China’s present growth story is built on malinvestment

Late last year, I predicted that China, as a major exporter to the West, would feel a huge impact from the meltdown in the global economy, taking it’s growth rate down to 2% (See Top ten predictions for the 2009 global economy). Forgetting about the fact that data are highly suspect in China, I see that prediction as very unlikely to come true due to huge fiscal stimulus in China.The Chinese government is very much wedded to its 8% growth target and will do whatever it takes to come close to that target – including flooding the domestic banks with a wall of money to lend.

However, preventing a downturn with easy money is a dangerous way to reflate the economy. The likely malinvestment will be large, something about which Andy Xie has recently warned.  Moreover, despite the implosion in house prices and shares in the Chinese market during the acute phases through to November 2008, a bubble has re-asserted itself there.  In a recent post, “Does Ben Bernanke blow bubbles too?,”I referred to research by James Montier, now at GMO, which indicated that large increases in liquidity can and will reinflate bubbles even in the face of investors who feel chastened by a previous downturn.  This seems very much to the point in China, where equity prices have risen some 60-odd percent since the trough in November.

Of course, all of this can continue for quite some time. And the Chinese are pulling out all the stops as the recent note by Marc Chandler, Chief Currency Strategist at Brown Brothers Harriman, attests.

There are several developments to note in China.

First, with deflationary forces still gripping the economy (year-over-year CPI has been negative by more than 1% since Feb), weakness in exports, Chinese officials are unlikely to allow the yuan to appreciate very much during the second half of the calendar year.  The pricing of the non-deliverable forward implies expectation for less than 1% appreciation against the dollar over the next 12-months, the smallest expected gain in a couple of months.  Next month will be the one year anniversary of the Chinese decision that in essence appears largely tantamount to re-pegging the yuan to the greenback.  It has been confined to a little more than a 1% range since.  Recall that under the fixed exchange rate regime of Bretton Woods, currencies were allowed to move in 1% bands.  Last July the pricing of the 1-yr yuan NDF implied a 6% appreciation.

Second, the 63% rise in the Shanghai Composite Index has been among the world’s top equity markets in H1 09.  The story is often told is that the large fiscal stimulus efforts has ensured that the economy will gain new traction.  Yet the stimulative measures are impacting perhaps in a way different from the conventional narrative.  Part of the stimulative measures, included removing curbs on bank loans.  Bank loans in China have surged by CNY5.8 trillion.  The rating agency Fitch warned earlier today of the dangers of the massive rise in lending.  Part of the lending–some reports suggest as much as 20% or some $170 bln–has found its way into the equity market. Third, China and Hong Kong are expected to sign an accord shortly that will allow the settlement of bilateral trade to be conducted in yuan.  Back in April the PBOC announced it would let Shanghai and 4 other cities in the Gungdong province to begin settled traded in yuan.  China subsequently announced CNY650 bln (~$95 bln) in swap lines with a handful of countries, including Argentina, Belarus, Hong Kong, Malaysia and South Korea.  Since Hong Kong is a special administration region for China that a greater share of its bilateral trade is settle in yuan is hardly earth-shattering, but there may be some interesting implications.  Often Hong Kong is used by China and its trading partners to conceal trade as goods often get re-exported from HK.  China and its trading partners often disagree on how such trade should be counted.  More importantly, it takes more than diktat to determine an invoicing currency.  As the SAFE (the State Administration of Foreign Exchange) made clear today, China recognizes that the US dollar will continue to dominate global trade.  China’s desire for the yuan to be more of an international currency and invoicing currency is not greater than its desire to maintain firm control of the currency.   This is to say, China’s ambitions are continue to hemmed in by the realities of a currency that is still not convertible.

The Chinese government is committed to 8% growth for 2009. Hence the massive stimulus and bank lending. But, as Chandler notes, it is doing its best to transition away from an export-led dynamic over the longer-term. Hence, the numerous reports of China doing trade in Yuan and buying up commodities with its U.S. dollar stash.

So, where does that leave us over the medium-term?  In my view, it leaves us in a situation in which the Chinese economic policy is supportive of commodity prices and economic growth worldwide.  To the degree that medium-term economic recovery in the West is dependent on Chinese stimulus, we should feel confident that things are looking good.

The longer-term is quite a bit more murky and here I want to transit to a rather more sinister outlook as established by Ambrose Evans-Pritchardt.gif in the Telegraph at the weekend.  Evans-Pritchard sees malinvestment as a worry and quotes from a Fitch rating agency report which says an enormous spike in non-performing loans at Chinese banks is likely.

China’s banks are veering out of control. The half-reformed economy of the People’s Republic cannot absorb the $1,000bn (£600bn) blitz of new lending issued since December.

Money is leaking instead into Shanghai’s stock casino, or being used to keep bankrupt builders on life support. It is doing very little to help lift the world economy out of slump.

Fitch Ratings has been warning for some time that China’s lenders are wading into dangerous waters, but its latest report is even grimmer than bears had suspected.

“With much of the world immersed in crisis, China appears to be one of the few countries where the financial system continues to function largely without a glitch, but Fitch is growing increasingly wary,” it said.

“Future losses on stimulus could turn out to be larger than expected, and it is unclear what share the central and/or local governments ultimately will be willing or able to bear.”

Evans-Pritchard also quotes from Andy Xie who sees the massive over-stocking of commodity inventories in China as an accident waiting to happen, one which will precipitate a double-dip downturn.  While this makes good copy for bearish doom and gloom forecasts, it is a scenario about which we should be worried.

In reality, this crash scenario is pure but not idle speculation.  What seems clear is that the medium-term is looking more positive due to the huge surge in liquidity in China’s domestic economy.  This seems to be a gambit by the Chinese to spur enough domestic demand over the medium-term such that when the next global downturn hits, the Chinese will be insulated from U.S. dollar and America-related events. But, the Chinese are blowing serious bubbles, expanding excessive amounts of credit, and creating serious malinvestments.  In short, the Chinese are playing a dangerous game. If they lose, everyone in the global economy will lose with them.

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Originally published at Credit Writedowns and reproduced here with the author’s permission.

3 Responses to "China’s present growth story is built on malinvestment"

  1. Mandarin   June 30, 2009 at 5:10 pm

    Very sound analysis. There is an urgency to easing bank credit in bad times-and good!-that stems from the Communist party’s insecurity about its rule and a global inferiority complex. Five years ago there were major problems with their banks; after papering these over the country went into a boom which by 2007 resulted in a vigorous inflation. You remember the cooking-oil riots of 2008? In knee-jerk fashion the government decreed price controls on some foods, tightened credit and burst the real estate bubble in literally two or three months.Yet in a deflationary environment the regime has room to make mistakes. And surely on balance it feels that too much stimulus and too much easing is preferable to too little. It will also pay the price in supporting the dollar – the export sector has an enormous fixed investment in ships, ports, railroad and productive plant that cannot be abandoned in favor of a hypothetical ‘domestic market’ that really doesn’t exist outside of the major cities. So the cost in writedowns and writeoffs will be high, but they’ll be borne as long as necessary.Though we can and should greatly discount any growth figures coming out of China for this year and next, it’s a given that as long as the present leadership remains in power we’re going to continue to see very easy money and a cheap Yuan, with the limit being double digit food price increases and riots in the shops.In my personal opinion, having personally witnessed the market frenzy of 2006-7 and the subsequent crash, investing in Chinese equities is always dangerous. Remember that by law, the government is allowed to buy stock and it uses this and other means to pump up the market when it needs the investing public to feel flush. Inevitably, this leads to excesses and in knee jerk fashion there’s a tightening and a plunge. The ride up is so heady that all perspective is lost, and there’s no warning when the big Stop is hit.

  2. God of Finance   July 2, 2009 at 10:15 pm

    God of FinanceEarthlings, listen up. I am your God, stupid, not him, your God of Finance. I, as you know …hadn’d been with you as long; only 700 years since Emperor Kublai Khan started paying paper instead of silver money. Of course scoundrels immediately started to cheat with faked look-alikes but the punishment was sufficient to deter these devious beings to spoil my coming-out party, heard of Death-by-a-Thousand-Cuts.I was once almost dead, chained by these little rules that they called regulations and destroyed over half of the planet by the halfling who called himself Marx. Devilish wasn’t he; the you-know-who compensated for his you-know-what by that gigantic beard. I was then freed by that odd couple, Ron and Margaret; each of them had their own the other, I thought; but it was she, I believe, said “can do business”.Sorry to say it, but it is true that I am a fickle god and there had been many upheavals, not only in the land of my origin in the Yuan empire but also in much of the new European ones like that has-been Holy Roman province of the Tulip fields, the kill-all-the-Reds British South Seas, the new-paradigm swamps of the French Mississippi, the Versailles victimized Weimar, and of course the blindly blissful 1929 New York, and the pacified, but-yet-lost-decade Tokyo, not to mention the baht kicked Bangkok.Well, admit it; you are living in one!Contrary to common belief, I do not usually strike a touch of anger unannounced. There were some unchained souls like M. Roubini, Shiller, and even this halfling Krugman; all gentlemen of immense intelligence, and almost my ego, surely would have spoiled my next party, had it not been for your, say, l’armour d’argent.Ah, the causes. It was actually quit simple despite what your weatherman tells you; I naturally live in your economy, which usually has a productive side, and a financial side. Like, some work and put food on the table, and others count it. So long as the two are balanced, the financial side supports the productive side and the productive side puts more demand on the financial side, which creates the wealth, you know, things like that shining suit on your chest, the sleek iPod in your pocket, and even that seedy establishment, you call it the mall, that you frequent.But unlike me, who is divine, you are only human. Every so often, especially with Ron and Margaret in business, you mistake the shenanigans as “Financial Innovation” – something like “efficient finance” actually produces real wealth by counting it many times. It happens like this. Production gets you feeling rich; you then juice it up by borrowing. Being low in intelligence and high on greed, you are carried away by borrowing so much, until that is, there is nowhere to borrow, only debts to repay, as your losses are also piling up, if you can repay at all. .But, but, but… This time it’s different! You say, you have a New Economy. Of course you do, thanks to me; how convenient I had given these enormous gifts to you of the talented banksters. They came in all falvours, much like your candyman’s chocolate, for your pleasure of choosing: your investment banksers, your shadow banksters, your mortgage banksters, your analyst banksters, and your tanned and untanned banksters. In good time, your friendly neighbourhood bankers, if you still remember them, and your scholarly central bankers, you see, are no longer your ally; much now mine and more of his, you know, the one who is denoted 666.I always had this small column of i-banksters, but this splendid army, I have to thank your Green spinomist, and your weatherman in many a fine season. They gave me the s-banksters, and with their aid, I won over these your-smiling-uncle banksters with huge bonuses and you-know-you-don’t-understand giant pay-packages. To make it certain, I make sure they are paid each year-end so I can have my joyous party on year 5. Even your dignified officials, you know the ones you elect, are in my banksters’ pockets. How do you think they are elected? Not to mention their Italian white shoes, English hand-tailored pinstripes, and trophy blondes around the elbows.You know you cannot win, but still tempted to jump in with these NYSE TRAPs; I deliberately stir them up each quarter so you feel you have no choice. With each passing high-and-low, you feel your gut churn and churn, and I just watch on the sidelines with amusement. Just to magnify my drama, I reward your greed with higher-and-higher highs, and of course, when the end comes, I slap that fateful tsunami on your fine behind.Like all gods, I cannot have mercy. I will have to punish you hard until you are pants down. I remember in 1929, those who feared me jumped and many a widow had been thrown on the streets. This year, there hadn’t been a lot of that, only that little puddle of French red, but still it wasn’t fun. The thing is, if you are illusory thinking you all can get ahead by counting money, instead of producing it, you will be very sorry indeed. Like this year, your economy is really lopsided; so many counting, so few producing, and all are greedy.It looks like, all over again, nothing is learned. Your weatherman, he was a bean counter, wasn’t he, is telling you that great for your taxes, you will be on it again; it is all very predictable. What is going to happen is just going to be “the same old game of the same people, intoxicated with the same old drug, pushing around the same amount of real money and each taking a same amount of little cut and then pushes it to the next stop”. After enough of that go-around, you know there won’t be any cuts left but for the one on your tummy, almost sounds familiar. Oh really, it is not even the same amount of real money, remember you will have to repay your debts. When you are sorry again these more years, don’t say I haven’t told you so.

  3. Guest   July 3, 2009 at 2:12 pm

    How is China supposed to pull the world out of the doldrums with its stimulus package? By making more stuff nobody now wants to buy?I think this article has it backwards; the world needs to pull the Chinese economy up by going back to its unsustainable consumption. This Chinese stimulus plan just keeps the factories afloat while waiting for future consumption to resume!