China’s New Leaders Face Legacy Issues From 2008 Economic Stimulus

China’s Economy in Q3: Not All Bad News

China announced last week that annual real GDP growth slowed to +7.4% in Q3 from +7.6% in Q2. The Chinese government has targeted real GDP growth of +7.5% for the full calendar year of 2012. This official growth target was revised down from +8.0% earlier this year. The deceleration in the year-over-year growth rate, however, masks acceleration in the annualised quarterly growth rate to +9.1% from +7.4% in Q2. The Q3 annualised quarterly growth rate is the quickest for four quarters, leading some commentators to conjecture that the economy may, in fact, be bottoming out. The reaction of China’s current leaders to the data does not suggest that panic has set in. Data for industrial production and retail sales in September both exceeded expectations. Restrictions to prevent real estate speculation, however, still remain in place. Real estate inflation continued to cool in Q3.

Much of the global slowdown in 2012 has been in manufacturing. The source of the slowdown is probably related to destocking that had the effect of depressing new orders and production. The composite US ISM manufacturing index seems to suggest a recovery in activity during September. The rebound in the new orders component coincides with a recovery in Chinese exports, possibly indicating that the global inventory cycle may have switched back to restocking. If this thesis is correct, then purchasing managers’ surveys should start to display more broadly-based geographic improvement during Q4.

The New Standing Committee: Crucial to Future Growth Rates

China’s political leadership changes every ten years. The new Standing Committee will be revealed at the 18th Communist Party Congress commencing on 8 November. This change in the Standing Committee is regarded as being particularly important. There will also be changes of leadership in the military, the People’s Bank of China, and the sovereign wealth fund. Until the identity of the new Standing Committee is revealed, it will be difficult to assess how China’s economy will be run in the future. There are, however, two distinctive schools of thought about the future of the Chinese economy.

The “optimistic” school believes that 7-8% GDP growth is sustainable for the next 20 years. While this would be below the 10.5% average growth rate achieved over the past 20 years, it will still enable China to overtake the US as the world’s largest economy. The optimists also believe that, after an initial transition phase, the new Standing Committee will institute bold economic reforms. Maintaining economic prosperity is, according to the optimists, essential for the Communist Party to maintain its grip on power.

Meanwhile, there is a “pessimistic” school which believes that unbalanced economic growth will continue due to deeply-engrained corruption within the Communist Party. This dynamic has resulted in rising social inequalities and unrest. Under the pessimistic school of thought, there is a risk of social chaos, analogous to that seen during the Cultural Revolution. The gulf between the predictions of the two schools of thought is significant, but both contain major implications for the global economy.

The current Vice President of China, Xi Jingpin, is widely expected to be the country’s new leader. It is believed Xi feels that stability must be maintained at all costs. This can only be achieved through ambitious reforms and tackling corruption.

Will the Legacy of Past Corruption Prevent Future Economic Stimulus?

The economic stimulus (14% of GDP) instituted in 2008 has left China with a legacy that could take years to solve, namely a huge amount of bank debt owed by provincial governments. Under the 2008 stimulus, banks were “encouraged” to lend to provincial governments who used land as collateral. The surge in bank credit, in fact, dwarfed the announced size of the stimulus. Many loans were used to finance investment projects offering poor returns. The role of corruption cannot be understated in trying to understand these lending practices.

Now that land prices are no longer rising due to Beijing’s efforts to cool real estate speculation, banks are now understandably wary about collateral quality. Banks also appear reluctant to pass on lower funding costs by reducing borrowing rates. Furthermore, lower returns on infrastructure projects have not enhanced the ability of provincial governments to pay back loans. The fear is that the ability of banks to make new loans has been impaired, potentially making it trickier to institute further stimulus if required.

Banks were pressured to lend to provincial governments in 2008, despite poor credit ratings, at low interest rates. The pressure exerted on the banks effectively reversed a long-period of banking reform in China, as well as undermining the quality of corporate governance. Banks were not allowed to be efficient allocators of capital. A full-blown repeat of the bank credit financed stimulus of 2008 could be difficult to implement to counter economic weakness. The 2008 stimulus achieved its goal of preventing a prolonged implosion in economic activity, but it was poorly constructed and there are legacy issues for the economy.

New Standing Committee=Faster Credit Growth?

Historically, the arrival of a new Standing Committee has been associated with a surge in credit growth. Given the extraordinary growth in bank lending between 2008 and 2010, it is difficult to envisage a return to similar rates of growth in bank credit. Broad money supply (M2) growth remains buoyant, rising +14.8% year-over-year in September. Bank lending in September was also healthy, climbing +16.3% on a year-over-year basis. Given that the bias of future monetary policy will be towards further easing, there is seemingly little risk of insufficient liquidity to support economic activity.

Until the restrictions imposed on real estate speculation are removed, there should be little chance of seeing an explosion in bank lending from current levels. Real estate speculation is associated with the “get rich quick” capitalism embraced by the now disgraced Bo Xilai. I strongly suspect that more socially equitable economic growth will be at the top of the agenda for the new Standing Committee. Social housing construction will be given greater priority.

The long-term outlook for credit growth in China will also depend on the willingness of the new Standing Committee to embrace financial reforms. Interest rates in China are not set by market forces. They are currently at abnormally low levels, partly due to the Fed. This has resulted in unbalanced growth, characterised by too much public fixed investment.

The Rebalancing of China’s Economic Growth

The pending arrival of a new economic team has resulted in increased media coverage of the structural problems facing China’s economy. The export-led model that prevailed prior to the financial crisis and Great Recession cannot be re-embraced. Consumers in the developed world are still deleveraging. China’s current account surplus has fallen from 9.1% of GDP in 2008 to 2.8% in 2011. Rebalancing is seemingly already in place, but institutional reforms are also required to ensure that financial capital is not misallocated.

Establishing full convertibility of the capital account is probably the biggest potential challenge facing the new Standing Committee. There would be significant upward pressure on the yuan, partly caused by higher and deregulated interest rates. Domestic producers would feel more price competition from cheaper imports and capital-intensive industries will face higher funding costs. The increase in funding costs for capital-intensive industries may force a shift in China’s industrial policies towards promoting less capital-intensive industries and services.

If the aforementioned structural reforms are undertaken, the next issue becomes one of timing. Structural economic policies in China are formulated under so-called Five Year Plans. The current plan will expire in 2015. It is unlikely that aggressive structural economic reforms will be drafted before the expiration of the current plan. Furthermore, the influence of the current Standing Committee will not disappear overnight, reinforcing the view that aggressive structural reforms will not occur any time soon.

Summary and Conclusions

China’s economic growth rate continued to contract on a year-over-year basis in Q3. The quarter-on-quarter growth rate for Q3 actually accelerated. Recently released economic data for September suggests the economy may have bottomed out. Any near-term reacceleration in economic growth will depend on the extent of global restocking in the manufacturing sector.

The composition of the new Standing Committee will be revealed in November. The Committee faces tough challenges in terms of maintaining economic stability, including undertaking further structural reforms, and preserving the Communist Party’s grip on political power.

Corrupt practices committed during the previous economic stimulus potentially thwart the ability of the new Standing Committee to engineer another major stimulus financed by bank credit. Provincial governments are saddled with large bank loans and have invested the funds in low-return infrastructure projects. Banks have accordingly reset their lending standards by not lowering borrowing rates as much as funding costs.

Historically, the arrival of a new Standing Committee has been associated with a surge in bank credit. The current growth rate of bank lending is, however, already buoyant. Any future surge in bank credit will probably require the repeal of current restrictions on real estate speculation.

The new Standing Committee will be forced to address the restructuring of China’s economy away from net exports and public fixed investment. This will require institutional reforms and capital account convertibility. There will be implications for China’s industrial policy, including a potential shift away from capital-intensive industries. The new Standing Committee will not undertake aggressive structural reforms until the current 5-Year Plan for the economy expires in 2015.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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