Morgan Stanley's Roach on a China slowdown

by: Ezra Marbach

Morgan Stanley's Stephen Roach believes the world should prepare for the increasing possibility of a meaningful slowdown of the Chinese economy. Here are the key points from Roach's May 23rd piece entitled "What if China Slows?":


Economic Growth

  • Supply-side numbers remain strong.
  • Re-acceleration of industrial output growth to 16.0% year-over-year (y-o-y) in April 2005.
  • Chinese GDP growth trajectory held at 9.5% in Q1 2005.
  • Momentum continues to be driven by surging Chinese exports.
  • Industrial output for exports estimated to have risen 29.9% y-o-y in April.
  • Chinese exports grew 32% y-o-y in April.
  • Fixed investment grew 26% this year through April.
  • While fixed investment growth is lower than the 40% comparisons of a year ago, they exceed the government’s official 16% growth target for the sector.
  • Fixed investment sector on track to exceed 50% of Chinese GDP this year.

Demand Side Shows Discomforting Signs

  • Evidence of a sharp slowdown in Chinese import growth.
  • From Jan-April 2005 y-o-y import growth was 13.5% versus 36% in all of 2004.
  • This has implications for the rest of the region, which provides China with capital equipment and intermediate inputs for its export businesses.

Chinese Import Growth Fuels Pan-Asian Exports

  • 20% of total exports from Korea, Taiwan, and Japan go to China (Singapore - 10%).
  • Slowdown in Chinese import growth is already affecting Asia.
  • In Taiwan, export growth slipped to just 1.2% y-o-y in Q1 2005.
  • Japan's exports showed a -0.8% q-o-q, annualized export decline in Q1 2005.
  • Hong Kong (+3.5% y-o-y in March), Korea (+7.4% in Q1 2005), and Singapore (+6.2% in March for non-oil domestic exports). 
  • In all of the countries mentioned above, the latest export comparisons represent a sharp deceleration from gains six months ago, when the Chinese import boom was cresting.

China's Import Slowdown Affecting Commodity Inflation

  • This reflects China’s dominant role in driving world demand for industrial materials. 
  • Morgan estimates that China accounted for 8% of global consumption of crude oil, 20% of aluminum, and 30-35% of steel, iron, and coal. 
  • Deceleration of Chinese imports has been accompanied by a sharp deceleration of non-oil commodity inflation.
  • The Journal of Commerce composite index of industrial materials is now down 3% y-o-y through May 20. Peak increases of close to 35% in early 2004. 
  • Commodity prices are one of the best real-time gauges of the interplay between global supply and demand.
  • Emergence of negative comparisons for industrial commodity prices could well be a good leading indicator of further weakness to come in Chinese industrial activity.

Efforts to Curb the Property Bubble

  • China's recent restraints on both supply and demand could finally lead to a bursting of coastal China’s property bubble.
  • This could also lead to a meaningful slowing of growth in fixed asset investment. 
  • Fixed asset investment accounted for 44% of total Chinese GDP in 2004.
  • Fixed asset investment was still growing at a 26.5% y-o-y rate in April 2005. 
  • Like exports, fixed asset investment is also accounting for about 11 percentage points of annualized Chinese GDP growth. 
  • Every ten percentage points of slowing in residential property investment could knock about one percentage point off total Chinese GDP growth.

Chinese GDP Growth Risks

  • Externally-imposed constraints on exports.
  • Internally-imposed restraints on property investment. 

Roach Believes China's Policymakers will be Cautious

  • Could mean a delay on currency reform. 
  • China’s new export taxes on textile products suggests that it may prefer tax policy over revaluation in order to restrain exports. 
  • Despite China’s intentions to manage its export problems, the US, which accounts for about 33% of total Chinese exports, seems prepared to make changes themselves.

Key Deficiencies of China’s Growth Model

  • Excess reliance on exports and fixed investment.
  • With little private consumption, the Chinese economy is vulnerable to shortfalls in either of these sectors.
  • Private consumption accounts for only 42% of China's GDP.

Conclusion

  • Conceivable there could be a meaningful slowing of the Chinese economy.
  • It is likely to be driven by China’s internal measures as well as by anti-China actions.
  • If that occurs, China’s Asian supply chain should be especially hard hit.
  • A China slowdown could also result in further downward pressures on commodity prices of oil and non-oil industrial materials. 
  • Could also temper inflationary expectations embedded in global bond markets. 
  • If there is a delay in revaluation, pressure on the US dollar could be tempered.

Why Now

  • New and more difficult challenges today than before. 
  • Property bubble is an increasingly worrisome source of internal instability. 
  • The currency-export nexus has become an increasingly intractable source of external instability. 
  • China faces growing pressures to make change. 

According to Roach:

....This time, it will be much tougher for China to avoid a meaningful slowdown.  It’s time for the rest of the world to prepare for just such a possibility.

Comment: Full article here.