1. The unsavory episodes of China's economy
For the better part of 2011, my concerns about China’s economy were constantly aggravated by depressing stories of entrepreneurs committing suicide or emigrating to the western world in droves. The media generally blames the government’s monetary tightening and the consequent credit crunch for these unsavory episodes. The public outcry over the impact these restrictions have had on Chinese entrepreneurship climaxed with the seemingly positive but tepid response by the People's Bank of China (PBOC) on Dec 5, 2011 to alleviate the liquidity crisis. It cut the reserve requirement ratio (RRR) to 21% from the record high of 21.5%.
Right now the outlook for the Chinese economy appears confused: should the government continue with painful structural adjustments to prick an economic bubble that has been building over a decade-long obsession with excessive growth? Or should it adopt an expansionary policy to reinvigorate economic growth? Either action will lead to unpalatable outcomes.
2. It's not a liquidity crisis; it’s a structural problem
It’s easy to lay the blame on tightened monetary policy, but this is not the real culprit; it’s structural change. China’s principle overseas markets, Europe and the US, are battling a possible recession, which greatly tightens their purse strings. To make matters worse, rising costs in China, especially wage costs are driving inflation, which makes China’s products more expensive. This is diminishing China’s comparative advantage in manufacturing. Rising wages though are caused by structural changes in the Chinese economy. They are unrelated to China’s tightened monetary policy.
In the figure above it is clear that the manufacturing sector is in trouble. The Purchasing Manager Index (PMI) has dropped to 49. This is lower than market expectations and it is the first time since Feb 2009 that the PMI has contracted. Orders are declining, especially overseas orders. Meanwhile, inventory is building.
There is no question that tight credit markets have hurt China’s private small and medium-sized businesses (SMBs), and SMBs are the driving force behind the country’s manufacturing industry. This though is not a new problem and it is unrelated to tighter monetary policy. More than 70% of China’s banking market is controlled by the “big four”- Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China and the Agricultural Bank of China. These state-owned commercial banks skew lending toward state-owned enterprises and other privileged corporations.
This practice has created a breeding ground for China’s huge and complicated shadow banking network, where most credit-starved private SMBs are forced to go and forced to pay very high interest rates. This unregulated, unmonitored shadow banking system has plenty of cash to lend, because people are chasing after higher yields than those available at the commercial banks. They have too. Interest rates at commercial banks don’t even compensate for inflation. In April 2011, 467.8 billion yuan of residential deposit left the commercial banks.
Contrary to popular opinion, China is not even close to suffering a liquidity crisis. China’s M2 has surpassed both the US and Japan. China’s M2 is around US $11.55 trillion. The US’s is $8.98 trillion and Japan’s is $ 9.63 trillion. Further, lending has not dried up. In 2010, Chinese banks issued 7.95 trillion yuan of loans, breaching the government's target ceiling of 7.5 trillion yuan. In 2011, the total value of new loans was near 7.5 trillion yuan.
As of October 2011, the outstanding balance of RMB deposits was 79.21 trillion yuan. This is a 13.6% increase from a year earlier. The PBOC's rate hike had the effect of taking 4.75 trillion yuan from circulation.
According to Fitch ratings, China's total social financing in 2011 is expected to top 18 trillion yuan ($2.8 trillion). This is a rise of 3.5 trillion yuan from the official target due. The rise is from non-banking liquidity. Meanwhile, the PBOC claimed that total social financing for the first three quarters in 2011 was 9.8 trillion yuan. This is 1.26 trillion yuan less than the year before. Who is right? The PBOC's data suggests a tightening of monetary policy while Fitch implies the opposite. Could it be that the PBOC has been unable to rein in the liquidity binge? Is it possible that Beijing has been indulging itself for so long that it finds it hard to stop?
Under such a gloomy context, China's credit expansion against all odds is still breath-taking.
Figure 95: Over the past decade, China's M2 has surged past the US's.
If all of this is true, it’s impossible to blame the so-called tight monetary policy for the sorry state of China's economy. Further, we cannot be too optimistic that a looser monetary policy will reverse the country’s fortunes.
3. The undoing of the Beijing consensus
Monetary policy alone won't fix structural deficiencies in China's economy. The well being of China's economy relies on Americans and Europeans continuing to consume the country’s goods. Their economic malaise becomes China’s economic malaise. The increasing substantial wealth gap in China has shackled the domestic demand so much that it fails to pick up the tab left over by the US and Europe markets.
China excess capacity has become a big problem. It is forcing down investment returns, and driving inflation and bubbles rather than propelling GDP and employment. Excess capacity is indicative of over-investing and overheating.
In 2010, China's export/GDP ratio was about 37% and its investment/GDP ratio was 45.8%. According to David M. Kotz and Andong Zhu's research, since 1999 China's exports plus fixed investment have been responsible for nearly 70% of GDP growth, while domestic consumption has been responsible for roughly 30%. This export/investment combo to power the economy ahead is what has become known as the Beijing Consensus. It worked well for the past decade when China had very low wages and the world was prosperous. With higher wages and lower growth in China’s principle markets, its power is greatly diminished.
Things could get worse before they get better. To raise economic growth in Europe and the US they could encourage policies that cause them to check their deficit-fueled consumption economies into rehab, encourage saving more to cure their chronic low savings rate, and produce more locally and import less. If this take place, export-led growth in China will take another beating.
See the figure above. According to Economist Intelligence Unit and US Bureau of Economics Analysis, China will depend on an export-led economy late until 2030.
4. A consumption-led economy is the only way out
The dire situation in the US and Europe may call for another round of quantitative easing. With both Japan and UK firmly committed to QE and market conditions deteriorating, the embattled US and Europe may be forced into implementing aggressive monetary policies. Could this turn into a global competition for currency devaluations? If it does, China and the US and Europe will lock horns over currency issues even more frequently and trade tensions will soar.
China’s best option is to turn its economy into one that is consumption led. The alternatives of fighting in vain for overseas markets and preparing for trade wars, or reigniting the economy with more wasteful investment that will drive asset bubbles and an inevitable epic hard landing just don’t make sense.
5. The outlook for China's inflation and economic bubble
Optimism that China has tamed the inflation problem is premature. China's CPI did tumble to 4.2%, which is the lowest level since September 2010, but the battle against inflation is far from over. China is the world's biggest importer of food and commodities. Global competition and loose monetary policies will continue to drive the prices of food and commodities and consequently inflation. China’s monetary policies won’t affect this aspect of inflation because it is beyond the country’s control. In combination with negative real interest rates and diminishing industry returns, this will push more and more money into asset investments and speculation. This will drive inflation higher and make structural problems worse.
There are internal structural factors and externally driven factors that are contributing to the making of an epic hard landing in China. China will be especially vulnerable if the US and Europe both unleash quantitative easing. Sadly, China cannot control this. The best China can do is to avoid the worst outcomes by continuing painful structural adjustments, such as: marketizing the “big four” dominated banking industry to allow for more efficient monetary allocation; transforming the intensive low-cost labor low value-added economy to a high value-added knowledge economy; reforming the wealth redistribution system to empower the broad consumer base to enable the promise of a consumption-led economy.
China's hard landing would be a tragedy to China and the world. Without China's continued growth the global economic recovery will be prolonged and more painful. It would be especially tragic if my conclusions in “The Boom And Bust Of China's Rise” were to come to fruition. China's economy has been standing close to the edge. Meanwhile speculators are pushing it and profiting handsomely from the chaos.
While the US enjoys the luxuries provided by the dollar’s primacy as a reserve currency and diplomatic alliances with many major trading partners where it can export its liquidity and inflation, China does not have these luxuries. They should view their dollar reserves with fear and doubt. The so called Beijing consensus no longer makes sense, because both China and the world are changing. Pegging the country’s growth to policies that pertain to a certain reserve currency (the US dollar) is equally dangerous. The battle between Keynes and Friedman has long proven the only consensus is to adapt and change. Right now China needs to adapt and change fast. If it doesn’t this will be the best time in history to short China.
(My dear friend Kathleen Brush and Francis Acosta from Financial Times have proofread this article for me. I am greatly indebted.)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.