I discussed in Part 1 the rapidly diminishing productivity of Chinese investment, driven by a dysfunctional system of resource allocation. This, along with the dependence on ever growing merchandise exports, is making the current growth model unsustainable. A straw in the wind: the World Bank estimated in early January that China's economic growth rate this year would be 11 percent; within two months, it revised its estimate to 9.6 percent. It is the first time an authoritative international economic institution has revised its estimate of China's growth rate to sub 10% in recent memory. The country's CPI began to rise at an accelerated pace in the second half of 2007 climbing to 8.3% in February. Crucially, food prices have soared in a country where food is still a third of household expenditure eg pork up 58 percent, meat, poultry and related products 41 percent, vegetables 14 percent.
China's economy has been growing at an annual 10.6 percent in the past five years, and there is debate about how much of that growth has been generated by net exports. The latest bullish analysis as represented in the graph above suggests that China is less exposed than commonly thought to a US slowdown on a net value added basis, because so much of Chinese export manufacturing now consists of 'screwdriver' assembly plants using largely imported components. I'm dubious about this given the poor quality of Chinese statistics but let's take this most optimistic view of China's exposure, so net exports contribute 10% or so to recent GDP growth, implying a direct reduction of 1-2% in a US recession scenario. Interestingly, the trade surplus slumped to $8.6bn in February from nearly $20bn in January, impacted by soaring commodity import costs. This is a trend worth watching.
Investment is still an amazing 40% plus of the economy, and as discussed previously this is the real problem as so much is duplicated and wasteful. Every $5 of investment generates just $1 of growth. Consumption is about a third of the economy, or half that prevailing in Western economies, and is assumed to be set to rise sharply, but with minimal social provision, a developed country demographic structure and soaring food inflation, this is misplaced optimism. Continued high savings rates are perfectly rational for Chinese households in the context of the uncertainties they face, particularly now the stock market bubble has burst. Note in the chart above how consumption today is no higher proportionately than it was in 1999. Why would it dramatically rise now?
Growth will also be negatively impacted by the 40% plus decline in the Chinese stock market (the Shanghai Composite peaked at just over 6000 in October) will also now be impacting consumption growth; Chinese households had about Rmb27.5 trillion of financial assets (about 112% of GDP) last Autumn at the stock market's peak of which about 25% (Rmb7 trillion) was in the form of stock holdings. Headline stock market capitalization stood at about Rmb25 trillion at the peak, but only about one-third of this was actually ‘marketable’ – i.e. available for investment by retail investors. The rest remains held by a small number of large shareholders (mostly the State). Thus far, assuming the value of other assets unchanged (although property is still buoyant), total household financial wealth has declined by almost 10% or Rmb2.5 trillion, equivalent to about 8.5% of GDP. This is a heavy blow to the millions of naive investors who flooded into the market in the first half of 2007, and combined with the squeeze from food inflation will depress domestic discretionary consumption and potentially sow the seeds of social unrest.
The plunge in the stock market will also have caused major damage to banks’ balance sheets and listed company profitability, given the scale of Japanese style cross-holdings driving exceptional profit gains. It is prudent to assume that banks have had large exposure – direct or indirect – to the stock market. In order to safeguard the quality of their assets and meet relevant prudential requirements, the banks may respond by raising their lending standards, squeezing overall bank lending and negatively affecting real economic activity. Since the China Banking Regulatory Commission prohibits Chinese banks from lending to investors to purchase stocks, no published official data are available on banks’ direct exposure to the stock market but it is almost inevitable that in some form bank money has found its way into the stock market, for instance via corporate lending where treasury operations at Chinese companies have commonly included blatant stock speculation. Anecdotal evidence suggests that, since mid-2006, when the A-share market started to take off, some households have increased their overall leverage ratio through conventional household loans (e.g. mortgage loans) to invest in the stock market.
In 2008 Chinese authorities will face the starkest trade-off between growth and inflation since the late 1980's, and it seems from recent official statements by Prime Minister Wen and others that out-of-control inflation is perceived as a bigger risk to social stability than lower GDP growth, particularly when combined with the sustained market slump. To dis-inflate the economy they can either raise rates (and apply administrative measures such as tighter lending policies/licence restrictions (policies which have had limited success so far given the scale of corruption) or alternatively more aggressively revalue the currency (currently rising about 4% a year), possibly even in a spectacular 'one-off' move of 10-15% which would have the bonus of alleviating political pressure in the US and Europe although at the cost of bankrupting huge swathes of already unprofitable domestic industry. It would also see huge losses on China's foreign investment holdings, and seems unlikely unless we see inflation hitting 10% plus later this year. Further rises in the bank reserve ratio, now at 14.5% after ten hikes last year, are more likely. M1 narrow money supply growth is still running above 20% and highly inflationary, a reflection of the difficulty in recycling excess liquidity from the trade surplus in a closed monetary economy without currency convertibility and negative real interest rates.
Either policy response is high-risk given the structural impasse the economy has reached on its current export and investment led model, and could turn a now inevitable cyclical slowdown to say 7-8 % growth into something far more dramatic and destabilising. Doing nothing and allowing double digit inflation to destabilise the political consensus is even riskier. When the Chinese say 'May you live in interesting times...' they mean it as a curse.
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