On May 6, I
reviewed the case for the meltdown of the allegedly
overheated Chinese economy and largely found it wanting
(The China syndrome in reverse?).
Evidence since then suggests that dangers persist
(inflation reached 3.8% in April after 3% in March,
producer prices rose 5% in April), but remain contained.
To switch to the aeronautical similes favored by
economists, a hard landing of the high-flying economy -
it grew by 9.1% in 2003 and at an annualized rate of
9.8% in the first quarter of this year - is improbable.
Nearly as unlikely, however, is that the government can
achieve the soft landing it desires and bring 2004 real
gross domestic product (GDP) growth down to 7%. Having
grown by 9.7% January to March and, by advance
indicators, not slowing in the second quarter (April
industrial output grew 19.1% year-on-year after 19.4% in
March), the economy would have to brake sharply in the
second half of the year to 5-6% growth levels for a 7%
overall 2004 result. Indeed, even a slowdown to an
annualized 7% rate in the fourth quarter would appear
unlikely short of a major financial calamity. The most
likely outcome on the current evidence is slight
moderation of the present cruising speed in the second
half of the year with some intermittent turbulence, for
2004 growth in the 8-9% range. In 2005, some further
slowing to 7-8% can be expected as global demand for
Chinese exports levels off and government cooling
measures begin to get traction.
Before
proceeding to more detailed analysis, some brief
definitions: "Overheating" generally refers to rapidly
rising goods and asset prices resulting from
supply-demand imbalances. A "hard landing" occurs when
asset bubbles burst, either as a result of financial
blowout or deliberate central bank and government action
(increased interest rates etc), leading to sharp
economic contraction. In contrast, a "soft landing"
signifies gradual price and growth reductions to
sustainable lower levels.
China experienced a
classical overheating episode in 1992-94 as GDP growth
led by consumer spending reached 14% and inflation
peaked at 28%. A belated series of interest rate hikes
and vigorous administrative measures executed by then
economic czar Zhu Rongji brought growth down to
officially 7%, but by private estimates much lower, by
1997/98, and consumer prices dropped into negative
territory through 2002. In formal terms, it wasn't a
hard landing, but certainly by all counts a bumpy one -
made no easier by the onset of the Asian crisis in July
1997.
The present "overheating" bears little
resemblance to the situation a decade ago. Inflation
risk remains contained. Even worst-case scenarios don't
project CPI (consumer price index) increases to
double-digit figures by year-end from the April 3.8%
reading. Overheating now is a supply-side phenomenon,
driven by overinvestment in select sectors (steel,
aluminum, cement, autos, property), not by an excess of
demand. Other sectors such as power and transportation
infrastructure actually experience supply shortages and
require large-scale added investment.
The most
serious problems at present are faced by the financial
and banking system. For lack of investment opportunities
in shallow domestic financial markets and unable to
invest abroad, companies and households deposit most of
their savings in bank accounts. The savings rate at 40%
is among the highest in the world and total savings have
reached 200% of GDP, or approximately US$2.8 trillion.
But total loans outstanding are just $2.2 trillion, for
a relatively low loan-to-deposit ratio of 78% - and that
ratio is continuing to drop as deposits keep mounting.
At the same time, according to a recent Standard &
Poor's estimate, bad loans ("impaired assets") in the
banking system make up 40% of total loans compared with
the official figure of just 16.6%.
In
combination, the overinvestment/underinvestment issue in
different industrial sectors and the parlous condition
of the banks pose a severe policy dilemma for the
government and People's Bank of China (PBOC). If - as
would be the norm in major developed economies facing
inflationary pressures and overinvestment - they raise
interest rates, they indiscriminately slow investment in
all industrial sectors and dampen loan growth across the
board. This would make existing energy and
transportation bottlenecks more severe. It would also
hurt the profitability of banks, which must pay interest
on growing deposits while experiencing lower income
growth as loan growth contracts. Moreover, the NPL
(non-performing loan) ratio would grow as the
denominator (total loans) stagnates while more loans go
sour and must be provisioned for on the balance sheet.
If, on the other hand, low interest rates (of 5.31%
since 1995) are maintained, more severe distortions and
the growth of mini-bubbles in the overinvested sectors
is inevitable.
To date, the financial
authorities have attempted to cope with the dilemma
through administrative means, decreeing a halt to new
projects in overheated sectors and instructing banks to
cease lending to industrial undertakings in those
sectors. An extensive project black list was published
last month. The question now is the effectiveness of
enforcement. Every local government wants a new steel
mill or motor vehicle factory. Property developers in
the main coastal provinces are on a rampage since
government housing has been privatized and flats were
acquired by residents for a pittance and can now be used
as collateral for new mortgages.
Problems of
enforcement notwithstanding, the government to all
appearances has decided to give selective administrative
slowdown action its best shot and - at least for the
time being - forgo catch-all market economy measures,
most notably tighter monetary policy (higher base
lending rates) and/or currency revaluation. According to
Premier Wen Jiabao, speaking before an audience in the
Great Hall of the People last Thursday, the crackdown on
new projects in outlawed sectors is beginning to show
results. His words have been echoed by PBOC officials
denying that an interest rate hike is necessary or
imminent.
Time will tell. Higher rates at some
point in the second half of the year can certainly not
be ruled out. But the government and PBOC will most
likely wait until the full data for the first half of
2004 are in and properly evaluated. Meanwhile, the
economy will make neither a soft nor a hard landing, but
will just keep on flying. A critical benchmark is
whether CPI will exceed 5%. Second quarter GDP growth is
of relatively less significance as last year's second
quarter, affected by severe acute respiratory syndrome,
showed relatively low growth of 6.7% and constitutes a
low baseline for year-on-year growth.
In any
case, no matter what the authorities' assessment and
actions turn out to be, China will not experience an
Asian-crisis-type meltdown. It has accumulated $440
billion in international reserves as of April - the
world's second largest after Japan; its current account,
though it has fallen into negative territory in the
first four months of the year, remains basically in
balance; its fiscal balance of minus-2.5% of GDP in 2003
is low; its capital account remains closed permitting no
massive and rapid capital outflows. The conditions for
an Asian-crisis-style financial catastrophe do not
exist.
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