When does push come to shove in China’s economic slowdown?
According to this very interesting BIS study, China’s money supply (M2) and C&I loans both grew at a rate in excess of 20% in2003, which is clearly an unsustainable pace. The IHT says that China has not had great success in slowing things down in2004 and 2005:
Signs of rapid growth abound. Exports jumped 37 percent in the first two months of the year, while industrial output climbed 17 percent and retail sales gained 14 percent. In January and February, investment in China’s factories, roads and other fixed assets in urban areas rose 24.5 percent. A slowdown? Perhaps. Victory against overheating? Hardly.
China’s money supply is still increasing apace. In February, M2, which includes cash and all deposits, expanded 13.9 percent from a year earlier after growing 14.1 percent in January. While down from the 19 percent pace seen at times last year, China needs much slower money growth to avoid overheating.
The hypergrowth at the beginning of 2005 may be a phantasm — a result, in part, of the cratering of the dollar, which is currently being slowly corrected by the Fed. But slower money growth depends upon slower credit growth, according to Asia Times:
A report of Deutsche Bank even predicts that while M2 maintains a growth of 15%, China’s gross domestic product (GDP) may grow about 8.4% in 2005. Can China realize the target?
This will hinge on whether the newly increased 2.5 trillion yuan loans will be completed, according to experts. In China, the private indirect financing makes up over 90% of total financing. Under such circumstances, money supply to a large extent hinges on the newly increased amount of yuan loans. The 14.5% growth for M2 in 2004 is closely related with the 2.2 trillion yuan loan increase in the year, so was the 19.58% growth for M2 with the 2.99 trillion yuan loan increase in 2003.
The Globe and Mail reports China’s official goals for M2 and loan expansion in the 15% area (which still seems to high to us). But who will be borrowing, and for what purposes? Andy Xie of Morgan Stanley says there are four clearly unsustainable reasons for real estate investment, which he pegs as the major source of incremental borrowing demand:
First, a negative real interest rate is prompting Chinese households to advance demand for properties for wealth preservation. Ten years ago, Chinese people bought refrigerators and TVs to hedge against inflation. Property is now the hedge. This type of demand borrows from the future. The low mortgage rate also misleads, as all mortgages are on adjustable rates. The devaluation in 1992 and 1993 caused the inflation in the previous boom. Food and oil are causing the current bout of inflation.
Second, pent-up demand phenomenon in a new market has also exaggerated demand. China introduced mortgage financing in 1998, which kicked off the private housing market. In a new market, the initial buyers have high income, which exaggerates the market’s buying power. China’s auto market has gone through the same process. The auto demand was growing rapidly despite prices that were higher than in rich countries in the previous two years. As the pent-up demand from high-income population is met, the selling prices have to connect with average income. This is why auto prices are falling while the sales are stagnating. The average selling prices for properties in most cities I have visited are above ten times household annual income and are not sustainable, in my view.
Third, corruption has generated a significant chunk of property demand. Many cities that I have visited benefit from strong demand from western and northeastern provinces. These regions are the poorest in the country and have received government-directed loans in the past few years. Part of the demand from these provinces could be due to laundering corruption-related money. Property demand from non-residents is a major factor virtually in all major cities. A disproportionate share of such demand, I believe, comes from government officials and executives at state-owned enterprises.
Fourth, speculation is a major force in property demand. In the hottest markets, I believe speculative demand may constitute over 20% of the total demand. As property prices have risen rapidly in an environment of negative real interest rate, speculative demand has jumped onto the bandwagon. The importance of this demand is limiting the will of local governments to crack down on speculation. Chinese people need properties in large volumes but not at the current prices, in my view. The sustainable demand at the current prices could be only half as much as what we are seeing today.
Renminbi (Rmb) based loans drive China’s ability to increase its money supply, given that it operates its currency pegged to the dollar. But the pace of credit expansion is simply not sustainable, and it appears that credit standards have all but disappeared, according to the Morgan Stanley analysis.
Our view, for what it’s worth, is that situations like this always end both badly and unexpectedly. Alan Greenspan’s quarter-point-every-meeting policy is a double whammy against China, which will increase China’s cost of exports as well as cost of capital at the same time as they somewhat dampen demand. The correction certainly could be this year, though betting both direction and timing is a fool’s game.