Yesterday’s 27 bp rate cut and 50 bp reduction in minimum reserve requirements by the PBoC had the expected impact on the stock market: None. The SSE Composite declined 0.8% today to close at 2075. Another day like yesterday and we’ll be testing 2000 once again.
Of course it is unrealistic to expect that the PBoC’s actions should have had an immediate impact on either the economy or the stock market. The consequences of monetary policies are only supposed to reveal themselves over a several month period, during which time the hope here was that companies will have been given greater access to loans and consequently will more aggressively borrow and invest. The one-day market reaction was inevitably going to be colored by a lot more than just the immediate consequences on economic fundamentals of the PBoC actions, and I don’t doubt that bad markets overseas didn’t help.
But even over the medium term will the consequences be positive? I already said yesterday that I was skeptical:
It seems to me that at least part of the reason for slowing loan growth has been corporate reluctance to borrow. If that is the case, I doubt whether lower rates (let alone lower minimum reserves) will have much impact. After all it hasn’t been high interest rates that have constrained borrowing in the past. We will need to watch loan growth figures closely in the next few months.
Let me explain a little further why I worry that easier lending terms won’t cause a surge in borrowing and investing (as they didn’t either in Japan during the 1990s, by the way). For lending and investment to surge, it isn’t enough that banks make it easier to borrow. Corporations must also want to borrow. And when I say “corporations”, I should make it clear that I mean corporations who plan to borrow to invest in new facilities, plant, equipment, distribution systems, etc. I don’t mean corporations who are holding illiquid assets and who are desperate for liquidity – of which I understand that there are quite a few, especially in the property sector.
But why should these “good” corporations want to borrow and invest? Obviously enough because they believe that there are profit opportunities that justify their taking the risk of increasing debt servicing costs. The problem is that if foreign demand for Chinese goods declines with the decline in the world economy, who is going to buy the newly-produced Chinese goods? With the huge amount of fixed asset investment we have seen in recent years, industrial production in China is very high and growing. As long as the world was also growing rapidly, China could export its excess production. If the world economy slows down, however, China might not be able to rely on foreign consumers to take up its excess.
So what about Chinese consumers? After all nearly everyone agrees that it is in China’s best interest to rebalance the economy, by engineering a transition from an export-led to a domestic economy. As Chinese households get richer, they are likely to ramp up their spending. Can they take up the buying slack?
Maybe, but I am doubtful that we are going to see the necessary surge in domestic private consumption, and although we won’t get September and October numbers for a while (July and August were probably tainted by Olympics-related buying), I think the poor auto sales in September may be a harbinger. Certainly it cannot be easy for Chinese households, confronted every day by terrifying stories of declining local stock and real estate markets and of foreign financial crises, to decide that now is the best time to draw down the savings account and splurge on new consumer goods.
So if neither export growth nor growth in private consumption is going to absorb the higher industrial production, who is going to buy? The stock answer to the question, and one much beloved of research analysts, has been: The government. The Chinese government, according to this argument, is in a very strong fiscal position – it runs a more-or-less balanced account and has relatively little outstanding debt – and so has plenty of room to borrow and spend without running into credibility constraints.
In fairness there are some analysts who disagree that fiscal spending can easily take up the slack. I think Stephen Green of Standard Chartered pointed out several times that turning on fiscal spending is likely to be a lot harder and slower than simply announcing a fiscal expansion package.
I agree with Green, but in addition, as I have argued many times, I don’t think the government is in nearly as strong a fiscal position as most other analysts think. Total direct and indirect debt (and I am not including long term obligations like unfunded pension liabilities) is probably much higher than the official numbers which, depending on how you count, range from 15% to 30% of GDP (by contrast I think US government debt is around 30-35% of GDP and European government debt averages around 60-65% of GDP, albeit with big variations around the average).
However, for reasons I have discussed many times before on this blog, I think actual Chinese government debt exceeds the visible debt. My guess is that without counting the possibility of rising NPLs in case of an economic slowdown (which ultimately can become contingent liabilities of the government), total government debt in China is probably 50% of GDP or higher. That means that China has a lot less room for running large fiscal deficits than we might suppose, and during the time it most needs to run a deficit – when the economy is slowing sharply – we may anyway see a surge in contingent debt as bank NPLs surge.
And it is not just that there may more debt out there than we expect. There is also a problem with the current fiscal balance – it is not as stable as might at first appear. On that topic last week’s Economic Observer has an article by Xi Si titled “Shrinking Coffers Challenge Chinese Finance Ministry.” According to the article:
Slower tax revenue growth and higher pressure for more spending have posed a challenge to Chinese budget planners in the ongoing drafting of the 2009 budget. Tax revenue growth stumbled in July and August and was likely to continue falling, but there was a growing need for more spending to stabilize prices in China and rebuild disaster-hit areas.
Official data showed that in July, China’s state revenue grew by 16.5% compared with the same period last year, 14 percentage points lower than in June. The growth rate continued to fall in August, when state income dropped below 400 billion yuan. “There will be no problem meeting the budget, but there may not be as much excess income as last year,” an official from the Ministry of Finance (MOF) told the EO.
Compared to the same time last year, budgeted revenue for the beginning of 2008 was up by 14%. By the end of August, the actual revenue saw a year-on-year growth of 28.4%. Judging from this, the above-mentioned official believed there would still be excessive revenue even if the growth rate continued to stumble in the next four months.
The current economic situation at home and abroad, as well as companies’ profit-earning ability, explained why state income had fallen for two consecutive months. Many officials and scholars thus worried that the high revenue era of China might come to an end.
My basic problem with the fiscal numbers has always been that, with both revenues and expenses surging by 30% a year or more, it wouldn’t take much of a shift in the relationship between the two to swing the budget into a large surplus or deficit. With global and domestic conditions in a seeming downturn, it is easy to posit a plausible scenario in which expenses begin radically to outpace revenues. I don’t know if this is happening or not, but even though the conservative in me is happy to see fiscal balance, the bond guy in me gets very nervous when the balance is achieved on the back of such rapidly surging revenues. Very rapidly changing numbers create very volatile potential outcomes.
Originally published at China Financial Markets on Oct 9, 2008 and reproduced here with the author’s permission.