China’s ability to sustain its economic transformation in the face of an explosion of credit and over-investment has repeatedly been doubted. Indeed, predicting a Chinese economic implosion has become almost an international sport over the last three years.
However, the doubters have repeatedly been proved wrong. And with the consensus among economists at institutions such as the Asian Development Bank, IMF and World Bank suggesting that the world’s second largest economy can continue to grow its way out of trouble, it seems more unwise than ever to bet against the ability of the Chinese government to manage the transition from control economy to a market model successfully.
But according to William Thomson, chairman of Private Capital, an advisory company in Hong Kong, and director of Finavestment in London, such a benign outcome cannot be taken for granted. “This time [the naysayers] seem to have a better case,” he tells Emerging Markets.
Thomson speaks with experience, having been an executive director and vice-president of the ADB as well as with the US Treasury. “China has entered a tricky period of transition from investment-led growth to more consumer-led growth,” he says. “That will almost inevitably lead to slower growth as the transition kicks in until it stabilises at a new equilibrium.”
CHINA’S MOMENT
However, he warns that “if the transition goes wrong we could have a Minsky moment and a plunge in growth rates.”
(A Minsky moment, lest we forget, is a sudden major collapse of asset values that have been pushed up by speculators usually using borrowed money, triggering a sharp drop in market liquidity, and a severe demand for cash. The term was coined by Paul McCulley of Pimco to describe the 1997 Asia debt crisis and was named after economist Hyman Minsky.)
Former managing director of Goldman Sachs Asia and chief economist at Deutsche Bank Asia, Kenneth Courtis, is equally blunt about the risks that China faces. “China has engaged in a vast programme of change in a context where the world economy and geopolitics are already saturated with risk,” says Courtis, who now heads Starfort Investments in Hong Kong. “By any measure, China has a complex agenda ahead and because it is a $10tr economy, how well China manages its seven transitions carries major and multiple implications for the world economy and for global commodity markets.”
China, he says, “is perhaps the one country in the world — together maybe with Germany — that does have a state with real execution capacity. But still what has now started is monumentally challenging.”
Courtis lists these seven transitions as: “Developing and shrinking China’s state owned sector; interest rate liberalisation; opening of the capital account and full exchange rate convertibility; marketisation of rural land ownership; urbanisation of another 250m people; moves from external focused to domestic demand-driven growth and more market-based allocation of capital, labour, land and technology.”
SLOWDOWN SPILLOVER
The outcome will be critical to the rest of the world. As IMF deputy managing director Naoyuki Shinohara says, “China has become a hub of the global supply chain and is the second largest economy in the world. Its major shift of economic gears has implications for the global economy, not just Japan or the US but the trade linkage with Europe is also very strong.
“There are resource-rich countries that have exported large amounts of commodities to China. They are feeling an impact from the slowdown of the Chinese economy because commodity prices [have become] a little weaker and exports of commodities to China are slowing. Both China’s exports and its imports are affected by the slowdown.”
The potential spillover effects of China’s slowdown on Asia and on the rest of the world also concern other IMF officials. Changyong Rhee, who took over earlier this year as head of the IMF’s Asia and Pacific department after a number of years as chief economist at the ADB, is one of them.
“Trade integration with China has created important benefits for the rest of the region, but it also creates challenges for policymakers by increasing spillovers and cyclical co-movement between economies,” he says. “Because China is more integrated with the rest of Asia than with the rest of the world, the impact of a 1% growth decline in China is about twice as large for Asia as for non-Asia.” The most exposed countries “are those within China’s supply chain”, he says, adding that these are too numerous to specify individually.
Data produced by Courtis’s Starfort show Singapore, Taiwan and South Korea as the three territories likely to be most hit by China’s slowdown in terms of exports to GDP ratio. After that come Myanmar, Thailand, Australia, New Zealand, Indonesia, the Philippines and India.
Japan too stands to be badly affected by any severe slowdown in China, which remains its single biggest export market and overall trading partner (exports to China rose 15% in the year to March 31) despite the sharp deterioration in diplomatic relations between Asia’s two biggest economies over territorial and other disputes.
BUBBLE TROUBLE
It is not only China’s trading partners that have grounds for concerns — investors in the country are also right to be fearful. “In 2008, China was a lightly leveraged country but its total debt to GDP figures are now comparable to [those of] the US before [the 2008 financial crisis],” says Private Capital’s Thomson. “From that perspective things do not look good.”
“China’s real estate bubble is losing air or popping in the weaker tier three and tier four cities,” he says, but at least “China’s banking system appears to be in better shape than [that of] the US ... in 2008, mainly because China does not have the same exposure to toxic derivatives that really precipitated the US crisis.”
Even officials in the public sector acknowledge that there are likely to be wobbles en route to China’s hoped-for new equilibrium. “As we have flagged in our recent Article IV reports on China, vulnerabilities in the financial sector, local government financing vehicles and the property sector are key risks for the region’s largest economy,” says the IMF’s Rhee.
“For now, we believe there are enough buffers in place but the margins of safety are diminishing. As long as China’s growth remains heavily dependent on credit and investment, these vulnerabilities will increase. The current slowdown of China’s growth should be regarded as a desirable adjustment to a more sustainable path to address this credit led growth.
“Policy priority should be given to reining in credit growth. This may involve accepting somewhat slower growth as the economy adjusts to the new trajectory, but it is a trade-off worth making since it comes with the benefit of permanently higher living standards in the long run.”
The IMF’s Shinohara, meanwhile, remains quite upbeat about China’s ability to deal with its problems. “Recent indicators have been a little weak, especially since the beginning of the year, but we are not very much worried,” he says.
“Some degree of slowdown is inevitable and it is good for the Chinese economy. They have to rein in the expansion of social financing and on the expansion of credit in the economy. They need to strike a good balance between control and economic growth. The government is very flexible in aiming at a growth target of 7.5%. It could be lower or it could be a little higher but I think they are moving in the right direction.”
NO QUICK ADJUSTMENT
The question for many is how long this adjustment process will take. Shinohara claims it to be a “medium term process”, but refrains from specifying any further, adding, “I don’t know how many years. It is a shift from too much investment to a more consumption-driven growth and more distribution of wealth to people in general. It is not something that can be achieved in a short period of time. This is the challenge China faces in shifting the economy from a high growth model to a more moderate level.”
He emphasises, however, that the IMF is not expecting a hard landing in China. “I think it is under control,” he states. “The policy package [that the Chinese government] announced last year during the Third Plenary session [represents moves] in the right direction. They are moving toward a more market-driven economy, gradually. Some slowdown is necessary but we are not expecting it to be disruptive.”
Meanwhile, one saving factor for China, according to Private Capital’s Thomson, is the lack of complete currency convertibility, “so [any] outflow of funds should be manageable”.
He adds: “I suspect that the country might welcome some easing of the exchange rate in the short run to maintain export competitiveness in the event of an export slump. China has had plenty of time to plan its response and it can see how Japan and the West have mishandled their crises.”
The fact that China is not in denial about the seriousness of its problems is seen as encouraging by Christopher Wood, managing director and chief equity strategist at brokerage CLSA in Hong Kong. “While this does not guarantee that these challenges can be overcome,” he says, “it does give Beijing a much better chance of meeting the challenge, particularly if China refrains from implementing full-scale financial liberalisation, at which point a ‘Minsky moment’ becomes much more likely.”
But, says Wood, who spends a good deal of time in the country, while China’s capital account has “become more porous in recent years” if authorities there “were to decide tomorrow that capital outflow was becoming a problem, then they still have the means under the current structure to reassert control very quickly”.
This is a critical point, he says. “As for the currency, the consensus on the People’s Bank of China (PBOC)’s recent move to weaken the renminbi is that it was driven by a desire to hurt speculators — an exercise that has clearly worked.”
There is no panic to get out of renminbi, says Wood, but “it will be surprising if the recent trend of hot money inflows [into China] does not reverse in coming months”.
MINEFIELDS AHEAD
There are “clearly some minefields” for Chinese authorities to step through in coming quarters, Wood suggested recently in his Greed & Fear investment monitor, given the looming overhang of maturing trust products in China. China Reality Research estimates that there are at least RMB2tr worth of trust products maturing in the second half of 2014 and RMB3.6tr in 2015.
“The trick here,” says Wood, “will be to introduce some discipline into the system, in terms of imposing some losses, without precipitating a full-scale retail panic. That there is a refreshing willingness to impose some losses can be seen in the recent bond defaults, even if this is not the China Lehman moment hyped by the global media.”
But Wood acknowledges that if there is one area where officialdom is concerned that China’s economy could weaken more than currently anticipated, it is the property market. “The weakening trend in tier three and smaller cities is widely acknowledged,” he says. “Investors, even if they do not own property stocks, need to keep a close eye on data for the residential property market this year, particularly in tier one cities.” Residential property sales in 12 big cities declined by 36% year on year in March, he notes.
Chinese property data has been weak in the first quarter of this year and, says Wood, “there is a real risk that the weakness feeds on itself with secondary market prices in Beijing, for example, down 5.8% in the last two months from recent peak levels. Tightening of credit is also an issue since banks are not chasing mortgage business any more. Rather, the opposite applies. Thus, first-time buyers now have to pay 7.2% for a mortgage, or a 10% premium over the benchmark rate. That is a very high real rate of borrowing [in China].”
But he adds: “If the property market sees real downward momentum, the government does have the ability to remove or relax remaining tightening policies, most particularly in the bigger cities, though I would not expect such a development any time soon. Meanwhile, the small cities represent a much bigger challenge because of high inventory levels and weak demand.”