Earlier this week I was talking to my grad student Shang Ning about the awful markets around the world, and he suggested that maybe it was a good thing that Chinese stock markets were closed this week for National Day since this would act as an extended circuit breaker that might protect them from collapsing in sympathy with the rest of the world. We agreed, however, that whether or not next week would open with a big downward break would depend crucially on whether the rescue bill was passed by the US Congress and, if so, would cause markets around the world to soar.
Well, the bill was passed Friday, but markets continued to fall. Hong Kong’s Hang Seng Index lost 2.9% yesterday capping the fifth consecutive losing week with a loss of 5.4%. Unless the government announces some extraordinary measure over the weekend to boost stock prices I expect that next week is going to start out badly.
It would be only reasonable if it did. On Friday the US government reported that the US economy had lost 159,000 jobs in September, making it the ninth consecutive month that the US job market has contracted, and suggesting that it is going to be harder and harder for the US to avoid a slowdown in consumption. China has bet its economic future very heavily on sustained US consumption driving its economy forward, and faltering US demand – coupled, as it is almost sure to be, with faltering European demand – cannot help but slow China’s export growth.
This is, in my opinion, one of the two most likely channels by which global financial difficulties will become Chinese financial difficulties (the other is if perceptions of rising risk cause liquidity outflows from the banks). If exports slow, and domestic consumption is unable to accelerate sufficiently to replace it – and in fact I expect domestic private demand to slow – there is a good chance that domestic investment will also slow, after a lag that sees rising inventories. In that case three of the four pistons in China’s economic engine will falter.
This is dangerous for the financial system, of course, because any economic slowdown will finally put the Chinese financial system to its first real test since the massive expansion of the past four years, and I am not sure it will pass the test very easily. The current issue of Caijing actually has an interesting article on the subject, indicating that quite a lot of people are becoming increasingly worried about that particular risk. The article says:
It’s the most pain China’s commercial banks have felt since a reform of the shareholding system began under fairly good economic conditions. Now, as economic growth slows, factors such as changing liquidity positions, fluctuating equity prices, loan quality downgrades and policy adjustments may bring adverse effects. All this change has given commercial banks a full-scale test, especially in terms of incentive mechanisms, risk control maintenance and income growth styles. This testing process has five key aspects.
First, the NPL ratio is likely to bounce. The overall ratio in the banking industry may rise if most economic adjustments occur in the nation’s eastern coastal area. Data show NPL ratios for loans to small- and medium-sized enterprises have been rising in this region.
Second, the loan growth rate is falling. Commercial bank income from intermediary business has expanded steadily in recent years, but interest income is still the main income source. With a guaranteed loan-deposit interest rate differential, banks rely heavily on loan growth to generate profit. In the second half of 2008, the People’s Bank of China loosened its credit control by five percent. But July and August statistics did not show a rebound for loan growth. Even if the quota were further relaxed, loan growth this year would hardly match 2007’s.
Third, the loan-deposit interest rate gap may further shrink. On inflation concerns, a loosening of monetary policy will likely be handled in an asymmetric style. That is, loan rates will be cut while deposit rates remain unchanged, which is what the central bank did September 15.
Fourth, loans to the real estate sector and local governments will become more risky. Personal mortgages and property developer loans currently account for more than 20 percent of the lending at major banks. If house prices continue falling, however, NPLs in real estate may soar.
Fifth, administrative measures may bring side-effects. Loosening credit controls and the “double cut” decision to trim loan interest rates while lowering the required reserve ratio for banks are steps aimed at encouraging banks to lend. If the government sets loan targets for commercial banks through administrative measures, banks will lower their standards for qualified borrowers, which could lead to even more NPLs.
I have often argued that the financial system (including off-balance sheet transactions, unrecorded municipal and provincial activity, and the informal banking system) has been growing much more quickly and in a much more chaotic way than most analysts realize, and its vulnerability to a slowdown may be significantly greater than we think. If three of the four pistons in China’s economic engine are faltering, fiscal expansion is left as the main driver of the economy, and although I have little doubt that we will see fiscal expansion, its impact is likely to be slow, the adjustment forced into the banks difficult, and it will only lead to greater imbalances in the economy.
On that note Standard Chartered’s Stephen Green, who regularly puts out some of the best and most interesting economic analyses of China, has a new piece out today called “The world just changed, China hasn’t.” In it he says:
We hate to be killjoys, but we have some bad news for anyone claiming that China’s transition to a new growth model – one with more consumption, less investment, more domestic demand, and less exports – is already underway. We would love to believe it too, but it just ain’t so. Worse, the US financial crisis and the coming global economic slowdown will show China’s present model to be even less sustainable than was thought before. But they also present Beijing with an opportunity to unleash new growth drivers. The world just changed, and now is the time for Beijing to change too.
Green argues that while the debate over China’s growth model suggests that policy-makers are in principle acknowledging the need for China to shift from an export-led growth model to a domestic-consumption-led one, in practice this hasn’t happened. What is worse, one consequence of the global slowdown is actually likely to be a concerted effort to reinforce the “old” model in a desperate attempt to protect the economy from the impact of a slowdown in exports.
The problem also has to do with the gulf between aspirations and actual policy choices, which are often driven by short-term concerns. To reduce the economy’s dependence upon exports, one needs to reduce exports. It sounds simple, but even with 10% real export growth at present, Beijing has apparently decided to throw incentives back to exporters by topping CNY appreciation and increasing tax rebates to textile producers, and even seems poised to increase them for electronics and machine tool exporters too. To reduce the amount of heavy industry, one needs to raise manufacturers’ cost of electricity, but there is still no effective system to prevent local governments from protecting their local steel, aluminium, and copper plants from higher power tariffs.
To slow down the investment boom, one needs real positive interest rates (banks currently have negative ones), rigorous dividend payments by state firms into the budget (a reform which is still a small-scale experiment), and local officials whose performance is not measured on investment and tax revenues alone. To discourage people from investing in the domestic market, one needs a fairly priced exchange rate, but since 2005 it has been fixed and under-valued, as it still is despite the 7% gain in the effective exchange rate over the past year.
To really encourage innovation, one does not need quotas for patent applications, but a reliable civil law system which allows companies to protect their own valuable IPR. To allow people to get decent healthcare, one must allow private hospitals to participate in the state’s insurance system and regulate them. To increase the scale of the service sector, one needs to tackle the state-protected oligopolies that currently dominate – think telecommunications, parts of financial services, health and education, as well as the entertainment business. As PBoC governor Zhou Xiaochuan liked to say a couple of years ago, and everyone else asked themselves more recently with the success of Kung Fu Panda, where on earth is China’s creative film industry?
Green is fairly pessimistic, it seems to me, about the likelihood that China will take the necessary policy steps to shift its economy towards a more sustainable model. That shouldn’t come as a surprise. It is always difficult to make major necessary adjustments when external conditions are bad, and yet it seems unnecessary to do so when external conditions are good. I have mentioned before in this blog the difficult experience of the US in the early 19th Century when the US economy shifted from being driven primarily by exports to the UK, Europe and the Caribbean to being driven primarily by the development of its own internal market.
This shift did not occur in a gradual way and according to the best thought-out plans of businessmen and government leaders. The change was forced onto the US and happened mainly because beginning in 1797 the Napoleonic wars and an especially vicious spread of smallpox along the coastal cities decimated the US export business, ushering in a very long depression. It took the ensuing financial crisis and depression to reorient the economy towards its domestic market, and not without a great deal of difficulty
The “silver lining” in the current global slowdown for China may very well be that China is also forced kicking and screaming into doing what it should have done much earlier, although I suspect Green is right that in the early stages it will actually try to strengthen the export and investment orientation of its economy as a way of slowing job loss. This would be a mistake in the long run, but may be a natural reaction for a government that greatly fears the short-term political consequences of rising unemployment.
By the way and on a completely different and unrelated topic, for some reason some outfit called Forexecutor keeps trying to sneak their advertisements onto the Comments section of my blog. I checked them out to try to get them to stop. After running thought their site I have to say that in my opinion they are a scam. If you see their ads anywhere on this blog please know that I do not endorse them at all. On the contrary, you should beware of using their “products.”