Nomura has published a monster report, attaching 1-in-3 chance of a China economic hard landing by the end of 2014, defined as an “abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters”. They believe that the growth potential for China is 8% in real term, thus 5% growth would be 3 percentage point below growth potential in their hard landing scenario.
There are six reasons why Nomura now thinks that there could be a one-in-three chance to hard-landing, which most of us have actually been pretty familiar with, namely:
1) Overinvestment and excessive credit, which we all know about
2) Rudimentary monetary architecture, which is losing its effectiveness in conducting monetary policy
3) The privileged state-owned enterprises (SOEs), which are actually performing worse than the private sector
4) Unintended consequences of financial liberalization
5) The Lewis turning point, which says that there isn’t any labour surplus from rural area left to fuel growth in urban area
6) The setting in of growing pain, referring to the demographic challenges.
They do expect that policymakers will do what they have to to stimulate the economy in the event of hard landing, but they believe that the effectiveness of the new round of policy response could be less than the previous one in 2008-2009, and also less massive and slower. On the monetary side, they expect “aggressive cuts in the bank RRR and CNY/USD appreciation to once again be halted (if there were to be large net capital outflows rather than allowing CNY/USD depreciation, we would expect the PBC to drawdown its USD3.2trn of FX reserves to keep CNY/USD stable)”, while they see less chance of cutting rates aggressively:
One reason is because of greater inflation pressures today, with CPI inflation currently much higher (6.1% y-o-y in September 2011) than the 2.5% in 4Q 2008. Moreover, core CPI inflation, which excludes food and energy items, has also risen steadily over the past two years to 2.4% y-o-y in Q3 2011, the highest since the government began publishing the data in 2005, suggesting that a structural inflation problem is emerging… Another reason is what we believe is growing recognition among China‟s policymakers that interest rates were set fundamentally too low in the past, and that this cheap cost of capital contributed to over-investment. As such, we would expect to see greater official resistance to rate cuts than in the past.
On the fiscal side, they expect a stimulus package which will probably gear towards investment as that is more effective in generating GDP growth. But with the growthin local government debts and government’s contingent future liabilities, the fiscal stimulus, they believe, will be less effective. And certainly, as we all now know that there is an over-investment in China, so whether it makes good sense to invest even more to stimulate growth is questionable:
… government-influenced investment comprises about one-third of total investment, to avoid a fall in total investment public investment must grow by twice as much as any decline in private investment growth. The government “doubling up” with another public-led investment boom could heighten concerns over misallocated, wasteful investment, increasing fears of an even bigger hard landing further out – the private response could be to pull back investment even more.
When it comes to the timing of a hard landing, they believe that the policymakers have incentive to delay it to until March 2013 after the leadership transition, although there are risks that it can’t be delayed that long because:
1) the ratios of investment to GDP and credit to GDP are so high
2) support from exports is likely to be less than before
3) the economy has become so large and complex that many of the structural problems are becoming more interrelated
4) policy responses are likely less effective than before
A pretty gloomy picture, but the good news is that the chance of hard landing is only one-in-three!