China: a 2010 clouded in uncertainty

The latest economic data published in Asia have shown that the major economies of the region have emerged successfully from the crisis of recent years. Smaller countries such as the Philippines and Indonesia have completely avoided plunging into recession, Singapore emerged from the crisis in the second quarter, while South Korea’s GDP grew 2.9% in the third quarter of this year. India, thanks to increasing flows of direct investment, is likely to come as a positive surprise in the coming months. All this has resulted in an upward revision to IMF’s economic growth estimates for Asia both in 2009 and 2010. The Washington Institute now forecasts 2.8% and a 5.8% growth in Asia in 2009 and 2010 respectively against earlier estimates of 1.2% and 4.3%.

But investor attention remains focused on China’s economic growth. The recently published third quarter data has suggested that the worst may be behind for the Chinese economy. The most encouraging indication came from GDP, + 8.9% y/y in real terms from +7.9% y/y in the second quarter and +6.1% y/y in the first quarter. Indeed, it is commonly believed that the Chinese economy needs to grow around 9% a year not to record higher unemployment rates. Further signs of improvement came from industrial production, up 13.9% y/y in September, and exports, whose pace of decline slowed to 15.2% yoy from 23.4% in August. Retail sales should continue to move upward in the medium term (+15.5% y/y in September vs. +15.4% y/y in August), mainly driven by improved sales of cars (+44.5% y/y), furnishing (+34% y/y) and construction materials (30.2% y/y). A boost to private consumption (down from 67% in 1981 to 48% in 2007 as a percentage of GDP) to the detriment of exports was, in fact, considered key by most economists to help rebalance the Chinese economy when the crisis broke out.

However, many investors and economists fear that the ongoing recovery might not be due to the strength of the economy, as argued by Goldman Sachs economists, but only to the aggressive expansionary policy pursued by the Government and that 2010 may produce negative surprises.

In the face of last two years’ crisis, in fact, the Chinese government has implemented a USD586bn fiscal stimulus plan, mainly aimed at infrastructure construction, post-earthquake reconstruction and affordable housing building.

More importantly, major domestic banks and small regional banks have started easing credit standards following the directives enacted by the central government. In the first nine months of 2009, in fact, new loans amounted to 8670 billion yuan, compared with 3480 for the same period last year. Although new loans have began to slow in the second half of this year (from a monthly average of 1230 billion in the first half to 428 trillion in the first 3 months of the second quarter), loan growth remains significant, hence raising fears that the Chinese economy could soon begin to suffer from excessive indebtedness.

Chinese authorities are particularly concerned that a large share of these new loans were not used to underpin the real economy but to heighten speculation on financial and real estate markets, increasing the risk of new speculative bubbles. For example, China Business News, citing government sources, indicated that almost 20% of the new loans in the first six months of the year had been invested in the Shanghai stock market. New loans to the property market also rose sharply. According to the National Office of Statistics, house prices in 70 reference cities rose by 2.8% y/y in September, up from +2% y/y in August. The sharp improvement led Moody's upgrade its outlook for the Chinese residential market from negative to stable.

Considering also the higher-than-60% stock market rebound since the beginning of this year, the Chinese authorities appear to be ready to take action to prevent this trend from jeopardising the country’s financial stability.

The Commission for banking regulation will introduce new measures to ensure that the new loans are not used for purposes other than supporting the real economy. According to a draft reform published in the Commission's website, loans exceeding 300 thousand yuans (about 30 thousand Euros) would be paid directly to the counterparty. "This is the first step towards a removal of the expansionary policy and it was decided after the latest reassuring economic data" said Gabriel Gondard, Fortune SGAM Fund Management CIO in Shanghai to Bloomberg news agency. Nevertheless, market experts are divided over the Chinese authorities’ future economic incentives choices. For example, economists at UBS and Credit Suisse believe that reserves to be held at the Central Bank by commercial banks will be increased by the end of the year. By contrast, Stephen Roach, chairman of Morgan Stanley Asia, said that Chinese authorities aim to maintain social stability, which can be only guaranteed by sustained growth. A new economic downturn, a clear possibility in 2010 should the Government remove the fiscal stimulus, is, therefore, to avoid.

The trend of prices is another factor that helps maintain the ongoing expansionary policy in place. Despite the sharp increase in M2 money supply (+29% y/y in September), consumer prices (-0.8% y/y in September) are expected to edge up in 2010. Economists at Morgan Stanley, for example, see inflation averaging at 2.5% in 2010, with an upward pressure that should only come from a stronger-than-expected international recovery, which would push higher commodity prices. According to Morgan Stanley, the government will not raise rates ahead of any such move by the Fed, which is expected to start tightening in mid-2010, given the close relationship between the Dollar and the Yuan.

The Council of State has shown that a continuation of government stimuli would be necessary to rebalance the Chinese industrial sector, which is skewed towards given sectors. As a first step, the government decreased the number of financing projects for the production of aluminium, steel and cement to prevent excess capacity. The challenge facing the Chinese economy in 2010 will therefore be to sustain economic growth while avoiding over-indebtedness. This will be crucial not only for the country’s but also for the global economy. Should a rebalancing of the economy fail to materialize, a renewed focus on exports would be inevitable.

What’s happening to China’s stock market?

Notwithstanding the continued uptrend in major international equity indices, the Chinese equity market lost 21.81% in August, compounding investors’ fears over the country’s economic outlook. Not only did these fears (which were only partially dispelled by a recovery towards the end of last week) weigh on the equity indices of other emerging markets, but also on leading international equity markets. Although the decline in the Chinese stock market was not the main trigger for the downtrend in western equity markets, which was due to persistent doubts over the sustainability of the current economic upturn, it certainly played a role in it.

Both the decline and the upsurge of the Chinese market have been mainly sparked by the sharp increase in liquidity and bank loans due to expansionary monetary and fiscal policy implemented by the Chinese Central Bank. Indeed rumours circulated in August that the Bank is highly likely to tighten its monetary policy in the second half of 2009. Based on data released by the China Business News, as much as 20% of the largest loans granted in the first half of this year have been invested in the Shanghai stock market. The latest press rumours suggesting that new loans slumped to 300 billion yuan in August from 356 billion yuan in July and an average of 1.231 trillion in the first half of the year have reinforced fears of a slowdown in liquidity growth.

Worries about a possible exit from the current accommodation have led investors to play down encouraging signs of an early recovery in the real economy. The manufacturing PMI hit 54 in August, its highest for the past 16 months and a figure suggesting positive growth in the manufacturing sector.

Robert Zoellick, World Bank president, said that the outlook for the global economy has improved recently thanks to reassuring signals coming from China. The World Bank president also confirmed that the Chinese economy is expected to grow by 8% in 2009, but he recommended not to remove the monetary stimulus as the economic recovery is fragile and inflation is not cause for concern at present.

In an article published on his website (http://www.mpettis.com/), Michael Pettis, professor of finance at Peking University and one of the foremost experts on the Chinese economy, confirmed that the market decline was due mainly to factors related to developments in speculative liquidity. “Why did the market collapse? Forget about fundamentals. As I have argued many times before, China lacks the necessary tools that fundamental investors use (e.g. good macro data, good financial statements, a clear corporate governance framework, a stable regulatory environment, a market discount rate) and so no matter what people say, there are no fundamental investing here. There is only speculation, and the two things above all that drive the markets are those old speculator favorites, changes in underlying liquidity and government signaling". The weak correlation between economic fundamentals and stock markets’ trend in emerging countries has been also underlined by Paul Marson, CIO of Lombard Odier, in a recent article published in the Financial Times. 

China’s Premier Wen Jiabao, following the declines of recent weeks, gave a

speech on Tuesday September 1st (the day after the 6.7% drop in the stock market) to assure that the expansionary monetary and fiscal policy will not be removed shortly as the recovery is still at a critical point. The market response to Wen Jabao’s speech has been positive, with the Shanghai market index partially recovering the ground lost on Monday 31 August.

Moreover, a further slump in the Chinese equity market would hamper the effectiveness of the stimuli implemented recently by Beijing. For this reason, Pettis believes “that if the local stock markets do not soon recover their bounce (and they won’t without government help) and, even worse, if we start to see the awful sentiment seep into the real estate sector, Beijing will once again push forcefully for credit and fiscal expansion”.

Pessimistic about the outlook for the Chinese stock market is Andy Xie (Andy's article published in August), a former chief economist for the Asian economies at Morgan Stanley and now an independent analyst. According to Xie, it is very likely that both the stock and the real estate market are in a new bubble. "Chinese asset markets have become a giant Ponzi scheme. The prices are supported by appreciation expectation. As more people and liquidity are sucked in, the resulting surging prices validate the expectation, which prompts more people to join the party. This sort of bubble ends when there isn’t enough liquidity to feed the beast”. However, current liquidity levels are not cause for concern. Xie, who considers the equity market 25% overvalued and estimates that it will fall below the 2000-point threshold, believes that the stock market can continue to hover around these bubble levels for some time to fall permanently in Q4 or during next year. The main trigger for the downturn should be a strengthening dollar, historically a source of danger for the emerging markets, which should be underpinned by a rise in interest rates as a result of a possible higher inflation.

Overall, the outlook for the Chinese stock market is clouded in uncertainty. Although the strong liquidity injection will likely support the equity market in the short term, the inevitable withdrawal of excess liquidity will have negative effects on Shanghai going forward. And the severe repercussions of excess credit and liquidity on western economies are still there for everyone. For these reasons, staying away from the Chinese equity market will prove to be the wiser choice for European investors (by contrast it could be a golden opportunity for traders due to its high volatility). However, the trend shown by the country’s equity market in the last few days is clear evidence that the decline in the Chinese stock market will certainly impact on western European markets. European investors are highly recommended to give every morning a look at the Chinese stock market close.

China between excessive loan growth and consumer spending revival

Rebalancing China’s ecomomy towards sharper growth in domestic consumption: this is one of the recipes suggested by the authorities following the deepening of the crisis of many major developed economies to allow a return of the world economy to a path of sustainable growth. Indeed over the last few years the Chinese economy has focused on boosting exports and expanding investment. The share of private consumption to GDP dropped from 67% in 1981 to 48.8% in 2007, while the trade balance went from negative in 1985 (- 4%) to positive in 2007 (8.9%). Rebalancing consumption is also the number one priority for the Chinese government, which aims to make the country less vulnerable to the global recession. The 26% decrease in exports for May is clear evidence that China can no longer rely on exports to bolster its economy.

"Easier said than done": this is the recent trenchant comment made by the Central Bank Governor Zhou Xiaochuan, who highlighted the need to lower the rate of household (around 20% on average) and corporate savings (to 22.9%). With this in mind, the government has recently launched a 850bn yuan plan aimed at boosting consumption and financing a healthcare reform plan by slashing taxes on new car purchases (which soared by 48% in June compared to the same period last year) and granting incentives to farmers to buy goods for their own homes. Nevertheless, large part of the fiscal stimulus (4000bn yuan) is based on investment incentives, which are “necessary to monitor to prevent them being wasted", said Zhou.

However, a major threat that has severely damaged the leading western economies over recent years is looming on the Chinese horizon: over-indebtedness. The Bank of China’s recently published data have shown that new loans have risen to 737bn yuan, an increase of over 200% over the same period last year. New loans have thus exceeded by 47% the minimum 2009 target set by the Central Bank following the government intervention to ease lending criteria with a view to limiting the impact of export collapse. The sharp increase in new lending has led to a bounce in equity markets and to a steep rise in property prices. According to some government sources quoted by China Business News, 20% of the increase in new lending granted in the period is thought to have been invested in Shanghai stock market. "The speculation on the stock market is less than a concern" wrote Michael Pettis, professor at the University of Beijing, in an article published in China Financial News, "there is at least some possibility that some of these will be repaid. I'm not sure this is true for all other loans that have been made". Voices have already risen to warn of the dangers of a too pronounced rise in indebtedness. The Chinese banking regulatory authority has warned that such rapid growth poses risks to the financial system and the ratings agency Fitch has pointed out that future loan losses may be greater than expected and has questioned whether public authorities will be able to absorb these losses.

The central bank is understood to have already embarked on a restrictive policy. After only 8 months the bank has recently returned to place 1-year government bonds. According to estimates by Isaac Meng, a senior economist at BNP Paribas, credit should slow dramatically in the second half of this year.
China is therefore highly unlikely to act as the international driving force given that a repositioning of the country’s economy towards boosting consumption has yet to materialise. Moreover, dropping a growth model based on exports would lead the government to float the yuan at a value more in line with the country’s economic fundamentals. According to a recent study by William Cline and John Williamson (Equilibrium Exchange Rates), the yuan should appreciate by more than an unrealistic 40% against the dollar to realign itself with fundamentals. Overall, China appears unlikely to act as a long-lasting and strong growth trigger for major global economies but will likely spark short-lived rebounds.