It’s inevitable that a growing nation will suffer serious ups and downs. But will China slide softly into a needed dip, or will it suffer a hard landing? MoneyShow’s Jim Jubak, also of Jubak’s Picks, shares his take.
The panic of 1873, and what is often called the Long Depression. The panic of 1896. The panic of 1907, with the run on the Knickerbocker Trust, which built momentum for the creation of the Federal Reserve.
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, the official growth rate for China’s gross domestic product dropped from 9.3% in 1997 to 7.8% in 1998, and to 7.6% in 1999, before recovering to 8.4% 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-to-1999 growth recession this year or next. Economists outside China are looking for an 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 the 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 could it drop to something even worse, say 6%?
The current data are ambiguous, to say the least, and in my opinion, point to three possible interpretations:
- No. 1: The Chinese government blew its resources in overstimulating 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.
- No. 2: The ruling Communist party is immobilized by an internal power struggle and the purge of Bo Xilai, formerly a candidate for the nine-man standing committee of the Politburo that effectively runs China, and the Beijing government is letting a chance to address the slowdown slip away.
- No. 3: The Chinese government meant it when it said it wanted to rebalance the economy away from infrastructure investments and exports and toward consumer spending, and it is willing to risk some growth in order to achieve that end.
No. 3 strikes me as the most likely—although I can see elements of all three scenarios at work. Let me tell you why I think that, and what it means for China as a short- and long-term investment.
Crunch Go the Numbers
Those growth numbers—8.1%, 7.5%, 7.1, and even 6%—don’t seem like crisis numbers, and they certainly aren’t low enough to send global financial markets into a tizzy. That is, until you consider three things.
First, many economists think China’s official GDP numbers are highly suspect. Those economists look to less easily manipulated numbers as a check on the official rate.
And those figures suggest 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, compared with the official 8.1% GDP growth rate in the first quarter.
Second, many observers believe that China needs a minimum of 7% economic growth to avoid more unrest and protest. 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. Rural unemployment is somewhere near 20%.
That’s led to a continued increase—even in official statistics—in 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 ten percentage points, to 60%. These trends are certainly not what a Chinese Communist Party negotiating a transfer of power wants to see.
Third, an economic slowdown in China, even if just to a growth rate that most developed economies would envy, 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 nonperforming loans could reach 12%. If the economy slows more than expected, the percentage of nonperforming loans would climb.
This last point is crucial to those who believe 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 of the Lehman Brothers bankruptcy, official stimulus came to a whopping $586 billion.
But not all of that money came from the national government in Beijing. 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 China’s local governments and banks could match that stimulus total this time—even if they wanted to.
|pagebreak|Needed Slowdown?
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 as if 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% 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 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 it was 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 was set to drop even lower in the second quarter. In April, factory output climbed by just 9.3%, down from 11.9% 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 agreement about what to do to avoid repeating the problems of 2008. The People’s Bank is very slowly reducing bank reserve requirements, leaving policy on hold for March and April before announcing a 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 stimulus packages.
Yes, Premier Wen Jiabao continues to tour the country delivering Greenspan-esque statements about the government’s intention to stimulate growth. In Wuhan last week, 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 expect smaller initiatives than in the past…and expect those to arrive more slowly.
Power and Money
That doesn’t mean there isn’t a very real battle going in the Politburo between a group that would like to push economic reforms, which 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 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 to radically change the terms of China’s economic debate. The bulk of bank credit will continue to flow to state-controlled companies, for example, and small and midsize companies will continue to be starved for capital. But I do see them able to block a repeat of the infrastructure/export-oriented stimulus package of 2008.
In the short run, that power struggle and likely stalemate raise the risk that China’s 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 lower as well.
In the long 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 push China’s already unbalanced economy even further out of balance.
Private consumption, which accounts for 70% of US 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 7 percentage points.
Higher Wages as Stimulus
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 that, because demographics have started to slow the growth in China’s workforce, 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 21%.
Exactly how inflationary those wage 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 in 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 under way at the People’s Bank—to stop the slide in China’s growth rate and to start it moving upward again?
The answer depends on how deep and long the recession in Europe turns out to be, because Europe is China’s biggest trading partner. It also depends on whether the United States can maintain its recent 2% or better rate of growth.
A severe European recession would probably cut deeply enough into China’s exports to drag China’s growth rates toward 7%. 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 likely accelerate inflation and increase the pressure on China’s banking system. That combination of stimulus and wage increases would likely increase growth in 2012, but I’d worry about a replay of the inflation worries of 2010 and 2011 in 2013.
3 Rules for the Road Ahead
There are lots of moving parts here and lot of alternative scenarios. Let me try to extract three observations for investors.
- China seems committed to a program to increase economic growth—but 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, 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 US-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 US investors, but it’s worth asking your broker about the shares of food companies such as Tingyi Holding and Want Want Holdings, which 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.
