China warnings

In the past few days there have been three new interesting media outputs that warn of growing risks of a Chinese hard landing. The first is by, of all institutions, the Australian Treasury. In a new Working Paper full text below), Treasury offers a respectable assessment of Chinese macroeconomic navigation through the GFC, and the growing imbalances that have resulted.

The paper includes a measured but nonetheless thumping critique of the notion of “decoupling” that took hold of the weak minded in 2008:

Arguments about decoupling were based on the growing trade integration in Asia, centred on China, and the large potential within the Chinese economy for domestically‐driven demand. According to this argument, China and its regional trading partners increasingly represented an independent engine of growth for the world economy, less dependent on demand from the USA and the major economies of Europe. Moreover, notwithstanding the People’s Bank of China’s (PBoC) substantial holdings of US treasuries, China’s financial sector had limited exposure to that of the USA. The counter argument was that China’s growth continued to be highly dependent on final demand for exports in the advanced economies, suggesting a severe downturn in the USA and other advanced economies would have to impact the Chinese economy.

While China’s relatively closed capital markets protected it from the financial fallout from the crisis, trade proved to be a key channel for transmitting the financial crisis to the Chinese economy. The growth rate of exports and imports declined in November 2008 and continued to be negative until November 2009 (see Chart 2). The USA, the EU, and Japan account for about half of China’s exports. China’s exports to these regions fell substantially as demand in these economies contracted.

It continues with some detail of the stimulus package before turning to risks that are now gathering, firstly of excess liquidity, the housing bubble and general inflation:

While pumping liquidity into the economy supported China through the crisis, there are increasing signs of excess liquidity. Property prices have reached levels well beyond the reach of average income earners in some of China’s major cities, such as Beijing and Shanghai, leading to concerns of a property price bubble. Speculative investment has appeared in areas asobscure as tea and garlic as investors seek returns through capital gains across the economy.

Next, the threat of a too low currency:

The cost of a gradual nominal exchange rate adjustment is that China will continue to accumulate foreign reserves, making it even more difficult to control liquidity, fuelling inflation pressures. It also makes China susceptible to speculative capital flows attracted by expected appreciation of the RMB. To help combat inflation, the Central Government may need to reassess the speed at which it allows the nominal exchange rate to adjust.

And the threat of rising defaults:

Excessive reliance on debt leads to concerns about the possibility of non‐performing loans (NPLs). The CBRC has indicated that RMB 1.76 trillion out of RMB 7.66 trillion of the local government financing vehicles loans in June 2010 were at risk of default (www.chinanews.com, 2010).

NPLs are likely to increase, with most outstanding debts ultimately falling upon the Central Government. This is because the NPLs will largely belong to government banks offering loans to LGFVs. With the Chinese Government working under a single hierarchy, any debts in the government‐owned banks and local governments will ultimately be passed to the Central Government.

And finally, the difficulty in raising consumption share:

There are three broad drivers of growth in the Chinese economy: consumption, investment, and net exports. The Central Government is committed to raising the consumption share of the economy. However, consumption is a relatively stable contributor to economic growth, and it will take many years for policy to raise the consumption share substantially. It will require reforms to raise household incomes, including social security and health reforms, and policies aimed at raising the wage and capital incomes of households. It will also require a reduction in the savings rate at a time when the aging of the population will raise the dependency ratio and increase incentives for households to save.

Ultimately, the study is optimistic but it’s not bad for a government department whose bosses have hung the nation’s hat on this one single peg.

Of course, none of this is remotely new. And some perspective on how conservative this one release is is offered by a recent CCTV discussion in which a spectacularly paternalistic anchor led a lively debate with the excellent Patrick Chovanec and the head of the Financial Times Chinese wesbite. I mean, if the Chinese government’s media mouthpiece can discuss a hard landing and the need to sustain growth for political control, then the Australian Treasury’s single research paper looks a bit paltry:

Finally, last week, BusinessWeek published a story on the likely fallout from a Chinese hard landing. It included a nice assessment of the recent ratings agency concerns about the NPL problem:

Moody’s Investors Service (MCO), the credit ratings agency, says China has underestimated by half a trillion dollars the exposure of state-owned banks’ loan portfolios to local governments. Despite five interest rate hikes since last October, inflation is now running at 6.4 percent, the fastest since 2008. Second-quarter gross domestic product grew at 9.5 percent, its slowest pace in almost two years.

… If a crash or slowdown occurs—which most analysts define as growth below 7 percent—it will be brought about either by inflation or a reversal in real estate. The Chinese Communist Party is loath to allow high inflation, says Chovanec. In the 1940s, hyperinflation turned ordinary Chinese into Communists. Inflation of around 20 percent was one reason protesters took to Tiananmen Square in 1989. Should inflation exceed 10 percent for long, “they pull a Volcker,” says Chovanec. Paul Volcker, the former U.S. Federal Reserve chairman, defeated high inflation in the U.S. with rates so steep they plunged the country into severe recession.

In real estate, the party has gone on too long. As Nicholas Lardy of the Peterson Institute for International Economics points out, inflation in China is outstripping the one-year savings deposit rate of 3.5 percent. That prompted many Chinese to pour parts of their savings into apartments. Already, 9 percent of economic output comes from residential housing investment. It was 3.4 percent in 2003. With the building boom well under way, supply is finally outstripping demand. The unsold inventory of apartments has gone from zero last summer to about three months’ worth now, according to Standard Chartered Bank.

If apartment prices fall steeply, ordinary Chinese could lose their savings, and local governments will be unable to pay off the loans they took out to invest in residential and commercial projects. Local governments also rely on land sales for over 60 percent of their revenues in some cases, says City University of Hong Kong political scientist Joseph Cheng. In a property bust, few will be buying land. A real estate reversal would drag down local makers of steel, cement, and household furnishings.

Victor Shih, a political scientist at Northwestern University who studies the local debt problem, says the banks are reacting to poor returns on their investments in everything from real estate to subway lines. “Banks’ focus now is to use existing credit to ensure loans don’t go into default,” says Shih. “That makes credit to new projects more difficult—one reason we are seeing a slowdown.”

Moody’s estimates that 8 percent to 12 percent of China’s total loan portfolio could be nonperforming: The official figure is 1.2 percent. Earlier this year, Fitch Ratings warned that nonperforming loans could reach as high as 30 percent. Especially vulnerable are small businesses. They account for 80 percent of employment, according to China’s Ministry of Industry and Information Technology, yet struggle to get credit. “They don’t have adequate liquidity at all,” says Dong Tao, Hong Kong-based chief regional economist at Credit Suisse.

The piece goes on to offer the following assessment of the effects:

Fitch, which in June published an essay on what slow growth in China would do to the world, says China’s key trading partners in the Asia-Pacific region would be most affected. If China grew only 4 percent in 2012, says the Fitch report, a sharp drop in commodity exports to China would hurt the Australian dollar, which in turn would force interest rates up, which would finally hurt the overheated housing market.

That last bit is a pile (in fact, the whole piece could be better). If China grew at 4%, commodities would be routed, Australian inflation would collapse along with the dollar. There’d be no reason to raise rates. That’s not to say that housing would benefit. The Australian banks would come under major hedge fund assault. The outcome would depend entirely on what kind of support was given to the bank/housing complex. I suspect it would be everything and the kitchen sink.