Financial markets are clearly worried about the outlook for the global economy. Risky assets have struggled in an environment where signs of economic deceleration have outnumbered evidence of faster growth. It is hardly surprising that, against this backdrop, government bond markets have flourished, particularly in the US and Japan due to their perceived safe-haven status. This is the third successive year where risky assets have struggled in the second quarter after a bright start to the year. On this particular occasion, however, China’s prospective growth path has come under much tougher examination. I have spent the past nine days in Asia, and the overwhelming concern, notwithstanding perennial worries about the euro zone, is just how events in China will play out over the next twelve months.
Can We Trust Chinese Economic Data?
Interpreting China’s economic data is notoriously difficult. The standard method of presenting data is on a year-on-year basis. These measures can, therefore, be subject to “base-effect” influence, as well as short-term shifts in economic momentum. The “cleanest” measure of short-term shifts in momentum appears to be the Purchasing Managers’ Survey. This measure has, without question, weakened in 2012, although even this indicator can fall victim to powerful seasonal forces (particularly the timing of Chinese New Year).
External Demand Continues To Contract
Since the financial crisis, the Chinese authorities have accepted the need to undertake economic policies that re-balance the growth dynamics of the country: this process is not smooth and can have unpredictable outcomes. Chinese export growth has fallen sharply in 2012, hardly a surprising outcome given Europe’s recession and moderate US economic expansion. Meanwhile, other monthly data for the Chinese economy has clearly deteriorated more meaningfully in 2012, giving rise to fears that the domestic economy is unable to fill the void left by net exports.
Expectations for Q2 real GDP growth are gravitating to +7.9% year-over-year. This does not necessarily spell disaster for the economy. Some commentators believe the soft patch will last just one quarter, before evidence of re-acceleration re-appears in Q3. The economic “slowdown” was induced by central government aimed at curbing inflation, rampant credit growth and real estate speculation. It was achieved via a combination of increases in interest rates and the required reserve ratio (RRR). Now that growth has eased, it remains far from certain if simply reversing these measures will re-ignite faster growth.
Housing and Politics Dominate Monetary Policy
The current administration in Beijing appears reluctant to massively ease measures aimed at curbing speculative property demand. First-time buyers are, however, being supported by lower mortgage rates and down-payment requirements. The hope is that residential investment, which accounts for 13 per cent of GDP, will receive a boost. This strategy could be due for refinement when the administration in Beijing changes in 2013. The new administration will be placing more emphasis on so-called social housing than its predecessor.
Housing is an important asset class in China, along with the rest of Asia. The gap between the affluent and those less wealthy is partly due to a credit boom that pushed up residential property prices too quickly. The policy of raising the RRR appears to have done its job of mopping up excess liquidity. The first casualty has been residential property prices, where prices continue to fall. Moreover, the geographic breadth of the fall in property prices has spread: forty-six out of 70 monitored cities experienced price declines in April. Tighter liquidity conditions are also partly responsible for a sizeable decline in mainlanders’ purchases of properties in Hong Kong.
Future Chinese Liquidity Conditions Remain Tricky To Interpret
In the aftermath of the massive fiscal expansion in late-2008 which resulted in a huge surge in credit, the People’s Bank of China attempted to cool excessive liquidity in the banking system by raising the minimum RRR at banks. This policy was seen to be more effective than raising interest rates which could have put unwanted upward pressure on the renminbi. After peaking at 21.5%, the RRR has been gradually reduced to its current level of 20%. While there is widespread agreement that the RRR will be lowered further in 2012, there is massive debate about the timing and magnitude of prospective cuts.
Bank Lending Appears To Have Stalled
The reductions in the RRR have hitherto failed to arrest the deceleration in the economy, as well as boosting bank lending. While these reductions will enhance the ability of banks to lend more against a given level of deposits, financial disintermediation is offsetting the cuts in the RRR. Banks are finding it harder to retain deposits. Historically, strong deposit inflows from households have provided banks with a huge source of loanable funds. This former benign source of funds can no longer be guaranteed: households are shifting to other short-term instruments offered by banks at significantly higher rates of return than deposits. In April, deposit growth at banks, although a seemingly healthy +11.4% on a year ago, fell to its slowest pace in 12-years.
The slowing pace of deposit growth at small –and-medium sized banks has created problems: loans are pegged at 75% of deposits at banks. Approximately 20% of lending in China is done by small banks. Their market share has fallen from 31% in early-2011, because they struggle to attract new deposits. The more difficult environment for small banks to make new loans has impacted supply chains. State-owned enterprises commonly provide working capital for their suppliers due to difficulties obtaining new loans from small banks and other private lenders.
Problems in China’s banking system are not confined to small banks. The dearth of new lending appears to be afflicting the country’s four largest banks. Loan growth ground to a halt in April. Lending to property developers and local government infrastructure projects is out of favour. Meanwhile, private sector investment projects have not been enough of an offset. This is hardly surprising given the surge in private investment in recent years, boosting industrial capacity and reducing returns on investment.
Will Growth Require More Central Government Infrastructure Projects?
Injecting more liquidity into the system is a necessary but not sufficient condition to get China’s economic growth rate rising again. The issue is not insufficient liquidity, but weaker loan demand. It remains doubtful if exports and consumption can smoothly act to offset each other. Going from “Made in China” to “Sold in China” will require changes to the tax structure. Currently, exporters enjoy exemptions from tariffs for imports of components and machinery. Domestic producers do not enjoy this luxury. Re-balancing the economy will therefore require time and could produce temporary headwinds.
In the interim, it may require more infrastructure projects by central government in Beijing to boost growth. It has recently been hinted that a number of infrastructure projects will be brought forward to counter slowing growth. Central government infrastructure spending is running at its lowest rate in nearly a decade.
The Real Policy Goal: Sustainable Growth with Better Social Outcomes via Financial Reforms
Economic commentators and financial markets appear fixated by annual economic growth having to be in excess of 8%. The average annual growth rate for the first decade of the 21st century has been 10%. This has resulted in rising social inequalities within the country, accentuated by property speculation. The new incoming administration aims to tackle social inequality more diligently. A slower and more stable rate of growth could probably help to achieve this policy goal, along with essential financial reforms.
Reform of the financial system is seen as crucial to achieving more equitable and sustainable growth. Better access to credit for small and medium-sized businesses is essential if the economy is to avoid a hard landing. It is estimated these firms contribute as much as 65% to China’s GDP and 80% of employment. State-owned banks tend to fund state-owned businesses. Faced with this bias, many small businesses turn to informal and private sources for credit. The interest rates charged on these loans are often exorbitant, as testified by last year’s credit crisis in the city of Wenzhou. The city is currently undergoing financial reforms, which could be used as a template elsewhere. Measures include allowing loan companies to become deposit-takers and the creation of a private lending centre where borrowers and lenders are potentially matched. It is hoped these reforms will create better financial and, de facto, social stability by reducing the monopoly power of state-owned banks in credit origination.
