China continues to rebuff U.S. demands for a stronger renminbi, which some U.S. economists judge to be undervalued by 25 percent or more - as a direct result of China manipulating its exchange rate. The stated Chinese perspective has been that the exchange rate is a simple result of globalization, and something that will last for a time. In either case, what is clear is that this issue is now highly politicized, and that the U.S.'s balance-of-trade concerns go well beyond simple currency valuation considerations. And the reality is that China is in big economic trouble, and is currently staving off the inevitable.
So what really is going on with China's economy and markets?
Depending on the kindness of strangers
China has painted itself into a corner by trying to accelerate its GDP growth through faster export growth over the last decade. In just 8 years, exports had quintupled in value, doubling as a share of GDP to 42% by the end of 2008 – a lot of dependence on foreign cooperation.
- Like the Great Leap Forward (1958-64), which ended in disaster, this is an attempt to leap from one stage of development to another quickly. Of course, it is much better thought out than Mao’s experiment, but the consequences of any failure could still be catastrophic for both the poor and investors – and, thus, for the Communist Party and recovery-optimists in the US.
China’s break-out strategy breaks down
- Until a few years ago, the attempt to rapidly transform inefficient SOE (State-Owned Enterprise) labor into private-sector labor, while foreigners paid for it, was working better than anyone had imagined, achieving nominal GDP growth rates of 13-28% per year, while export values doubled every three years – unheard of…
- The combination of cooperative American consumers & bankers, plus a wisely open policy toward FDI (Foreign Direct Investment) quickly integrated China’s factories into the Asian supply chain that ended in department stores and cell phones everywhere. Yet, half those exports needed foreign management.
- And China has been caught out in mid-leap. Like high rates of fixed-asset investment directed by the State (averaging 28% over the previous 5 years, approaching 50% last year), the policy tool of export acceleration has been driven to its logical conclusion, i.e. self-destruction. It has been pushed too far, too fast. It presumed an inelastic demand for labor-intensive goods and a highly elastic labor supply. The opposite has proven true, generating cost inflation and consumption volatility.
- The State stepped in grandly with a new wave of State spending and forced loans, to the awe of OECD governments. But filling the 6% gap in GDP left by collapsing foreign demand is only a short game. The 35% leap in heavy capital exports to poor countries over the 4Q09, funded by Chexim (the Export-Import Bank of China) trade credits, is just more taxpayer money spent to protect jobs at home.
It’s about jobs, Stupid!
- And jobs are the battlefront. This shows in the CPI-PPI gap, as SOEs held capacity in place last year, driving the cost of basic goods down and stockpiling finished goods (included in “retail sales”) to limit consumer deflation. SOEs still have the role of social buffer, not productivity.
- After global trade declined by 20% in the 1H09, China’s apparent export recovery is seen as taking more jobs from others, when export-market politicians need them most. China is already in the early stages of an escalating trade war with the EU and US. Protectionism on all sides could easily do more damage this year and next than the credit squeeze did in the last two. A potential escape from this is a sustained narrowing of the trade balance, but rising imports also depend too much on continued State intervention. So, the risk persists.
- It is not just the Chinese economy that is surviving on government transfer payments, of course. The partial recovery that its exports to the US made owes most of its value to public transfer payments in the US. There was some shift toward low-cost Chinese goods by the beleaguered US consumer, but recent volatility in everyone’s PMI (Purchasing Manager's Index) levels show demand weakness. And the low-cost benefit is already suffering from old-fashioned trade protectionism – that will only get worse this year.
Masking fear & weakness with fiery rhetoric
- It is not clear how long government spending or directed lending can support high growth rates in the face of a weak or transient global recovery. This predicament helps explain why the government has taken to the offensive in the debates over currency, global investment and consumption. Its accelerating export rate on the back of 5 years of G8 (world's 8 most industrialized economies) debt expansion has become its Achilles’s heel.
- Size matters; not always in a good way. China’s export growth over the last 20 years has mostly followed the Japan model adopted by other East Asia economies before it. And like Japan in the 1980s, China is running against the limits of export-led growth because of its size compared with the rest of the world. At USD1.2 trillion, its 2009 exports, even after falling by almost a fifth from 2008 levels, still rose to 26% of Asia’s and over 9% of global exports. This is the level that helped prompt the Plaza Accord, at Japan’s expense. This pressure will not go away.
- A corollary problem of last year’s jury-rig demand replacement is that it makes China’s export dependence so obvious. This, in turn, has put China’s leadership in a very tight spot, having to fend off Western protectionism at the same time as domestic anger. The Republican safety valve is gone in the US. Deflecting domestic stress into nationalism and suppressing rabble rousers are acts of desperation. The ghosts of Tienanmen persist.
The politics of Inflation
Both the Party and the central bank are guardians of the State, but ultimately they have very different goals. That is once again becoming obvious. Price stability is a deeply held goal within the PBoC (People's Bank of China). But it is only an expediency for the Party, whose first goal is to keep its head by avoiding mass discontent.
- To take advantage of the Great Moderation in the West, the Party raised ever more through equity listings, supported by rapidly expanding bank credit over the 2005-07 run. Overheating of global commodity markets in 2007 resulted from this sprint for growth and doubling of exports. That drove the PBoC to tighten and slow credit growth in 2008, while flooding the market with its own bills to soak up liquidity – an unpopular-but-necessary move. Sadly, this is not precision finance or a controlled experiment, but blunt policy tools being used on a national scale and against political pressure.
- To offset the slowing of SOE loans, PBoC opened up the corporate bond market, which doubled in size over the next 18 months. But non-SOEs and second-tier companies were squeezed, slowing the economy by 2H08, just in time for the bank disaster in the West – a double whammy that prompted a 90% collapse in charter rates and a 20% fall in FDI. The consequences of too much cheap credit hit China from home and abroad.
- The aftershocks are not finished and last year’s pump-priming was overplayed, which has prompted the PBoC to tighten again, now in synch with the US FED. This tightening may also prove temporary, but if so it will need to be repeated this year. The combination of this and the release in mid-December of more previously non-tradable SOE shares may be enough to drain excess liquidity without slowing growth, but another slowdown looks more likely.
Partly cloudy skies ahead
- As the net issuance chart shows, this still leaves room for China’s 2010 IPO target of USD50-60 bn by the second half, when new issues usually peak. One cost of last year’s credit splurge is balance-sheet repair for the major banks. Recently announced cash calls total over $9 bn; more than $20 bn more lie ahead. But there is a risk that world demand for these may slow a bit, leaving the teaming masses at home to pick up the tab. Negative real interest rates for retail investors have supported this for the last 3 years. So, even as IPOs have taken their toll on demand recently, this year’s target is half of last year’s volume.
- One of the steps recognized in raising domestic consumption is improved healthcare. The State’s goal of spending USD124 bn over the next three years in reforming this sector is likely to open several new avenues for foreign participation. Novartis has already announced a USD1 bn expansion plan for its current facilities near Shanghai. Much more progress must become visible to change behavior, but the direction appears to be on improving services rather than just pushing more pills.
- As the earnings-growth projections, above and historical returns here show, some sectors have been the state-owned work horses, others the fierce battleground for consumer service and a few the prime channels for key infrastructure finance. Some of these latter are likely to continue garnering the lion’s share of profits in the value change, but regulatory risk is a constant threat in China, as China Mobile shareholders know all too well.
- Further west, the rural population may receive some relief from recent land reforms. By pushing through the ability for individuals to transfer land-use rights, the government has finally created the mechanism for farmers to combine their land into commercial cooperatives to share engineering and capital expenses. This shift is greatly increasing farm yields and improving many farmers’ lives, just when migrant workers have been sent home. It will increase future demand for manufactured goods.
- The CBRC (China Banking Regulatory Commission) is building upon these quasi-property rights to allow forestry and fishing rights as collateral in its goal of providing basic financial services to every town by 2013. While credit card use may grow more slowly, there will be periodic surges in use that create temporary default problems, as in 2007-08. But there should be a rapid rise in the channels for micro-credit in general. The technology for this is still being developed in China and offers room for foreign expertise.
6 risks you can count upon (from most to least likely)
- Down-shift in global growth. Japan and the EU as a whole show no growth in public spending over 2009 (highly likely) or reduce spending overall (probable) while their private sector fights a two-front war: low consumer demand and weak productivity a year after labor cuts. Recent PMI data confirm this risk. This will require the State to push new corporate bonds and bank credit back up to USD1 trillion or more to hold the line on urban unemployment.
- Capacity hibernation. Rising foreign protectionism, exacerbated by China’s export-price cuts, slows global trade further and especially at China’s expense. Factory utilization falls further, making it harder to maintain employment levels. Wider budget deficits (plenty of powder) plus asset inflation, or riots.
- Political capture progresses with trophy projects. The need to protect semi-skilled, non-migrant jobs continues to keep SOEs afloat rather than pushing for consolidation, slowing productivity further. More successful firms are forced into SOEs to reverse this trend and capital expenditure becomes even more of a political choice than it already is. The infrastructure story begins to wear thin.
- Rigged markets can not last. The key to China’s success in bringing 2009 gross exports back up the level of 2007 was using a combination of price reduction (absorbed as losses in SOEs), subsidies & tariffs (state transfers & concessionary credit) and geographic expansion (especially that to poorer countries, on cheap credit). None of these three are sustainable methods; all at once is quite expensive, and at least two will end this year. Refinancing old bank debt with IPOs is a mezzanine- fund gambit that the State has been playing for five years with their trophy assets – not all of them were real gems, either. Slowing growth and lower-quality assets will make that swap more expensive.
- Stale bait on a populist pitchfork. Protectionist damage in China’s preferred export markets, plus urban inflation, plus continued regulatory risk combine to further dampen foreign enthusiasm. FDI gross inflow would fall below USD60 bn, maybe another 20% down, narrowing options.
- Spendthrift flu hits equity markets. Big banks continue to be policy tools and suffer more asset damage in spite of new government guarantees. Foreign investors get nervous, making equity cash calls more expensive. A-share market may catch the cold from the Hong Kong market.
Future scenarios – Guidelines
While all of these risks are interlinked, one does not necessarily lead to another. So, many aspects of world trade and bank rehabilitation depend political decisions. The foreign politicians are the hardest to predict. The only reliable truths are that the Party will spend where it needs to for political stability and within limits the PBoC can hold, plus foreign investors will continue to follow the pied piper of growth, so long as China’s government can play the tune convincingly.
- Decathlon winner. (15% chance)
1) Normal lending allocation to productive sectors returns or improves with corporate bond-market expansion, after a bruising period of abuse;
2) subsidies & tariffs manage to reverse the declining terms of trade during 2010 without raising protectionist retaliation;
3) exports to customers who can pay returns to the levels of 2Q08 by YE10;
4) the Western and Rural strategies shift local gears to create a material level of new domestic consumption by 2012;
5) the property bubbles deflate enough to cool speculative demand and lower the cost of housing back below 50% of disposable income by 2011.
>>> In such a scenario, buying the long-term growth sectors pays off.
- Muddling through. (55% chance)
1) Policy intervention hits a balance by late 2010 between stabilizing terms of trade and a level of unsubsidized exports that is less than 60% of that required in mid-2009;
2) PBoC’s cooling measures slow import growth in time to hold the current-account surplus at 3% of GDP for 2010 and shift local property development back to demand-driven growth by 2011;
3) the infrastructure push levels off by 2011 at about USD300 bn per year, pushing basic commodities and shipping rates to peak then;
4) domestic demand grows gradually but not enough to lift true GDP real growth over 5% until 2013.
>>> Avoid financials until they are cleaned up in 2011; contrarian purchases pay off when the property and commodity markets finally correct.
- Bump in the road. (30% chance)
1) Political necessity leads to a renewed lending or public-spending splurge and an expanded IPO schedule, to the temporary joy of Hong Kong brokers, but this pushes inflation over 8% by 4Q10;
2) global commodity prices accelerate again, drawing PBoC back in with more severe tightening, along with other central banks;
3) the Eurozone remains weak, US election-year protectionism mounts and slow growth encourages the FED to continue a slow pace of tightening, all causing China’s export volumes to stagnate until 2H11;
4) the State absorbs all the emerging NPLs but these signs of weakness and the subsequent credit squeeze drive the Hong Kong and Shanghai stock markets down 20% during 2H10 for a multi-year bear market until 4Q12.
>>> Buy H-share puts with wild abandon and start some long-term bargain hunting in 4Q10.
 - China's Great Leap Forward was an economic and social plan used from 1958 to 1961 to rapidly transform China from an agrarian economy into a modern communist society through the process of agriculturalization, industrialization, and collectivization. The Great Leap ended in catastrophe, triggering a widespread famine that resulted in up to over two hundred million deaths.
 - In People's Republic of China terminology, a state-owned enterprise (SOE) refers to a particular corporate form, which is increasingly being replaced by the listed company. State-owned enterprises are governed by both local governments and, in the central government, the national State-owned Assets Supervision and Administration Commission of the State Council.
 - The Organisation for Economic Co-operation and Development (OECD) is a Paris-based international economic organisation of 30 countries. Most OECD members are high-income economies with a high Human Development Index (HDI) and are regarded as developed countries.
 - CPI-PPI. The consumer price index (CPI) is a measure estimating the average price of consumer goods and services purchased by households. The producer price index (PPI) measures average changes in prices received by domestic producers for their output.
 - The Purchasing Managers Index (PMI) is an indicator for economic activity. Roughly speaking it reflects the percentage of purchasing managers in a certain economic sector that reported better business conditions than in the previous month.
 - The Plaza Accord was an agreement between the governments of France, West Germany, Japan, the United States, and the United Kingdom, to depreciate the U.S. dollar in relation to the Japanese yen and German Deutsche Mark by intervening in currency markets. Its name derives from the accord's signing on September 22, 1985 at the Plaza Hotel in New York City.
 - H shares refers to the shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange. Many companies float their shares simultaneously on the Hong Kong market and one of the two mainland Chinese stock exchanges. Huge price discrepancies between the H shares and the A share counterparts of the same company are not uncommon. A shares generally trade at a premium to H shares as the People's Republic of China government restricts mainland Chinese people from investing abroad, and foreigners from investing in the A-share markets in mainland China.
About the author
Marshall Mays is a Director of Emerging Alpha Advisors, a fund management company covering 15 Asian markets, where he advises on equity and debt portfolio strategy, and on risk management. He is also a Director of the Asian Bond Market Forum, an independent research institute dedicated to building Asia’s financial infrastructure. He has spent over 30 years investing in Asia, managing investment and IT-dependent businesses. He has also advised the People’s Bank of China on a consolidated regulatory framework for China’s financial system (banking, securities and insurance).