Don't Bet on China's Meltdown
Business Times 2 April 2011
IS CHINA'S economic bubble about to burst soon? This is a question often posed by investment professionals. This is also not the first time that doomsayers are foretelling doom and gloom for the Chinese economy. But this time, they are not economists backed by empirical data but hedge fund managers who have enjoyed past successes in exploiting the excesses of irresponsible governments. Some of them are now convinced that Chinese growth is not real but manufactured by the state.
Some have followed up their prediction with the launching of 'distressed China funds' in anticipation of a possible meltdown of the overheated Chinese economy.
One of the landmark economic moments of recent times has been China's as the world's second largest economy in 2010, when it overtook Japan. Given the huge Chinese population, this may not be surprising. But what is shocking is the short span of only five years that China took to more than double the size of its economy, from 18.3 trillion yuan in 2005 to 39.8 trillion yuan in 2010, especially when the world was embroiled in a major financial crisis followed by a recession during two of those years.
The Chinese government had wanted to act as early as 2007 to reduce the economy's overdependence on investment to drive growth. The outbreak of the global financial crisis, however, not only delayed economic reforms but also worsened the structural imbalances. With the fall in interest rate to 5.31 per cent by December 2008 followed by the unleashing of the 4 trillion yuan stimulus, money supply spiked.
Three quarters of the money for the stimulus came from state banks. Officially, loans amounting to 9.95 trillion yuan and 7.95 trillion yuan were issued in 2009 and 2010 respectively.
In reality, actual credit created was much larger as banks evaded credit controls by developing a shadow banking system that kept dealings off balance sheets. In the end, the total social financing which includes loans from all other nonbank sources hit about 15 trillion yuan in 2010, almost double that of total official new lending.
With tight capital outflow controls in place, the credits created could only be used for domestic investments which inevitably led to asset inflation in the housing and stock markets. At the same time, the decline of net exports had to be compensated by government investments in order to achieve the growth target of at least 8 per cent. An estimated US$1.7 trillion has been reportedly loaned, for example, to local state entities. Worse, many of the loans are for projects that may not be commercially viable and are backed by collateral comprising land with inflated values, triggering worries of rising nonperforming loans.
In addition, policymakers have to face mounting inflationary pressures. While GDP growth recovered to 10.3 per cent by 2010, fixed asset investment also rose by 23.8 per cent in 2010 to reach 27.8 trillion yuan or about 70 per cent of GDP, fuelling inflationary pressures.
The inflationary situation was aggravated by the re-pegging of the yuan to the US dollar in 2008, causing China to lose some degree of monetary independence. Its interest rates were kept low, albeit higher than that of the US, and its currency remained weak. While the undervalued yuan and the relatively higher interest rates attracted inflows of hot money, the high economic growth attracted FDI. Coupled with a sizable net trade surplus, the high capital inflow caused foreign exchange reserves to swell 23 per cent in 2009 to reach US$2.4 trillion and another 18.7 per cent in 2010 to reach US$2.85 trillion, fuelling further concerns over excessive liquidity.
While there is truth in the talk that the Chinese economy has been put on life support system since the advent of the global financial crisis, a quick meltdown is far from imminent.
There is risk concentrated particularly in the banking sector because of the relatively underdeveloped financial market. However, the risk is mitigated by the fact that debts in China are financed mostly by domestic savings. Any non-performing loan issue is very much an 'internal matter' and can be resolved without much external pressure or interference.
At the same time, tight control over inflows limits the impact of hot money inflows. Most of the capital inflows are FDIs which cannot be easily withdrawn. The remaining liabilities in the international investment position can be covered more than adequately by China's foreign exchange reserves. Strict capital outflow controls also reduce the likelihood of capital reversal which has been a key factor triggering crises among the emerging economies.
More importantly, Chinese policymakers are planning or have begun implementing several important structural reforms. To start with, instead of focusing on monetary aggregates like M2, policymakers plan also to look at total social financing which will allow them to better monitor overall liquidity conditions and curb inflation.
Next, interest rate controls are being liberalised so that cost of capital can more accurately reflect market forces as well as borrower risks. To broaden the financial market and provide additional funding sources for enterprises, Chinese policymakers are also encouraging the growth of a bond market which will also help to diversify risks away from the banking sector.
In addition, as part of its efforts to internationalise the yuan, China has allowed international trades to be settled using the Chinese currency. Capital outflow controls have also been relaxed to support overseas direct investment efforts of enterprises going global.
Meanwhile, the Shanghai stock exchange plans to start an international board to allow cross listings by foreign companies. Besides allowing foreign companies to raise funds in China, the move also enables Chinese residents to invest directly overseas.
Among other things, these new measures help to deepen and broaden the financial system, diversify risk, moderate excessive liquidity, and ease inflationary pressures.
As for the overheated property market, the effects of recent administrative measures to curb speculation are beginning to show. Many property agents in major cities have downsized as interests in resale properties dissipate. In addition, the injection of 36 million units of subsidised public housing over the next five years will go a long way in moderating prices and cooling speculation in the property market.
More pertinently, even though bubbles may exist in asset markets especially in some first line cities and industrial over-capacity looms, the real economy is far from being a bubble and will, over time, be driven increasingly by internally generated growth underpinned by the rising pace of urbanisation.
The real challenge for China's policymakers is in controlling inflation while allowing economic rebalancing and restructuring to proceed uninhibited.
In recent years, to nurture the nascent domestic hedge fund industry, Chinese regulators have begun introducing tools such as short selling, margin trading, and stock index futures.
However, foreign hedge funds do not have unrestricted access. To begin with, foreign speculators' room to manoeuvre may already be limited: Chinese equity markets are relatively closed to foreign investors who have access to probably only less than 1 per cent of China's total market capitalisation.
Furthermore, China is unlike other emerging economies many of which have only limited means. The Chinese government also has more power than most others in influencing its domestic markets through their control over the local governments, state banks and state-owned enterprises. This explains, to a certain extent, why the Chinese government succeeded in pulling off a fast recovery where the US government failed.
One should never underestimate the Chinese policymakers' resolve in defending China's national interests. Allowing foreign speculators to benefit at the expense of China's misfortune will put the government in an extremely bad light in the eyes of its people. Therefore, expect the already well-honed and crisis-seasoned Chinese policymakers to do whatever it takes, including instituting temporary anti-market measures, to restrict destructive market activities. In the end, 'distressed China' fund managers' hopes of making a quick windfall may just fall through.
Perhaps, a surer way to profit from China is to find more constructive ways to contribute to the Chinese economy. Opportunities still abound despite the talk of bubbles. For example, the US hedge fund and buyout group, Fortress Investments plans to team up with a local partner in China to provide housing for China's elderly who will number some 260 million by 2020. Betting on the Chinese economy's continued growth and transformation is likely to be more lucrative than betting on its meltdown.
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