For China, a revaluation of the RMB would pose serious risks to the requisite job absorption in its thriving export sector. A currency-driven solution works best in a market-based economy. For a command economy like China’s, credit allocation should work just fine. The best news of all is that’s exactly what’s now happening in China. I am confident that the coming soft landing will be nothing more than a bump in the road of Chinese prosperity. Yes, it’s an important test for China’s new leadership but one that I believe it will manage with extraordinary success. I wish I could say the same for the rest of the world.
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