China: No reason to frighten the analysts
By Samuel Baker
Concerns over China's economy are preoccupying analysts all over the world. Samuel Baker toured the country recently and found that visions of disaster are overblown.
BEIJING - Although bubble-like conditions are emerging in sectors of China's booming economy like luxury real estate, car manufacturing and steel, the distortions don't appear widespread enough to amount to a systemic risk to financial markets or to the economy.
Over the next 12-18 months, some of these red-hot sectors could cool off or even crash, either under their own weight or as a result of policy interventions. But the effect on gross domestic product (GDP) growth will more than likely be muted. As with the case of this year's severe acute respiratory syndrome (SARS) epidemic, GDP growth would likely fall below trend for a quarter, bouncing back quickly and without significant risk to average 8 percent-plus for 2004.
Concerns over a financial bubble like the one that wreaked havoc on the economy in 1994 and required a severe bloodletting by former prime minister Zhu Rongji to straighten it out, have been a growing preoccupation for market analysts, economists and journalists for months. Certainly, the biggest question in Beijing at the moment is whether the economy is overheating. One decade-long Beijing veteran simply says it is not a matter of if the bubble bursts, but when.
Without a doubt, cranes and new apartment buildings are sprouting up here, there and everywhere all over Beijing. A panoramic view from the 15th floor of a building in Beijing's Western District turns up no fewer than 20 such construction cranes. However, one leading Chinese economist with the China Center for Economic Research at Peking University points out that it is more precise to analyze specific sectors and regions of China's economy. His analysis scrutinizes specific dynamics behind the hyperbolic headlines and anecdotes and provides a more reasonable perspective from which one can accurately assess the case for China's economy being dangerously overheated and imminently vulnerable to serious macroeconomic risk.
The first question is over inflation. As measured by the Consumer Price Index (CPI), it is inching up, but remains at a low absolute level, rising 1.1 percent year-on-year in September compared with a 0.7 percent gain for the first nine months of the year. Producer prices follow a similar story line - they are rising but still remain at a low absolute level, up just 1.4 percent on the year in September. It could become more of a cause for concern when the CPI gets closer to 2 or 2.5 percent. A 3 percent rate is quite sustainable given an economy that is growing at an 8 percent trend growth rate. It's true that inflation can spike quickly even from low levels, but there is a minimal risk of a repeat of 1994, when the CPI soared to over 20 percent.
First, the macroeconomic situation does not yet fit a normal market model in which surging money supply correlates closely with high inflation. The lack of worrisome consumer price inflation, despite broad money supply surging 20 percent year-on-year for some months now, suggests among other things that liquidity is not finding its way into the hands of consumers.
In a more efficient market economy, such expansionary money supply growth would likely result in significantly stronger upward pressure on consumer prices as more currency chases a fixed amount of goods. In China, however, the lion's share of liquidity is being funneled to fixed asset investments, which grew 30.5 percent from January to September compared with the same year-earlier period.
This is an investment boom not seen since the 1994 period when inflation spiked to over 20 percent, forcing policymakers to shock the economy into a hard landing via a forced credit crunch as the government ordered banks to stop lending.
Fixed-asset investment is not spurring runaway inflation this time because first, China's infrastructure and the efficiency of its distribution networks are vastly improved compared to 1994 - the result of a decade of concentrated investment outlays, successfully connecting the country via a national highway system and upgrading other essential public infrastructure. Thus, there are fewer supply chain disruptions and resulting price pressures from distribution bottlenecks.
Second, China in 1994 was still transitioning from a scarcity economy, the legacy of central planning, to a surplus economy that is now characterized by chronic industrial overcapacity. Supply constraints inherent in the economy of the early 1990s can help explain the much faster pass-through of inflation in 1994 in the wake of a similar-sized investment boom compared to today. The transition from a chronic shortage economy to a surplus economy, one with a chronic overcapacity "problem" is paradoxically helping to moderate price rises.
Christian Murk, the chairman of the American Chamber of Commerce (AMCHAM) in Beijing, says he has not yet heard complaints from his organization's members in either Beijing or Shanghai about domestic supply chain bottlenecks, a surprise given the given the media hype about how growth is straining global logistical capacity and fueling price hikes for shipping services and commodity prices.
A top US official in Shanghai corroborates Murk's observations. He said he has heard not one complaint about supply chain issues from US firms. This feedback provides excellent anecdotal evidence as to why inflationary pressures have remained tame thus far and why they should remain relatively so given the latest official economic data suggesting that loan growth and fixed asset investment have peaked.
Fortunately for China, a delayed cleanup of the banking sector need not be fatal for some time yet. There appears to be limited near-term systemic risk for the economy despite what has been and continues to be unsustainably high growth in bank credit, which is fueling frothy investment dynamics in a number of industry sectors, including the aforementioned luxury apartments, passenger cars, mobile phones, cement and steel among others.
There are a number of extenuating factors - some general and some very industry specific - that limit the macroeconomic impact of surging loan and investment.
Positive earnings help. Foreign firms in a wide range of industries are making money, a distinct change from decades of difficulty when the promise receded into the future. The latest AMCHAM poll of business conditions in Beijing and Shanghai, two of the most vulnerable regions to overcapacity, indicates that the tide appears to have turned. Some 75 percent of companies polled said they were making money in China, and 40 percent said their margins in China were the higher than anywhere else in the world - the highest numbers ever for both categories since AMCHAM started tracking them. These favorable measures of business dynamics across the widest possible range of industrial sectors in China tend to contradict notions of an economy on the verge of a crisis, notwithstanding the fact that this is only the foreign community talking.
Surging demand supports capacity expansion. New-car production was up an absolutely jaw-dropping 87.23 percent from a year earlier, although car sales were only up 68.83 percent during the same period, suggesting overcapacity. A Western press article recently focused on this disparity. However, much of the production differential went to catching up to demand. Comparing the number of new cars produced (1.41 million) and sold (1.34 million) leaves only 70,000 cars produced beyond sales, which is less than 5 percent of total sales, hardly worrisome. Meantime, car sales are expected to grow over 50 percent again in 2005 to over 2 million units.
Time lag reduces risk of near-term gluts. "Money has been flowing around [China] so fast that we are eventually looking at an investment fiasco," according to Dong Tao, the chief regional economist for Credit Suisse First Boston as quoted in the New York Times. In the next line, however, Tao said, "Huge amounts of capacity will come online in about five years, prompting a deflationary situation." The two quotes highlight a key conclusion. The nature of the risks and the timing of those risks of investment bubbles and overheating in China are two separate issues.
Foreign ownership diversifies risks. For instance, apartment developers are almost exclusively Taiwanese and Hong Kong companies, Chinese firms are catching on in the mobile-phone business, but play a limited role at present, and all of the big car companies are foreign joint ventures. This means that if painful consolidation does take place in these sectors, the domestic Chinese banking system will not be left holding the bag, at least not completely, as many foreign firms operating in China are funded through home country sources.
Possible top for investment and loans. An October 17 economic release hints at a peak in the growth of fixed asset investment, which rose 26.5 percent in September, down from 30.5 percent for the first nine months of the year. Bank loan growth also fell in October, suggesting that fixed asset investment growth will continue to moderate. New loans by financial institutions in October were 61.6 billion yuan, which was 10.6 billion yuan less than new loans issued in October of last year. The year-on-year contraction in lending in October is likely the result of several factors, including an increase in the reserve ratio requirement announced on September 16 by the People's Bank of China from 6 percent to 7 percent. Sharp spikes in money market interest rates after the announcement suggest tighter credit conditions in the banking sector. The bank's issuance of stricter guidelines for bank loans, including to property developers, however, is the primary policy lever slowing down credit expansion.
China's reliance on administrative fiat to conduct monetary policy is a reflection of how inefficient and unresponsive the domestic banking sector remains to market dynamics. The continued reliance on such non-market based policy levers badly undermines efforts to commercialize the banking system.
Over time, systemic risks will inevitably build up in China's financial sector. However, for the foreseeable future, the government probably retains enough policy flexibility, including a low enough burden of public debt to GDP to keep bailing out the state banks with fresh injections of capital, thus allowing China's high-growth economy to continue roaring ahead.
Sam Baker is director of the Asia Group at Trans-National Research, a US-based independent research firm specializing in political and economic analysis of emerging markets. He leads research groups of senior institutional investor clients to Asia several times a year.
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