China hasn't seen a serious economic crisis since 1998-1999: Could the country be on the verge of another one now?
05/22/2012 8:30 am EST
That’s just a short list of financial and economic crises in the United States during the country’s rise to global economic power in the last half of the 19th century.
It would be extremely surprising if China didn’t suffer a few bumps on its rise to a similar position of global economic power. And it has. In the aftermath of the 1997 Asian Currency Crisis, for example, China’s official GDP growth rate dropped from 9.3% in 1997 to 7.8% in 1998 and to 7.6% in 1999 before recovering to 8.41% in 2000. The growth rate for China’s exports dropped to 0.5% in 1998 from 20% in 1997.
And now the worry is that China is looking at something like that 1998-1999 growth recession this year or next. Economists outside China are looking for official GDP growth for 2012 of something like 8.1% for the full year and for the economy’s official growth rate to bottom during the second or third quarter at 7% to 7.5%.
Is that worry justified? Could China be headed for a drop to something less than the expected 8.1% growth rate for 2012? Or to something like the dreaded “hard landing,” a vague term that I think means 7% growth or less. Or to something even worse, say, 6%?
Big questions for a country that most predictions show growing to the sky and very quickly. China’s economy is forecast to be larger than that of the United States as early as 2016. Among economists predicting that China will pass the U.S. 2025 is the most distant year I’ve been able to find. So deciding if the current bump in China’s economic path is just a bump or a sign of something more serious that could slow China’s growth rate significantly could be called very important.
The current data is ambiguous, to say the least, and in my opinion points to three possible interpretations of the recent slowdown and its longer-term significance.
No. 1: The Chinese government blew its resources in over-stimulating the Chinese economy after the global economic crisis and now, having stepped too hard on the brakes, doesn’t have the money to stimulate again. That makes this slowdown into more than a bump. Instead it is a major miscalculation with long-term negative consequences for China’s growth
No. 2: The ruling Communist party is immobilized by an internal power struggle and the purge of Bo Xilai, a candidate for the 9-man standing committee of the Politburo that effectively runs China, and the Beijing government is letting a chance to address the slowdown slip away. This too argues that this isn’t a mere bump but another data point on a trend that leads to the erosion of the power of the Communist Party and of the effectiveness of the central government. Again big long-term negative consequences.
No 3. The Chinese government really meant it when it said it wanted to rebalance the economy away from infrastructure investments and export and toward consumer spending and it is willing to risk some growth in order to achieve that end. If China can win this gamble, the country will have earned another stretched of hefty economic growth.
No. 3 strikes me as the most likely alternative—although I can see elements of all three scenarios at work. Let me tell you why I think so and what it means for China as a short- and long-term investment.
None of those growth numbers—8.1%, 7.5%, 7.1, or even 6%--seem like crisis numbers—certainly not enough to send global financial markets into a tizzy until you consider three things.
First, many economists outside the country think China’s official GDP numbers are highly suspect. Those economists look to other less easily manipulated numbers as a check on the official data. And those figures show a much slower growth than the official numbers. For example, electricity consumption, a frequently used check, recorded something between a 0.7% decline and a 3.7% increase in April when compared to the official 8.1% GDP growth rate in the first quarter.
Second, many China observers believe that the country needs a minimum of 7% economic growth to avoid a rising level of unrest and protest in China. China’s official unemployment rate always seems to come in near 4% but a better estimate of urban unemployment that includes unregistered workers is at least twice that and rural unemployment is somewhere near 20%. That’s led to a continued increase in even the official statistics for protests, riots, mass demonstrations, and mass petitions. The number of such events rose to 127,000 in 2010, according to the China Police Academy, from 90,000 in 2006. That’s a 41% increase. Citizens’ satisfaction with their own lives is also in decline, according to Horizon, a Beijing polling company. Confidence in the Chinese government has dropped by about 10 percentage points to 60%. These trends are certainly not what a Chinese Communist Party negotiating a transfer of power in 2012-2013 wants to see.
And, third, an economic slowdown in China, even if just to a growth rate that most developed economies would die for, could be a huge negative for China’s stressed banking system. The official estimate of bad loans in the portfolios of China’s big banks was just 1.15% in 2011, down from 1.34% in 2010, but nobody believes these figures and even if they did the country’s big banks aren’t where the worst problems are—those are in lenders associated with local governments. Moody’s Investors Service estimated back in July that local government debt was underestimated by $540 billion in official figures and that non-performing loans could reach 12%. If the economy slows more than expected, the percentage of non-performing loans would climb from even that level.
This last point is crucial to those who believe that China is headed for a hard landing because the government doesn’t have the resources to stimulate the economy that it had in 2008. In that year the post-Lehman bankruptcy official stimulus came to a whopping $586 billion, but not all of that money came from the national government in Beijing and the actual total was much higher as local governments pitched in with spending and as banks ramped up their lending. Local governments announced $1.4 trillion in stimulus spending in November 2008—although that included projects already budgeted. Banks made a record $1.4 trillion in new loans in 2009. There’s no way that China’s local governments and banks could match that stimulus total this time—even if they wanted to.
But that might actually be a good thing—and China’s inability to pursue this kind of big bomb stimulus approach may actually matter less than China’s unwillingness to repeat the experience of 2008.
By 2010 the huge stimulus package of 2008 looked like it had pushed China toward a serious inflation problem and a dangerous real estate bubble. Wholesale prices measured by the producer price index climbed at a 6.8% annual rate in April 2010. Money supply growth had hit an annual 21.5%. In April real estate prices were up 12.8% year over year, which was the biggest spike since 2005.
Yes, GDP would finish the year with a 10.4% growth rate but China was overheating.
By June 2011 inflation at the consumer level was running at a 6.4% annual rate, well above the government’s 4% inflation target. Real estate prices in the first half of the year soared by almost 33% from the first six months of 2010.
The People’s Bank and the government clamped down hard, slapping restrictions on mortgage lending, raising the bank reserve requirements, increasing interest rates, and setting lower quotas for bank loans. Those measures reduced inflation to an annual rate of 3.4% in April. But at a significant cost in growth. Not only did GDP growth slow to 8.1% in the first quarter but more recent data argue that growth is set to drop even lower in the second quarter. In April factory output climbed by just 9.3%, down from 11.9% growth in March. Last week the State Information Center forecast that second quarter GDP growth would come in at 7.5%.
The swings are huge: 10.4% GDP growth in 2010 and 6.4% inflation in June 2011 to 7.5% growth in the second quarter of 2012 and 3.4% inflation in April 2012.
You can imagine economists at the People’s Bank studying the data with concern and saying, “There has to be a better way.” And I can certainly imagine that members of the Politburo have connected these huge gyrations in inflation and growth to the increase in protest events and to falling confidence in the Chinese government.
There does seem to be a partial consensus about what to do to avoid repeating the problems of 2008. The People’s Bank is only very slowly reducing bank reserve requirements, leaving policy on hold for March and April before announcing another reduction in May. Many of the restrictions on mortgages put into effect to slow real estate speculation remain in place. The People’s Bank has yet to reduce actual interest rates. And the government, at the moment, seems to prefer jawboning to huge new stimulus packages. Premier Wen Jiabao continues to tour the country delivering Greenspan-esque statements about the government’s intention to stimulate growth. In Wuhan on May 18 he said that the government “should continue to implement a proactive fiscal policy and a prudent monetary policy, while giving more priority to maintaining growth.”
Boiled down that means the government and the central bank intend to pursue policies that will stimulate growth but don't expect very big initiatives and expect whatever is delivered to arrive more slowly than expected.
That doesn’t mean that there isn’t a very real battle going in the Politburo between a group that would like to push economic reforms that include a rebalancing of the current economy and a group that would like to keep things pretty much as they are.
A great deal of the wealth and power concentrated in the Communist party is linked to the old export/infrastructure investment model. Anything like cuts in subsidies and cheap loans to big state controlled companies would run smack into these entrenched interests. And these big companies provide lots of jobs at a time when unemployment in China is a big public concern. You can see the clout of the status quo in the recent announcement that the officials from the city of Weifang stepped in to help a state-controlled rayon maker, Shandong Helon, pay $60 million in commercial paper. That averted China’s first ever bond default. Even a relatively small state-controlled business like this is still too big to fail.
I don’t see economic reformers winning enough clout so that they can radically change the terms of China’s economic debate. (Although I do see the most connected and most wealthy of China’s citizens sending huge amounts of money out of the country. Estimates are that China’s wealthy have illegally transferred $120 billion overseas since 1990—and the pace is accelerating.) The bulk of bank credit will continue to flow to state-controlled companies, for example, and small and mid-size companies will continue to be starved for capital. But I do see the reformers able to block a repeat of the infrastructure/export oriented stimulus package of 2008.
In the short-run that power struggle and likely stalemate does raise the risk that China’s rate of economic growth will dip below expectations. The consensus among economists is already moving projections for the bottom in China’s economic growth from the second quarter of 2012 to the third. And we’re seeing the consensus projection on how low that bottom will be drift gradually lower as well.
But in the longer run this stalemate may actually be good for China’s economic health. A second big stimulus package built around infrastructure and export-driven industries would have pushed China’s already unbalanced economy even further into imbalance. Private consumption, which accounts for 70% of U.S. economic activity, accounted for just 46% of China’s GDP in 2000 and for an even lower 36% of GDP in 2007. The imbalance got worse during the financial crisis and the post-crisis stimulus. From 2007 through 2010 the share of GDP accounted for by real fixed investment (that is investment in everything from factories to roads to rail lines to housing) climbed by seven percentage points.
China’s biggest stimulus effort this time around isn’t to ramp up spending on roads or high-speed train lines. Instead it’s the 13% annual increase in the minimum wage written into the most recent five-year economic plan. Wages in China may actually rise faster than this because demographics have started to slow the growth in China’s work force and because the country’s growth has soaked up a big chunk of rural surplus labor. In 2011, for example, wages for China’s migrant workers increased by 21%.
Exactly how inflationary those wages hikes turn out to be will depend on what happens to productivity in China during the five-year plan. But the wage increases will put more money into the hands of China’s consumers. Over time that should both stimulate and rebalance China’s economy.
Will this kind of consumer-based stimulus be enough—when combined with the standard central bank policy moves now underway at the People’s Bank—to stop the slide in China’s growth rate and to start it moving upward again?
The answer to that depends on how deep and long the recession in Europe turns out to be. (Europe is China’s biggest trading partner.) And if the United States can maintain its recent 2% or better rates of growth. A severe European recession would probably cut deeply enough into China’s exports to drag China’s growth rates toward 7% country. That would, in turn, increase pressure on the government to do more to stimulate the economy via a scaled-back version of the 2008 stimulus package. Such a move, along with the wage increases written into the current five-year plan would be likely to accelerate inflation again and increase pressure on China’s banking system. That combination of stimulus and wage increases would likely be enough to increase growth in 2012, but I’d worry about a replay of the inflation worries of 2010-2011 in 2013.
And that’s a scenario that could lead to a significant drop in China’s long-term economic growth rate.
There are lots of moving parts here and lot of alternative scenarios. Let me try to exact three observations for investors.
- China seems committed to a program to increase economic growth—just at a somewhat slower pace than I expected six months ago. A bottom in the growth rate looks more likely for the third quarter than for the second.
- The emphasis in the current program favors domestic consumer companies and their stocks. If consumers have more money in their pockets, then these companies should see higher demand. That should, in turn, give them more power to raise prices to keep up with inflation. Some names to keep in mind are U.S. based consumer companies such as Yum! Brands (YUM) and Coach (COH) that are showing fast growth in the Chinese consumer market. Chinese consumer companies can be tough to buy for U.S. investors, but it’s worth asking your broker about the shares of food companies such as Tingyi Holdings (322.HK) and Want Want (151.HK) that trade in Hong Kong.
- I think there’s a very good chance that China will dodge an economic hard landing in 2012. But that doesn’t mean you should relax for 2013. China will face challenges from rising inflation and a financial system burdened with high levels of bad debt in 2013 that could produce yet more volatility.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Tingyi Holding as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/